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SFDR: Level 1 and Level 2
The EU Sustainable Finance Disclosure Regulation (‘SFDR’) is one of the legislative outcomes of the European Commission's action plan on financing sustainable growth set in 2018.
The regulation was adopted and published in the Official Journal in 2019, and its Level 1 requirements entered into force on 10 March 2021. The Level 1 requirements focus on general transparency obligations for all financial market participants and financial advisors. They mandate disclosures related to how sustainability risks are integrated into investment decisions and the adverse impacts of those decisions on sustainability factors.
The Regulation also has Level 2 Requirements, which entered into force on 1 January 2023, and emanate from a series of Delegated Legislation. Level 2 requirements, delve into more detailed and technical reporting obligations that only certain financial entities must disclose. These are outlined in Regulatory Technical Standards (RTS) and prescribe standardised templates, metrics, and methodologies to ensure consistent and comparable disclosures across the industry.
These two broad categories can be further divided into entity-level and product-level requirements. While entity-level disclosures require the entity to consider sustainability factors within its business strategy and investment decision-making process, product-level disclosures apply to financial products (e.g., funds) which are being marketed by the firm.
Entity-Level Requirements
Entity-level requirements are the first step towards ensuring that your firm is compliant with the Level 1 SFDR requirements, and can be further segregated into four categories:
i) sustainability risk disclosure
ii) principal adverse impact statement
iii) remuneration policy update to integrate sustainability risks, and
iv) updating marketing communications accordingly.
1. Sustainability Risks
You will first need to design a policy to integrate sustainability risks into the investment decision-making process. This requirement is specified in Article 3 SFDR.
This means you need to determine whether and to what extent your firm currently integrates sustainability risks into the various stages of the decision-making process. Depending on how much you already do on such issues, you're required to make a (potentially Board-level) formal decision on the new (or amended) implementation.
This means you also have to update your due diligence and risk management policies and processes accordingly.
For further information, please consult this article.
2. Principal Adverse Impact Statement
Next, you are required to make a decision for the consideration by your firm of the principal adverse impacts of its investment decisions on sustainability factors.
This requirement, provided in Article 4 SFDR, allows you to choose to either ‘comply’ with the Principal Adverse Impact (‘PAI’) framework, or ‘explain’ the reasons for non-consideration of the PAI indicators. This decision will determine whether you can claim to have sustainable characteristics or objectives (Article 8 or 9 SFDR) or not (Article 6 SFDR).
If you decide to explain reasons for not considering the PAIs, you have to publish a negative statement, published in a separate section of your website. The negative statement must begin with a declaration clarifying that you do not consider the adverse impacts of your investment decisions on sustainability factors. The explanation must provide the current reasons and whether that decision will be reconsidered in the future. In this scenario, you must update all your policies and marketing communications to reflect this lack of integration of ESG metrics, to avoid greenwashing.
If you decide to comply, you must draft a PAI statement.This document includes a table disclosing all the selected indicators’ data, how they compare to previous years’ results, and the actions leading and following such findings. There are 14 mandatory PAIs, and firms must select at least two (one environmental, one social) voluntary PAIs.
In addition, the document must contain descriptive information on the identification and prioritisation of the PAIs and brief summaries of the policies in place to address them, as well as compliance with internationally recognised standards.
With regard to the abovementioned policies for the integration of the PAIs in the investment decision-making process, these must incorporate an explanation on how they are maintained and applied, including:
i) a date of approval by the governing body of the fund;
ii) an allocation of responsibility for the implementation (incl. strategies/procedures);
iii) a description of the methodologies (incl. margin of error) to select the additional PAIs including an explanation of why those where chosen and how likely, severe, and irremediable they might be;
iv) a description of the data sources used; and
v) a description of best efforts taken to obtain as much information as possible on indicators where not all data is readily available.
3. Remuneration Policy
The third step is to update your remuneration policy to incorporate sustainability considerations into the determination of employee remuneration and, more generally, in the management of human resources. This step is specified in Article 5 SFDR.
For this, you must decide the amendments you want to make on your remuneration policy. For example, these amendments could consist in introducing ESG trainings or evaluation criteria into employee performance reviews or monetary incentives based on the attainment of previously set sustainability objectives in the compensation package.
To learn more about the requirements for your remuneration policy, check this article.
4. Marketing Materials
Finally, the last step of becoming entity-level compliant is to review all marketing communications to make sure they are consistent with your actual consideration of sustainability risks and adverse impacts.
Start with a list of all current and prospective marketing materials issued by your firm. This can include website publications, presentations, teasers, due diligence questionnaires, or pitch books, among other marketing tools.
Next, you must review all identified materials to ascertain that they do not contradict the disclosures and definitions emanating from theSFDR.
Finally, update all materials accordingly and ensure that such amendments have been communicated to all relevant internal and external parties (e.g., third-party distribution networks).
In this step, as there is no specific disclosure to be made but rather a long review process of disclosures, we will provide you with guidance throughout the review, to ensure that the materials do not contain any claims that could be identified as greenwashing.
Product-Level Requirements
Besides the abovementioned disclosures that concern the whole organisation managing financial products, each product must publish a series of documents with specific data and qualitative information pertaining to that specific product’s characteristics.
1. Principal Adverse Impact Statement
The decision to ‘comply or explain’ the calculation and consideration of PAI indicators outlined above must be made at entity-level, as well as for each particular product offered by the firm. In that regard, the firm must publish on its website as many negative or PAI statements as products provided. This allows each firm to offer different products with different levels of sustainability characteristics or objectives.
When it comes to Article 6 products, it suffices to publish the negative statement on the firm or fund’s website. On the contrary, the PAI compliance or explanation document for Article 8 and 9 products is merely the beginning of your product-level disclosure obligations under the SFDR.
2. Product-Level Requirements for Article 8/9 Products
If you have an Article 8 or 9 product, you will be subject to additional disclosure requirements.
You will be required to upload a website statement on showcasing how the financial product incorporates sustainable characteristics (Article 8) or aims to meet a sustainable objective and therefore makes sustainable investments (Article 9).
Moreover, you must publish your prospectus disclosure on the sustainable nature of your product. Typically, this is the document used for fundraising and can be a teaser, Private Placement Memorandum (PPM), pitch deck etc. The document should be available to all potential investors in your product. Given its purpose and the fact that it may contain sensitive financial information, the document can be placed in a data room that requires login, as long as access to all potential investors is granted.
Lastly, the periodic disclosure compares the results of two or more reporting periods and derives conclusions from the evolution of the data and the actions taken and planned in light of the findings.
414 specialises in assisting financial entities with SFDR compliance. Our tool enables private equity investors to measure all sustainability indicators of their portfolio companies and prepare disclosure documents at both entity and product levels. Additionally, we offer advisory services on sustainability reporting matters and provide tailored guidance throughout the reporting process.
