SFDR Regulation : Compliance in ESG Disclosures

In October 2024, the European Supervisory Authorities (ESAs)—comprising the European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA)—released the third annual update on the Sustainable Finance Disclosure Regulation (SFDR). This report underscores refinements in the regulatory framework, emphasizing improved transparency and data accessibility concerning sustainability-related disclosures.

Key updates focus on enhancing the quality, comparability, and accessibility of Principal Adverse Impact (PAI) disclosures at both entity and product levels, standardizing data collection, and setting stringent guidelines for disclosure practices to make sustainability metrics more actionable and meaningful for investors. These changes are intended to ensure that financial institutions can effectively disclose their environmental, social, and governance (ESG) impacts, aligning with Europe’s broader sustainability objectives. The 2024 updates provide specific examples of good and poor compliance practices and call for standardized methods for reporting indicators, such as greenhouse gas emissions and gender pay gaps, to streamline SFDR Regulation compliance across the industry.

Source

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ESAs publish 2024 Joint Report on principal adverse impacts disclosures under the Sustainable Finance Disclosure Regulation

The European Supervisory Authorities (EBA, EIOPA and ESMA – ESAs) have published their third annual Report on disclosures of principal adverse impacts under the Sustainable Finance Disclosure Regulation (SFDR).

European Insurance and Occupational Pensions Authority

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2024 Joint ESAs Annual Report on Principal Adverse Impact disclosures under the Sustainable Finance Disclosure Regulation

2024 Joint ESAs Annual Report on Principal Adverse Impact disclosures under the Sustainable Finance Disclosure Regulation

European Insurance and Occupational Pensions Authority

The Recent SFDR Regulation Changes

The Sustainable Finance Disclosure Regulation (SFDR) has undergone significant evolutions aimed at increasing transparency regarding environmental, social, and governance (ESG) impacts within the financial sector. Recent updates emphasize improving the quality and accessibility of disclosures across both entity and product levels. The latest SFDR guidelines, particularly under the 2024 European Supervisory Authorities (ESAs) report, introduce technical frameworks designed to enhance the depth and comparability of disclosures for financial institutions across Europe. Key updates include:

1. Improved Accessibility of Principal Adverse Impact (PAI) Disclosures: ESAs have mandated that Financial Market Participants (FMPs) and financial products must clearly disclose their PAIs, targeting improvements in accessibility and transparency for retail investors. This measure helps financial entities communicate the adverse environmental and social impacts their investments may have. Specifically, the guidelines require that PAI disclosures be easily accessible on the entity’s website under designated “Sustainability” or “SFDR” sections, enhancing transparency for retail investors.
2. Quality and Comparability Standards: The ESAs' latest guidelines provide standardized templates for PAI disclosures, improving comparability across different FMPs and their products. Enhanced consistency is anticipated to empower investors with clearer, more actionable ESG information. Detailed frameworks now outline best practices, such as separating regulatory and marketing disclosures and aligning disclosures with both mandatory and opt-in PAI indicators, to improve comparability and minimize discrepancies in data reporting across sectors.
3. Mandatory Disclosure Templates: Following the SFDR Delegated Regulation (EU) 2022/1288, FMPs with over 500 employees are now required to use standardized templates, facilitating uniformity across PAI disclosures. This regulation targets comprehensive PAI indicators, including energy consumption, greenhouse gas emissions, and biodiversity impacts. Additionally, the templates integrate opt-in indicators for deeper insights and cover specific reporting requirements for high-impact sectors, like fossil fuels, thus guiding smaller FMPs on voluntary compliance options aligned with full SFDR Regulation adherence.

Impacts of the 2024 SFDR Update

The 2024 SFDR report by the ESAs highlights both improvements and challenges in implementation across European markets:

• Enhanced Data Collection and Quality:
  The ESAs’ recent survey of national authorities reflects an uptick in data accuracy and the frequency of voluntary disclosures by FMPs. For instance, the use of standardized European ESG Templates (EET) has bolstered the quality of entity-level disclosures, particularly in asset management and insurance sectors. An analysis of 65 FMP entities showcased in the 2024 SFDR report indicates substantial improvements in data consistency, especially in sectors like energy and banking, which are now better able to quantify adverse impacts such as emissions and water usage.

• Greater Compliance among Large FMPs:
  Large FMPs, especially those within multinational groups, have shown better compliance in using SFDR templates and achieving regulatory requirements. This trend likely results from these groups’ access to more robust data-gathering resources, especially beneficial in areas like carbon emissions measurement. The SFDR guidelines emphasize that multinational FMPs need to demonstrate clear methodologies for calculating PAI indicators, addressing sector-specific requirements, and detailing resource allocation to improve data coverage for mandatory indicators like greenhouse gas intensity.

• Product-Level Disclosure Improvements:
  Product-level disclosures have also seen notable progress, although NCAs reported that the share of products providing comprehensive SFDR information remains modest. Disclosures for products under Article 8 (promoting environmental or social characteristics) and Article 9 (sustainable investments) demonstrate increased alignment with regulatory standards, with Article 9 disclosures achieving the most thorough compliance in tracking adverse impacts. The ESAs highlight the need for greater data completeness and comparability at the product level, encouraging FMPs to follow templates for product disclosures under Articles 8 and 9 of the SFDR Regulation, which are now accessible to the public as standardized ESG Templates (EET) improve data continuity.

Good and Bad Practices in SFDR Disclosure

A significant section of the 2024 report identifies common practices that either facilitate or hinder compliance with SFDR guidelines:

• Good Practices:
  • Prominent placement of sustainability disclosures on corporate websites, making information easily accessible to investors.
  • Clear language and well-structured formats enhance understanding, especially when disclosures are available in multiple languages.
  • The use of quantitative data, such as gender pay gap statistics and emissions metrics, allows for an objective assessment of FMPs’ adherence to SFDR standards. ESAs recommend setting interim targets to demonstrate alignment with objectives like the Paris Agreement to further clarify transparency and commitment levels within ESG disclosures.

• Bad Practices:
  • Disclosures placed in less intuitive sections of websites, making them challenging to locate without using search functions.
  • Generic, vague language that limits transparency, particularly in explaining why specific PAI indicators are not considered. Common deficiencies include lack of target dates for planned action or unclear descriptions in actions planned to reduce adverse impacts.
  • Marketing content commingled with regulatory disclosures, detracting from the clarity of regulatory content. ESAs identified that embedding SFDR disclosures in promotional materials often leads to misinterpretation and compromises investor understanding, which is why they advise against it as a best practice under SFDR Regulation.

Recommendations for Improved SFDR Implementation

To streamline compliance and maximize transparency, the ESAs recommend specific actions for both the European Commission and National Competent Authorities (NCAs):

• For the European Commission:
  • Consider reducing the frequency of ESA assessments to bi- or triennial intervals, allowing ESAs and NCAs to focus on comprehensive, meaningful analysis of FMP disclosures.
  • Reevaluate the current 500-employee threshold, as it may not adequately capture the full spectrum of adverse sustainability impacts. A threshold based on assets under management (AuM) might more accurately reflect an FMP’s potential ESG impact.

For NCAs

• Develop supervisory technology (Sup Tech) tools to aid in future market assessments.
  • As noted in the 2024 SFDR report, Sup Tech tools are crucial for facilitating efficient monitoring and analysis of FMP disclosures and compliance. Enhanced supervisory technology allows NCAs to capture detailed ESG data across the financial market, ensuring that disclosures adhere to the SFDR Regulation’s stringent guidelines on PAI indicators. Sup Tech tools could further support data comparison across jurisdictions, helping to identify FMPs that may require additional guidance to meet evolving SFDR standards.

• Engage in consistent communication with FMPs, including guidance on deadlines and regulatory expectations.
  • Regular communication between NCAs and FMPs is essential for bridging knowledge gaps around SFDR Regulation requirements. For instance, NCAs are encouraged to issue targeted guidance on complex PAI indicators, like biodiversity impacts and carbon emissions intensity. This guidance will also ensure that FMPs are consistently meeting submission deadlines, such as the annual June 30 reporting deadline for PAI disclosures, which remains a key area of focus.

• Focus supervision on risk-based assessments to identify and support FMPs facing compliance challenges.
  • The SFDR report highlights the importance of a risk-based approach for NCAs, particularly when supervising smaller FMPs that may lack the resources to fully comply with SFDR Regulation requirements. By focusing on high-risk areas such as climate-related disclosures or adherence to the Paris Agreement objectives, NCAs can allocate resources to support FMPs in aligning with the SFDR’s sustainability disclosure framework. A risk-based approach will also enhance the comparability of ESG disclosures across sectors, improving overall market transparency.

SFDR Regulation: What's Next?

The recent SFDR updates mark a critical evolution toward a more transparent and accountable financial ecosystem across Europe. While the enhanced reporting requirements have presented implementation challenges, especially for smaller FMPs, they are expected to yield long-term benefits:

1. Increased Investor Confidence:
   • Transparent and accessible ESG data is expected to build investor trust, allowing more informed decisions aligned with sustainability goals. Investors will have clearer insights into how FMPs address principal adverse impacts (PAIs), which, according to the SFDR, include mandatory indicators like greenhouse gas emissions, energy consumption, and gender diversity. This heightened transparency is anticipated to drive demand for sustainable financial products and help investors align with their sustainability objectives.
2. Incentivizing Sustainable Investment:
   • As FMPs align their practices with SFDR standards, sustainable investment options are likely to increase, encouraging a shift towards low-carbon, socially responsible portfolios. Article 8 and Article 9 financial products, which focus on promoting environmental or social characteristics and sustainable investments, respectively, are expected to become more prominent as FMPs work to enhance disclosures in line with SFDR Regulation. This shift supports the EU’s transition to a sustainable economy by channeling capital into green, socially beneficial projects, thus accelerating Europe’s decarbonization goals.
3. Potential Regulatory Expansion Beyond SFDR:
   • The success and challenges observed in SFDR implementation may influence future regulations across other sectors, pushing toward a unified European regulatory landscape for sustainable finance. For instance, the SFDR’s influence is expected to extend into other financial legislation, such as the Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD), where ESG-related disclosures may become standard practice. This regulatory expansion could create a fully integrated sustainability framework across EU financial services, enhancing the SFDR Regulation’s impact.