How the SFDR will disrupt the ESG landscape

The Sustainable Finance Disclosure Regulation (SFDR) may have a European focus, but its effects on environmental, social and governance (ESG) considerations will be far-reaching.

AlTi’s Chief Impact Officer Jed Emerson explains why this is a positive step in the evolution of ESG and its goals, even if there is still room for improvement.

The SFDR introduced a new reporting framework that makes it mandatory for any asset manager marketing products in the EU to disclose information about their ESG considerations.

The regulation is likely to have a significant—and positive—impact on the development of ESG in the coming decades. The SFDR brings greater clarity and consistency of language to a previously muddy set of issues, forcing asset managers to align with consistent terminology – which is what the asset-management industry needs to effectively communicate with investors regarding sustainability considerations.

We believe the SFDR will encourage countries outside the EU – including the US – to refine their own ESG reporting regulations as we move toward a global ESG framework.

We see this as an evolution and maturation of ESG, as global leaders come together to tackle pressing challenges such as global warming and the climate crisis. At AlTi, we are closely watching these developments as we integrate impact and ESG considerations within our own investment and business decisions. 

The meaning of the SFDR

First introduced in March 2021, SFDR reporting became mandatory for a wider range of products in January 2023 as it entered its level-two phase. The regulation applies to investment companies based in the EU and to investment managers outside the EU which market funds into the EU or provide portfolio management/investment advice services to EU firms which are themselves subject to SFDR.

The SFDR is raising the focus on sustainability metrics and reporting, supporting managers incorporating ESG considerations into their products and increasing the scrutiny on the corporate behavior of underlying companies within a portfolio.

The increased transparency will help investors make informed choices about supporting companies and projects with sustainability among their investing goals.

The regulation forms part of the EU’s wider Sustainable Finance Action Plan, which aims to encourage increased private funding into projects and investments that support a more sustainable economy.

Companies must report on factors ranging from carbon emissions, fossil-fuel exposure, and waste levels (E) to gender diversity and due diligence over human rights (S), and their record on exposure to corruption, bribery or other scandals (G).

There are three classifications within the SFDR:

• Article 6: ESG risk considerations are not integrated, or may be considered but not a focus
  
• Article 8: Products or investments with positive ESG characteristics, and which screen certain sectors, such as tobacco
  
• Article 9: Products or investments with ESG principles as their primary objective

Asset managers must now also detail how they are considering Principal Adverse Impacts (PAIs) that could have a negative impact on sustainability – for example, by investing in a company that produces significant carbon dioxide emissions or lacks gender diversity among board members.  

So, what does this mean?

At AlTi, we believe all capital and all companies have impact. ESG is simply one aspect of the impact created by firms and investors, and speaks to considerations of how environmental and social factors create risks for companies.

Analyzing and reporting on these risks – and understanding how they may, in turn, create positive or negative impacts on the world – are part of an informed process of understanding the extra-financial value of companies.

Therefore, analyzing and reporting on these metrics should apply to all investments and be of interest to all investors.

There are many aspects of the SFDR that we like:

• The standards apply to the whole market, including products, portfolios and financial advisors
• The standards help clarify terminology regarding ESG
• As the first regional-level framework, the SFDR serves as a baseline in establishing globally accepted ESG standards 
• The Article 9 classification will help investors ‘look through’ a manager to understand the social and environmental performance of underlying investments, reducing the risk of ‘greenwashing’

Of course, there are elements of the SFDR framework that could be improved:

First, the process of review and commentary has created some confusion in the financial market due to its complexity. There are many disclosure requirements for financial-market participants and advisors, which can be challenging to navigate as the standards evolve.

Second, the breadth of Article 8 – which should be seen as a minimum standard by the industry – is too broad to act as a differentiator. Some view it as a ‘catch-all’ category that spans too many approaches to ESG.

Despite these shortcomings, the overall impact of the SFDR is positive. As the framework evolves, these challenges should be resolved. The regulation is encouraging other nations to progress with plans to introduce their own ESG reporting standards, driving change and oversight of ESG issues worldwide.

In the UK, the Financial Conduct Authority will release Sustainability Disclosure Requirements later this year following an extensive consultation with the industry. In the US, the Securities and Exchange Commission is drawing up plans to require companies to disclose climate-related information and risks later this year. Other countries, including Australia and Japan, are looking at similar regulations.

Many companies, including AlTi, are already taking the lead and reporting on ESG factors voluntarily. At AlTi, we aspire to maintaining high standards of impact and ESG, consistent with the role we seek to play in our community, leading the way by supporting projects and companies that are making a real difference to the way we—and coming generations—live.  

As we evolve our reporting systems, we seek to be best in class in the creation of our reporting systems and discussion of our challenges. We seek to be vigorous in adhering to best practices and to aggregate data across all our custodians, including ESG and financial factors. Additionally, we work with MSCI ESG and ClarityAI to provide specific client-level reporting at the portfolio level. For clients with a sustainability and impact focus to their investment strategies, we produce a dedicated annual impact report outlining what their investments are supporting. And for those clients who do not think of themselves as “impact oriented”, we will seek to provide information on the impacts of their portfolios since, as a firm, we feel all investors should receive as complete information as possible with regard to the performance—both financial and extra-financial—of their investments.

In our own company, we hope to hit net zero and be carbon neutral by 2030 and are exploring what it might take for us to attain B Corps certification in the future. 

Our verdict

We believe the SFDR will pave the way to the creation of much-needed global ESG reporting standards, improve transparency in the financial-services industry and help investors make more-informed decisions regarding supporting sustainability and social change. Can it be improved? Yes. But it’s a good start!