Rome Wasn’t Built in a Day: SFDR’s Past, Present, and Future

The Sustainable Finance Disclosure Regulation (SFDR) is an integral part of the EU Action Plan on Sustainable Finance. The SFDR imposes minimum disclosure requirements on EU fund managers and financial advisors, buttressing the EU Action Plan’s program to achieve a comprehensive shift in how the financial industry works by re-orienting private capital toward environmentally sustainable and socially inclusive investment decisions.

Whether too late or too early, too little or too much, the SFDR crystallizes the following three key disciplines that will form part of buy-side operations in the new sustainable finance paradigm now re-shaping the conduct of investment funds and investors across the globe: (i) sustainability risk management, (ii) adverse impact assessment, and (iii) sustainable investing with new minimum standards.

Plenty of ink has been spilled concerning SFDR’s compliance nuts-and-bolts and lamenting the inchoate state of the data ecosystem within which SFDR actors will operate as consumers and producers of sustainability data. In these respects, SFDR is like many new financial regulations, which, by definition, involve complex data challenges and the design of new compliance operating models. One need merely to invoke “MiFID II” to place SFDR’s challenges into perspective. No one suffers illusions that ideal SFDR compliance is within immediate grasp. Rome wasn’t built in a day, as they say.

But, in this case, “Rome’s” principal avenues and neighborhoods have already been laid down, if somewhat haphazardly, by industry practice. None of the SFDR’s three core disciplines are truly novel in the fund management world; they have pre-SFDR analogs implemented by many buy-side firms voluntarily or in light of sectoral requirements. To develop the metaphor further, SFDR’s chief function is to impose minimum zoning regulation and basic building codes in the burgeoning sustainable finance metropolis by expressly defining three key buy-side activities (zones) and minimum standards (codes) for their fulfillment.

SFDR as Zoning Regulation

The SFDR framework regulation defines three key activities (zones) for the buy-side. Each activity has a pre-SFDR analog, and each activity is founded upon an open form, defined term.

With respect to the first two activities, SFDR’s main obligation (softened by optionality and principles-based discretion) is to integrate consideration of “sustainability risk” and adverse impact on (i.e., investment exposure to) “sustainability factors” into investment decision-making. The methods, metrics, and results of such integration are to be variously disclosed to the investing public.

Sustainability Risk

Under SFDR, integration of sustainability risk applies to all funds, whether ESG or not, because it pertains to managing material investment risk from ESG events or conditions. Firms will need to integrate a taxonomy of “ESG events or conditions” supplemented by a materiality framework (e.g., SASB), because the focus is on managing material investment risk—not any and all sustainability risks.

Over time, as firms improve sustainability risk integration, including via newly sourced data and analytical tools, longer-term thinking will naturally permeate capital allocation decisions, and funds might choose to more closely manage even substantial (if not material) sustainability risks.

Adverse Impact

Measurement and disclosure of aggregate investment exposure to negative sustainability factors (i.e., “adverse impact”), period-over-period, applies to large firms, whether ESG or not, as a finance industry analog to NFRD corporate disclosures. In contrast to sustainability risk, adverse impact entails no materiality threshold—any positive value counts as an impact.

Adverse impact assessment will be challenging, but the exercises encouraged by the SFDR are the conscious incorporation of adverse impact considerations into investment decisions and the reduction of such adverse impacts toward zero.

Sustainable Investment

On the positive impact side, SFDR accommodates existing ESG investing practices via funds that promote environmental or social characteristics (“Article 8” funds) and funds run to achieve a sustainability objective (“Article 9” funds). In broad terms, Article 8 funds include a range of existing ESG investing practices (whether exclusionary, best-in-class, etc.) while Article 9 funds are impact funds. Operation of sustainable investment funds requires additional minimum disclosures and enhanced rigor via investments that meet all prongs of the “sustainable investment” definition. Under SFDR, a single sustainability objective cannot be narrowly pursued to the exclusion of broader sustainability issues.

As new “sustainability performance” disclosures are used by financial intermediaries, investors will be able to select among comparable funds based on performance, with a degree of comfort that such funds are not perpetuating significant harmful impacts on other sustainability factors.

SFDR as Building Code

Sustainability Risk

Regarding sustainability risk, the SFDR furnishes few “building code” specifications, not least because material investment risk management is an existing obligation and mature industry discipline, and funds are increasingly adopting voluntary climate risk practices. However, one can imagine a future in which regulators promulgate sustainability risk management guidelines, similar to other investment risk domains, as unmanaged risks manifest and investors feel the effects.

Adverse Impact

At present, SFDR’s “building code” for adverse impact disclosure remains in draft form. While there will be a period during which only the framework requirements are in force, the industry is focusing on alignment with the draft Principal Adverse Impacts Statement—with 32 mandatory and 18 optional, plus discretionary, “indicators.” The challenges associated with the integration of adverse impact considerations in the investment process are formidable: identifying, prioritizing, monitoring, calculating, and disclosing adverse impacts across investments, with year-over-year comparison, across a range of difficult-to-source data items.

As vendors build out and refine data solutions in this space, and as similar fund requirements are developed globally, the cost of adverse impact assessment will come down, and funds for which it is not mandated might opt in.

Sustainable Investing

SFDR’s minimum standards for sustainable investing can leverage adverse impact workflows (with a “significance” filter not present in pure adverse impact assessment), but will require additional components to support (i) DNSH analysis (per future RTS), (ii) diligence to ensure compliance with the “sustainable investment” definition, (iii) integration of engagement efforts and results in disclosures, and (iv) a re-imagining of performance presentation in terms of sustainability performance.

The latter conceptual shift will be accompanied by innovations in performance measurement and attribution systems or supplemented by parallel systems that capture the qualitative metrics germane to many sustainability objectives. With uniform minimum standards in place, the market imperative to differentiate will drive funds’ efforts and results.

Sustainable Finance as Roman Empire?

As the industry develops the global sustainable finance metropolis, Rome—as a metaphor—provokes consideration of empire-building and historically undervalued and marginalized perspectives.

Industry reforms introduced by the SFDR are recognized as a necessary response to decades of economic development and investment that paid little heed to long-term sustainability and externalized costs. Colloquially, SFDR is medicine for what ails the planet—us—not as we are innately, but as we live conditionally.

As we increasingly account for environmental and social costs and risks wrought by the headlong pursuit of particular modes of progress and material well-being for particular communities, it bears recognition that many indigenous communities have for generations integrated sustainability philosophies and value systems, ingraining the practice of sustainable decision-making. “Seven Generation” thinking of the Sicangu Lakota is an exemplar. Multi-stakeholder Seven Generation thinking is written into their Native Nation governmental constitution and corporate mission statements and guides their sustainable development plans.

As we applaud the growth of sustainable finance as a global phenomenon, the celebration should be tempered by the recognition that the expert stakeholder viewpoints of Indigenous communities have been unevenly integrated into the global conversation. Such communities are, for related reasons, the subject of multiple UN Sustainable Development Goals (SDGs).

Toward Full Sustainability Integration

By sorting the SFDR’s formal chaff from its substantive grain, one more clearly sees the critical exercise invited by the Paris Agreement, the UN SDGs, and the EU Action Plan: to fully integrate sustainability considerations and objectives in new, effective ways, for example, through investment programs and deeper partnerships with indigenous communities who themselves are a source of profound sustainability insights. Sustainably sourced data—data sourced via operations that advance one or more UN SDGs—which complements complete sustainability integration, is another such possibility. As we, together, develop a cosmopolitan sustainable finance metropolis, we need to ensure construction does not unwittingly occur solely along existing roads serving well-heeled neighborhoods.