This article provides an overview of the different processes fund managers can set in place to ensure compliance with the SFDR's requirements on the consideration of sustainability risks, as specified in Article 3 SFDR.

As a summary of the actions you must take:

1. First, you must either draft or update a policy for the incorporation of sustainability risks into investment decision-making processes.  
2. Second, you must implement that policy. This requires assessing the likely impacts of sustainability risks on the returns of your investment products through the processes designed in your policy.  
3. Finally, you must publish the disclosure on your website.  

For an overview of the other documents you shall disclose under the SFDR, check this article.

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What should be included in a sustainability risk policy?

Typically, firms include between three to four steps to address and incorporate sustainability risk into the various stages of the investment process. The specific steps are designed and described in the Sustainability Policy. Additionally, firms may have an ESG policy, mirroring and expanding on the mandatory requirements for considering of sustainability risks in your investments.

During the conception of such a framework, you will have to decide on which risk assessment tools you will be incorporating, and at which stages of the investment process. Below is an overview of the most common steps.

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1) Exclusions in the Screening Stage

An Exclusion list usually contains economic activities that will never be considered to be included in a firm's portfolio. These vary per preference of the firm, but there are some activities that most firms can agree on:

i) Human rights denial

ii) Forced or child-labor in supply chain

iii) Destructive weapon manufacture

iv) Production of illegal products

v) Fossil fuel activities

vi) Production of tobacco, gambling, adult entertainment, and palm oil.

We believe that adopting and implementing an exclusion list is an absolute must if you wish to be classified as an Article 8 or 9 Fund.

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2) ESG Assessments in the Due Diligence Stage

Before a potential company of interest is added to a firm's portfolio, it usually undergoes a series of screenings. These screenings should incorporate the sustainability risks your firm has identified as relevant. In addition, policies need to be set in place for analysts to be able to engage with portfolio companies (PCs) and to use the information these companies obtain for analysis.

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3) Monitoring, Engagement and Risk Management in the Ownership Stage

The sustainability performance of the portfolio companies is often monitored by the fund in the ownership phase. Certain ESG metrics are set and reviewed annually.

In addition, and to further assist with their integration of sustainability risk-monitoring processes, your firm can engage with PCs by assessing the materiality of sustainability risks to their specific business. This is achieved through the implementation of two tools:

1. A climate risk/human rights risk assessment for your PCs.
2. Conceiving an engagement policy to assist PCs in monitoring their risks, and where relevant to help them manage any significant risks.
3. Incorporate the identified sustainability risks into your risk management policy, ensuing processes for oversight.

4) Annual Reporting

The performance of the portfolio companies across the portfolio are summarised in a report, which is usually reviewed by an independent third party such as a consultancy, and published annually. In your annual report, you must disclose the results of the monitoring of the sustainability risks (and other aspects, if applicable, such as negative externalities or principal adverse impact indicators) , and how you engage with PCs to make sure these risks are monitored and managed.

Sometimes, these reports also include an explanation of the likelihood of sustainability risks on the return of investment products. If a firm has properly monitored and engaged with their carefully screened portfolio companies, these risks can be kept low.

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Do you have difficulties getting started? This article might help.

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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 consultancy services on sustainability reporting matters and provide tailored guidance throughout the reporting process.