A Simple Guide to the EU Sustainability-Related Finance Regulations

Contents

• Summary
• SFDR
• EU Taxonomy
• MiFID II Regulation
• What’s Next

Summary

The Action Plan for Sustainable Growth was adopted by the European Commission in 2018 and has three main goals: reorienting capital flows towards a more sustainable economy, mainstreaming sustainability into risk management and fostering transparency and long-termism.¹ It is part of the EU Green Deal, which aims to make the continent achieve net zero greenhouse gas emissions by 2050.²

As part of the Action Plan, several pieces of legislation have been passed that impact asset managers, including the EU Sustainable Finance Disclosure Regulations (SFDR), the EU Taxonomy Regulation (TR) and the EU Market in Financial Instruments Sustainable Preference obligation (MiFID II).³

These regulations aim to standardize the disclosure of information regarding the sustainability profile of investment products in order to provide more transparency to investors. This allows clients to better understand and compare the sustainability profile of products, which enables asset managers to help them to make decisions aligned with their investing goals and reorient capital flows into investment products that support a more sustainable economy.

Timeline of Implementation

Source: J.P. Morgan Asset Management, SFDR Explained, 2022; VanEck.

SFDR

Summary

The SFDR mandates ESG disclosures from asset managers and other financial market participants. These disclosures are intended to make the sustainability profile of funds more transparent, which allows investors to compare investment products on sustainability and aims to reduce “greenwashing.”⁴

Fund Classifications

Under SFDR, funds are classified as Article 6 (grey), Article 8 (light green) or Article 9 (dark green).

Source: European Commission. Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector.

Required Disclosures

Asset managers must disclose factors at an entity (firm-wide) and product (fund-specific) level.

Key terms to know:

Sustainability Risks

A sustainability risk is defined as “an environmental, social or governance event or condition that, if it occurs, could cause a negative material impact on the value of the investment.”⁵ Examples of environmental events include climate change, social events include labor rights and governance events include shareholder rights.

PAIs

PAIs stand for Principle Adverse Indicators. They describe the negative impacts that a firm or an asset can have on the environment or society.⁶ Examples include the energy consumption of a company or exposure to controversial weapons.⁷

Entity-Level Disclosure Requirements include:

• Periodic Disclosures: include disclosures on how the firm incorporates sustainability risks into the investment decision-making process and how the firm identifies PAIs.⁸

Product-Level Disclosures include:

• Pre-contractual: include disclosure on sustainability risks and PAIs.
• Periodic Reporting: include disclosure on PAIs, plus additional disclosures of the sustainability profile for Article 8 and Article 9 products.
• Website: additional disclosures of the sustainability profile for Article 8 and Article 9 products.

EU Taxonomy

Summary

The EU Taxonomy Regulation (EU TR) provides a common language for firms and investors to identify which economic activities are “environmentally sustainable.”⁹

Under SFDR (Level II, which came into force in January 2023), asset managers have to report the taxonomy-alignment of their Article 8 and Article 9 products.

Article 8 and Article 9 Product Disclosures include:

Taxonomy alignment: Asset Managers have to report the proportion (%) of their portfolio invested in activities aligned with the EU taxonomy in SFDR’s product-level disclosures.

In order for an economic activity to meet the definition of environmentally sustainable and thus be considered Taxonomy-aligned, amongst other things it must:

• Contribute substantially to one or more of the six environmental objectives:

1. Climate change mitigation.
2. Climate change adaptation.
3. Sustainable use and protection of water and marine resources.
4. Transition to a circular economy.
5. Pollution prevention and control.
6. Protection of healthy ecosystems.

• Do no significant harm (DNSH) to any other environmental objective.
• Comply with minimum social safeguards.

MiFID II Regulation

Summary

The Markets in Financial Instruments regulation (MiFID II) requires asset managers to assess clients’ sustainability preferences and take them into account when offering investment advice or portfolio management services.¹⁰

Specifics

Sustainability preferences include whether and to what extent a client (or a potential client) wants to invest in environmentally sustainable investments,¹¹ sustainable investments¹² and investments that consider PAIs on sustainability factors.¹³

What’s Next

The EU SFDR, EU TR and MiFID II all contribute towards implementing the goals of the EU Action Plan for Sustainable Growth. They fit into the EU’s overarching aim to improve the transparency of the sustainability of investment products and reorient flows towards a more sustainable economy. The EU Commission is expected to roll out more regulations to support the goals of the Action Plan in the future, including potentially rolling out a social taxonomy¹⁴ and an extended environmental taxonomy.¹⁵ As investor interest and demand for ESG and sustainability-related financial products in the EU grow and the EU continues to work towards achieving the goals of the EU Green Deal, the regulation which supports the Action Plan will likely continue to evolve and expand.

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