As recently confirmed, the EU regulation on sustainability-related disclosures in the financial services sector, or SFDR, will go into effect on March 10, 2021, regardless of the market rumors of an official delay of its application or a non-action letter. The SFDR imposes requirements on institutions such as banks, insurance companies, pension funds, and investment firms. However, its implications go beyond the financial sector. This Client Alert discusses how the SFDR will impact the real economy.
- The SFDR will start applying in March 2021 and is expected to further shift market appetite towards sustainability-minded companies in their capacities as investees, borrowers, and issuers.
- The application of the SFDR will influence businesses’ capital-raising activities. Companies that are prepared and aligned with the SFDR’s requirements will have a competitive advantage in the corporate finance market.
- Companies can align with the SFDR’s requirements by preparing high-quality sustainability-related information, and by integrating sustainability factors into their existing and planned financing instruments.
Until now, financial regulation has largely required financial institutions (in their capacity as capital providers to the real economy) to focus on the financial risks of their clients. Increasingly, it is demanding these capital providers look at businesses’ sustainability risks and opportunities, as these factors can also ultimately impact capital returns.
The EU adopted the SFDR in November 2019. This regulation is a step towards implementing the EU’s commitments under the UN 2030 Agenda (and the corresponding Sustainable Development Goals) and the Paris Agreement by, among other strategies, mobilizing capital flows towards environmentally and socially sustainable economic activities.
THE CAPITAL PROVIDER’S PERSPECTIVE
The SFDR aims to protect end investors by allowing them to make informed decisions about their investments. It does so by demanding that organizations in the financial sector be transparent about:
1. how they integrate sustainability risks in their investment decision and advisory processes, including asset due diligence processes;
2. how they consider the adverse sustainability impacts of their investments (e.g., how the proceeds applied by investees, borrowers, and issuers have effects on environmental, social, and governance (ESG) matters); and
3. how sustainable their financial products are.
These transparency obligations require the disclosure of information in the financial sector’s pre-contractual documents and periodic reports, and on websites.
Integration of sustainability risks and consideration of adverse impacts
The SFDR addresses ESG issues within the whole investment cycle. On one hand, the SFDR looks at sustainability risks as ESG events or conditions that could cause a material impact on the value of the investment. On the other, the SFDR acknowledges that investment decisions may have principal adverse impacts (PAIs) on sustainability factors, i.e., environmental, social, and employee issues, respect for human rights, and anti-corruption and anti-bribery matters. Therefore, the SFDR encourages capital providers to consider sustainability risks alongside PAIs in all their processes.
In this context, it recommends that financial institutions consider the due diligence guidance for responsible business conduct developed by the OECD and the UN‐supported Principles for Responsible Investment.
To ensure clarity about how sustainable financial products really are, the SFDR creates two categories of ESG products:
(i) products that have sustainable investments as an objective, which are subject to strict requirements under Article 2(17) SFDR. To summarize, an investment shall qualify as a “sustainable investment” if:
- it is made in an economic activity that contributes to an environmental objective, e.g., measured by indicators for use of energy, renewable energy, raw materials, water and land, the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy; or a social objective, e.g., tackling inequality or fostering social cohesion, social integration, and labor relations, or in human capital or economically or socially disadvantaged communities;
- it does not significantly harm any of those objectives; and
- the investee company follows good governance practices, including sound management structures, employee relations, remuneration of staff, and tax compliance;
(ii) products that promote environmental and/or social characteristics, which are seen as a catch-all category for sustainability-promoting products that do not meet all requirements under Article 2(17) SFDR.
Indexes and benchmarks, including the amended EU Climate Transition Benchmarks, the EU Paris-aligned Benchmarks, and sustainability-related disclosures for benchmarks as set out under the EU Benchmark Regulation (EU Regulation 2019/2089), may be used to demonstrate how such financial products either promote environmental and/or social characteristics, or meet the sustainable investment objectives. On July 17, 2020, the European Commission adopted new rules setting out minimum technical requirements for the methodology of EU climate benchmarks (which are currently subject to a scrutiny period).
THE COMPANIES’ PERSPECTIVE
In practice, the SFDR requires that supervisory authorities verify whether financial institutions are providing “more specific and standardized” ESG information to end-investors. In order to do so, these institutions will need to obtain ESG information from companies in their capacities as investees, borrowers, and issuers.
While the last few years have already seen a dramatic shift in market appetite towards sustainability-minded companies, the forecasts see further mobilization during 2021. The SFDR is a key driver in this direction. Therefore, companies that are aligned with the SFDR’s requirements can become more attractive to capital providers and have a first-mover advantage (e.g., better costs of capital) in comparison to other less sustainability-minded companies.
What can companies do?
As first steps to become more aligned with the SFDR’s requirements and more prepared to engage with their own capital providers, companies may consider:
- assessing the sustainability risks which may impact their own activities with quantitative and qualitative metrics and accurate data, and producing internal reports;
- evaluating the PAIs of their own activities on sustainability factors, including what actions were taken or are planned to remedy these impacts, by applying, for example, the OECD due diligence guidance for responsible business conduct, and producing internal reports; and
- defining the strategic sustainability target for their own economic activities (as underlying assets for financial products), i.e., either as promoting environmental and/or social characteristics, or as contributing to an environmental or social objective based on quantitative and qualitative metrics and accurate data.
Particularly with respect to the last step, companies may take the following actions:
- map current and upcoming capital needs and understand the sustainability appetite of its existing and potential shareholders, investors, and other capital providers;
- collect and organize ESG information that is accurate, fair, clear, not misleading, simple, and concise, and disclose it in their annual reports in accordance with Directive 2013/34/EU (as implemented into national law) or in other communication channels with capital providers;
- apply methodologies to evaluate, measure, and monitor ESG matters, including identifying the main data sources and sustainability indicators;
- consider issuing or contracting ESG-related bonds and loans, as an exercise of alignment with recognized standards within the financial sector;
- examine indexes and benchmarks that may apply to their own securities, such as EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks under EU Regulation 2019/2089 and other sustainability-related indexes; and
- adhere to recognized general or sectoral responsible business conduct codes and reporting standards.
The Commission plans to adopt regulatory technical standards (RTS) supplementing the SFDR in the first quarter of 2021. A consultation paper with draft RTS was published in April 2020. Once adopted, the RTS will give companies clarity about which sustainability indicators will be measured. Annex I of the current draft includes three tables with examples of environmental and social indicators.
The next alert of the Sustainable Finance Series will review how EU Regulation 2020/852 on the sustainability taxonomy is expected to impact the real economy.