The Advent of Sustainable Financial Disclosure Requirements
In recent years, Environmental, Social and Governance (ESG) has become increasingly important for investors to determine where they wish to allocate their capital. Whilst financial returns still take centre stage, investors are no longer solely focused on the fiscal performance of their investments, and often wish for their investments to represent their values and commitments to a more sustainable future.
By way of a response to the growing demand for sustainable investment options, the European Union (EU) has introduced the Sustainable Financial Disclosure Requirements (SFDR). As part of these requirements, financial products (for the purposes of this article, we will be discussing investment funds) are separated into three distinct categories, Article 6, Article 8, and Article 9 funds. These discreet categories are designed to give investors clarity and visibility into the sustainability criteria of funds.
These SFDR are a critical component of the EU’s wider sustainable finance agenda. Adopted as part of the EU’s Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector, these disclosures aim to standardize the way financial products disclose their sustainability characteristics to investors. Thereby preventing “greenwashing” – the misleading marketing of investments as more sustainable than they are in reality.
Article 6 – This covers funds which do not place any emphasis on sustainability and do not commit themselves to promoting any specific environmental or social characteristics. Article 6 funds can invest in companies often excluded from ESG funds which can include tobacco companies or industrial thermal coal production. However, Article 6 funds must include the following descriptions in pre-contractual disclosures:
- The manner in which sustainability risks are integrated into their sustainability decisions.
- The results of this assessment and the likely impact of sustainability risks on the returns of financial products they make available.
- Where sustainability risks are not deemed to be relevant, the descriptions should include a clear and concise explanation as to why not.
Article 8 – Funds which are defined as Article 8 promote – among other characteristics – Environmental and Social properties. Additionally, the companies in which these funds are invested have to follow ‘good governance practices’. Further to the Article 6 disclosures, Article 8 funds must disclose the following in their pre-contractual disclosures:
- Information on how Environmental and Social characteristics are met.
- If an index has been designated as a reference benchmark, information on how this index is aligned and consistent with the aforementioned characteristics.
Article 9 – Represents funds which specifically commit themselves to sustainability a core objective, and a specific index has been nominated as a reference benchmark. In addition to the Article 8 disclosures, article 9 companies must include the following information:
How the designated index is aligned with the fund’s sustainability objectives.
Why and how the designated index aligned with this objective differs from a broad market index.
Key Implications for Investors and Funds
Investment funds are still ultimately in control of which classification they seek to attain, and therefore it cannot be guaranteed that the adoption of the SFDR guidelines will promote sustainable practices amongst financial products. However, these classifications allow investors to more easily determine where they wish to allocate their capital, and funds will likely adopt change if investor sentiment shifts towards financial products with increased sustainability credentials.
To comply with the requisite disclosure requirements for each classification, asset managers and fund managers need to be able to provide accurate and reliable information on their investment strategies and the sustainability impacts of their funds. This has led to a greater emphasis on data capture, reporting, and transparency within the financial industry.
Technological enhancements within the property sector have ensured that the collection of this investment quality data is more streamlined and cost effective than ever before. Additionally, this data can be used to drive behavioural change, which may be used as evidence of the promotion of specific environmental or social characteristics. This may prompt an increasing number of funds to seek a higher SFDR classification.
Wider Market Implications
Alongside regulations such as SDFR, new legislation is appearing such as the Streamlined Energy and Carbon Reporting and the inaugural ISSB standards. Further to this legislation, a number of companies are now aiming for non-legislative ESG and sustainability credentials such as BREAAM and NABERS. An increasing number of market participants are reporting on the effect of these credentials, with benefits including higher rental premiums for office space and increased sale prices on developments.
Developers are also reporting that financial institutions are recognising the enduring value of eco-conscious initiatives and have begun to offer favourable financing options to companies that demonstrate that they have incorporated ESG considerations into their corporate strategies. This can allow developers to fund larger projects, or reduce the financial burden associated with the repayment of loans. Furthermore, in order to attain sustainability certifications, companies often have to optimise the performance of their assets. This optimisation often comes with increasing the efficiency of operations, both through energy usage reduction and more effective resource allocation. By increasing efficiency in this manner, companies often benefit from an increased Net Operating Income (NOI), which increases the value of assets when it comes time to dispose of them.
Ultimately, as companies become more sustainable, financial products invested in these companies will become more sustainable by proxy. This may allow for an increased number of number of funds with higher SDFR classifications, increasing the availability of opportunities for investors.
The Sustainable Financial Disclosure Requirements (SFDR) mark a significant step in aligning financial investments with sustainability objectives. As investors increasingly seek to allocate capital in line with their values, the SFDR provides a crucial avenue for enhanced transparency. The delimitation between Article 6, Article 8, and Article 9 funds enables investors incorporate the environmental, social, and governance characteristics of investment products into their capital deployment decisions.
The influence of the SFDR framework extends beyond immediate disclosures and is in the process of driving a shift in the overall financial landscape. Whilst the adoption of SFDR classifications by funds remains voluntary, an increasing demand for sustainable investments may incentivise fund managers to prioritise the attainment of sustainability credentials to cater to evolving investor sentiments.
As the market is trending towards more eco-conscious practices, companies are reaping benefits through enhanced asset performance, favourable financing options, and improved property values. Additionally, as companies embrace sustainability, the financial products invested in them are poised to become inherently more sustainable, expanding the universe of investment opportunities.
As sustainability principles continue to intertwine with financial reporting, the financial industry may witness a broader landscape of opportunities that align profit with purpose.