On March 10, 2021, the European Union’s Sustainable Finance Disclosure Regulation (“SFDR”) came into force. The SFDR will require certain asset managers and Financial Advisers to make environmental, social, and governance (“ESG”) disclosures to potential and current investors. The SFDR is the first step by the EU in the establishment of a more comprehensive regulatory regime in sustainable finance. The disclosure regime will be further refined when regulatory technical standards (“RTS”) are introduced in 2022.
This article provides an overview of the ESG disclosure regime that arises from the SFDR, including who the regime applies to and what disclosures are required. The article also considers the significance of the SFDR for Canadian firms, both with respect to their potential disclosure obligations and whether similar obligations may arise in Canada.
The SFDR – An Overview
A. Who is subject to the SFDR?
The SFDR imposes disclosure obligations on “Financial Market Participants” and “Financial Advisers”, as defined in the SFDR. Financial Market Participants and Financial Advisers consist primarily of asset managers and Financial Advisers, namely:
- Investment firms and credit institutions providing portfolio management or investment advice;
- Alternative investment fund managers;
- Insurance‐based investment product providers including insurance intermediaries;
- Pension product providers;
- Managers of certain qualifying venture capital and social entrepreneurship funds; and
- UCITS management companies.
The scope of the SFDR is broad enough to capture Financial Market Participants and Financial Advisers based outside of the EU in certain situations. Notably, the regulation applies to non-EU fund managers that market funds under the EU’s National Private Placement Regime (“NPPR”).
B. When and how are the obligations engaged?
The SFDR requires asset managers and Financial Advisers to disclose how ESG factors are integrated into their firm’s risk processes. Disclosure obligations occur at two levels: the firm level and the product level.
At the firm level, the SFDR requires certain disclosures irrespective of the extent to which the firm has an ESG strategy. Firms within the scope of the regulation must disclose whether (and how) they consider the “principal adverse impacts” on sustainability of their investment decisions or advice. Firms that elect to not consider the adverse impacts of their investment decisions on sustainability will be required to publish reasons for why they do not do so, commonly referred to as the “comply or explain” model.
At the product level, firms will have additional obligations under the SFDR where their products promote environmental or social characteristics, or if the products have either sustainable investment or carbon emission reduction as their objectives. This is intended to address widespread concerns in the financial industry over “greenwashing”, and to build investor confidence.
The SFDR is prescriptive and sets out the information to be provided in relation to these products in order to ensure their regulatory compliance. The implementation of the RTS in 2022 will further detail disclosure obligations for these “green” financial products.
Notably, the SFDR also explicitly requires firms within its scope to provide certain information on their websites in a “clear, succinct and understandable” format. This includes, among other information, the descriptions of the sustainable investment objective or the environmental and social characteristics for each “green” investment product offered by a firm, as well as the methodologies used to analyze financial products for their sustainable objectives or social or environmental characteristics. Amendments to information disclosed under the SFDR must be explained and published on the same website.
What the EU’s new ESG rules mean for Canadian firms
A. The direct and indirect impacts of the EU regime
The impact of the SFDR will not be restricted to EU firms. Both direct and indirect impacts are likely to be felt by Canadian firms. As mentioned above, the SFDR will capture Canadian and other non-EU fund managers that market their funds to EU investors under the NPPR. Canadian firms whose product offerings are caught under the SFDR will therefore have to ensure those financial products are SFDR-compliant.
Canadian firms may also experience indirect impacts through their relationships with EU counterparts that must be SFDR-compliant. This might arise, for instance, where EU firms require data inputs from third parties, such as fund managers. An EU asset manager may ask a Canadian sub-adviser to provide information that will be incorporated into the EU firm’s disclosures. It also may be possible that firms will, out of prudence, request varying disclosure from Canadian firms until market consensus emerges.
The introduction of the RTS in 2022 will further clarify circumstances where the SFDR will effectively require some form of disclosure by non-EU firms.
B. The EU Regime as a bellwether for future Canadian disclosure requirements
With the SFDR, the EU has become a trailblazer in the regulation of ESG disclosures for market intermediaries. At the same time, influential countries like the United Kingdom and the United States have also turned their attention towards the introduction of similar regulatory regimes. This suggests that a global shift towards ESG disclosures is well underway, and Canada is unlikely to be any exception.
There have already been some signals at the federal level. In June 2019, the Expert Panel on Sustainable Finance (“Expert Panel”) delivered its final report, Mobilizing Finance for Sustainable Growth to the federal government. The report contains fifteen recommendations, many of which are comparable in substance to the obligations imposed under the SFDR. For example, Recommendation 5.1 from the report endorses the introduction of a “comply or explain” approach as part of a potential adoption of the increasingly popular Task Force on Climate-related Financial Disclosures (“TCFD”) framework.
The Expert Panel’s report signals that the introduction of a Canadian ESG disclosure regime is probably not a matter of “if” but rather of “when”. As the SFDR and comparable disclosure regimes in other countries and regions come into force, firms in Canada would be wise to initiate or accelerate existing ESG disclosure practices, either for the business as a whole or any product offerings with a sustainability component.
The bottom line
True to form, the European Union is ahead of the pack in implementing mandatory ESG disclosure beginning with the SFDR regime. This will be further refined when the RTS is introduced in 2022.
The SFDR is likely to have both direct and indirect impacts on Canadian firms. Not only should careful attention be paid to when compliance is required, but firms should also anticipate requests from EU colleagues for information that will be included in their disclosures.
Policy recommendations in numerous jurisdictions, including Canada, indicate that firm- and product-level disclosure requirements comparable to those in the SFDR will become global norms in ESG disclosure regimes. Canadian firms and their advisors should watch the market’s response to the SFDR in order to prepare for the potential arrival of similar obligations here in Canada. Accordingly, firms may wish to consider whether this is the right time to improve their ESG disclosure practices.