The future trends of SFDR in the financial institutions

Marion Duermael (MD): In the Asset Management world, a fund with an ESG objective is a fund composed of investments in companies that are committed to environmental conservation, social responsibility, and robust corporate governance practices. Those ESG funds aim to provide financial returns while positively impacting the environment.

Emilie Pitchot (EP): With the growing demand for ethical products addressing environmental and/or social issues, we have seen a rise in the offer of sustainable financial products. To avoid greenwashing, the regulator developed a few years ago a disclosure regime, the so-called “Sustainable Finance Disclosure Regulation” (SFDR). This initiative is part of a broader disclosure regime, “the EU sustainable finance framework” which includes other policies such as the EU taxonomy or the EU Green Bonds standard. This regulatory package contributes namely to reaching the objectives defined within the scope of the European Green Deal by channeling capital flows towards sustainable investments and by increasing transparency about sustainability risks that may have an impact on the financial system.

This is why we now have easy access to sustainability information in mainstream financial communications such as prospectus or annual reports of funds in which we invest.

Marion Duermael (MD): With the SFDR regulation, Financial market participants are required to disclose a similar set of ESG information about their funds. Therefore, the investor can compare the ESG commitments of different products, from different financial institutions (FIs) . The final goal is to increase investments in virtuous companies and to do so, investors need to be consistently informed. To put this into practice, financial advisors must now consider sustainability preferences of their clients following the MiFID II amendment, and the standardized SFDR reporting aims to support them in selecting compatible financial instruments.

MD: The new requirements introduced by the regulator impact financial institutions at various levels, which requires the adoption of a broad set of measures to address them.

The main challenges financial institutions face in implementing SFDR include the evolving nature of the regulation, requiring continuous adaptability and monitoring of interconnected policies with other fast-changing European policies. Maintaining a holistic regulatory watch has become even more essential now that a major update of SFDR will come into force in the coming year.

EP: Financial institutions face challenges with ESG data availability and quality, as ESG metrics are still emerging and often lack accuracy. Despite the development of standardized templates to exchange SFDR data between Financial Market Participants (called the “EET”), we see that the process is not always effective as the templates provided may be incomplete or inconsistent with its own methodology. SFDR's principle-based approach results in a lack of standardized data, complicating the comparability of financial products. Integrating new reporting requirements into existing systems is complex and costly, necessitating specialized skills and resources. 

MD: Integrating new SFDR reporting requirements into existing systems is challenging and costly for financial institutions. They must develop new data controls, continuously monitor, and adapt their infrastructure to handle both quantitative and qualitative ESG information. Regarding the Asset Managers’ reporting department, from a project management point of view, this complexity increases reporting costs and necessitates recruiting specialized SFDR/ESG experts which also has a price.. Organizations have created dedicated SFDR teams across various departments (disseminated in the Legal, Fund Management, Data Office, Marketing, and Reporting departments) and adapted IT systems to manage new data needs from Front Office to Reporting .

EP: On product development and client side, the lack of standardized data and the complexity of the regulation lead to subjective assessments.

Asset managers need to adapt their product range to align with the SFDR classifications and select relevant ESG indicators to help their business partners in addressing their own obligations under the MiFID II and the IDD. The concepts introduced by the regulation are complex which has led to discrepancies in the interpretation of several terminologies by financial market participants, preventing the provision of truly comparable information. This level of complexity is neither tailored to retail investors’ need to acquire sustainability information to make informed decisions. 

MD: With the coming review of SFDR, we expect a significant simplification of the reporting templates. Today, if the SFDR reports follow the same structure and requirements for all funds of all EU financial institutions, it is still difficult to read: few synthetic tables, long paragraphs… In the future, we should go towards a more user-friendly format, easier to read and compare, more concise with a better focus on relevant information. It will serve both the investor, with better fund documentation, and the financial institutions, with reduced costs.

EP: The current SFDR settings have led to increased ESG disclosures in investments, yet market concerns persist about its effectiveness in driving a sustainable economy.

In the coming years, I think that the information communicated through SFDR statements will become much more meaningful to investors. With the entry into force of the Corporate Sustainability Reporting Directive (CSRD), the level of ESG data availability will substantially increase and will become more comparable. The underlying European Sustainability Reporting Standards (ESRS) have been developed while taking into account the specific information needs of financial market participants to meet their reporting obligations under SFDR. On the other hand, challenges may arise from overlapping sustainability reporting regulations like CSRD and SFDR, which may require consistency across entity and product-level reporting. On that topic, the coming evolutions of the regulatory framework will have to be monitored.

MD: In parallel, the review of SFDR should introduce new reporting requirements, potentially focusing on forward-looking disclosures like GHG emissions reduction targets. But evolutions are not only expected at the level of the reporting templates which concern the “level II'' review expected by 2025. The Commission has also launched a reviewing process of the “level I” aiming to transition from a disclosure regime to a labeling system with specific criteria that restricts the flexibility in portfolio construction.

Overall, I am positive that these evolutions will shape more tailored financial products aligned with investor ESG preferences and promoting long-term sustainable investment strategies, As Japan’s pension fund chief Hiro Mizuno advocated with its concept of universal ownership :”We own the universe, so if we own the universe, we cannot beat the universe. So we should pay more attention to contributing to making the universe more sustainable”.

MD: From what we have seen, SFDR was initially viewed as a regulatory burden, necessitating substantial investments in ESG/SFDR knowledge and operational adjustments. But from now on, they can benefit from this and turn the cost into an investment. Instead of staying at the level of a compliance exercise, they should go further and benefit from synergies. For instance, SFDR/ESG data collected can be repurposed for other reports like factsheets and KIID, transforming regulatory costs into strategic investments.

EP: This involves transparently describing sustainable objectives and the environmental or social characteristics of financial products, emphasizing how these objectives are achieved. We would recommend the use of Principle Adverse Impacts (PAIs) indicators to enhance comparability across products, as these indicators are based on standardized methodologies and may become mandatory in the future. Additionally, defining explicit exclusion thresholds for each indicator and communicating them transparently is advised to bolster clarity and accountability.

MD: We also emphasize the adoption of a forward-looking perspective in defining sustainable finance strategies that enhances reporting consistency over time by integrating relative measures for quantitative indicators and tracking past data. This approach not only facilitates customer understanding of their contributions to sustainability transitions but also transforms SFDR from a mere compliance exercise into an opportunity for strategic reassessment. Financial institutions can leverage SFDR to influence investee companies towards sustainable business models through robust engagement and voting policies, with clear exit strategies for non-compliance.

SFDR is also an opportunity to broaden its services by developing new products with a more impactful design, addressing a broader set of ESG preferences to access new markets. 

Implementing holistic sustainability strategies with robust processes and transparent communications mitigates corporate risks, including reputational, operational, and compliance risks leading to legal penalties, and safeguards against greenwashing practices.

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