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SFDR: The Anti-Greenwashing Acronym You Need to Know
If you’re working on or investing in the energy transition, you’ve probably heard of ESG. While ESG has received criticism in recent months, it's not going away. In fact, a new ESG regulation is on the horizon that will meaningfully impact the way most investors do business. It’s called the Sustainable Financial Disclosure Regulation (SFDR). With the imminent implementation of SFDR, sustainability disclosure will now become mandatory for funds in the EU, as well as for funds — and this is crucial — that market to EU investors. Essentially, funds will need to clearly disclose what their sustainability goals are and will be classified in three categories depending on those objectives. This will create headaches for many. But for some — including investors and entrepreneurs operating in the climate space — SFDR will create meaningful opportunities.
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What is SFDR?
The SFDR is “a European regulation introduced to improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants.” Put simply, a fund will be classified as an Article 6, 8, or 9 fund depending on its sustainability objectives. Principle Adverse Impacts (PAIs) are the fancy name given to the KPIs that must be tracked at the fund level if you are seeking a sustainability designation (Article 8 or 9). The diagram below attempts to distill a 200 page regulatory document that outlines requirements for each of these labels, so of course we are now obligated to suggest that you do your own research, consult your attorney, etc.
Note: If Article 6 funds choose not to track PAIs, they must disclose why they choose not to consider sustainability in their investment process.
What does this mean for investors?
SFDR is designed to drive convergence in how funds describe themselves with respect to sustainability. This should reduce confusion in the market and make greenwashing much more difficult. For allocators (e.g., pension funds, university endowments, etc.), this will make it easier to steer capital towards fund managers that are truly aligned with the allocator’s investment objectives.
For managers of capital (e.g., venture capital, private equity, etc.), SFDR is yet another regulation and therefore yet another compliance challenge. But, for those funds that are already incorporating sustainability into their investment process, SFDR is also a great opportunity. By reducing greenwashing, SFDR will make it easier for funds that think and act sustainably to further stand out from the crowd.
If you manage a fund that markets to EU investors, you are probably already planning for SFDR. But if you haven’t started, now is the time. Though there is still some uncertainty in how these new regulations will be implemented, we know that funds identifying as Article 8 or Article 9 need to track PAIs from January 2023 onwards. A good first step is consulting knowledgeable counsel about SFDR. You’ll also want to make sure your team is aligned around your approach to sustainability and has a process in place for collecting the required data.
What does this mean for entrepreneurs?
Know your worth. As an impact or climate change entrepreneur, you have the opportunity to help investors and funds position themselves favorably to the market. Tides are shifting, and if your business has an underlying social or environmental thesis, you will be in high demand as SFDR regulations take effect.
Target like-minded funds. As you pitch to investors, be mindful of what their investment thesis is, and how aligned you are with that thesis — they are now subject to regulation and must disclose to the best of their knowledge their social and environmental impacts.
Arm yourself with data. If you’re intimidated by the prospect of putting in place a full-fledged ESG data collection program, you’re not alone. But collecting basic ESG data will help you demonstrate to prospective investors your commitment to sustainability. Start small, with data points that specifically tell the story of the impact you’re having.
Is another acronym really the answer?
SFDR is not the first EU regulation with global implications. If your business collects personal data of any kind, you’ve experienced the pain of complying with the General Data Protection Regulation (GDPR). While it is debatable whether GDPR has meaningfully advanced the cause of data privacy, it is clearly the case that GDPR has gone well beyond the EU borders and impacted nearly all businesses with an online presence.
So it will go with SFDR. Though nominally focused on European investors, it will undoubtedly have global reach given the amount of investment capital flowing across borders. It’s also inspiring similar regulations elsewhere. The U.S. Securities and Exchange Commission and the U.K. Financial Conduct Authority have their own proposals in the pipeline.
The interesting question is whether SFDR will accomplish its goal of reducing greenwashing. So far, nothing has done the trick. But there’s something compelling about the simplicity of the SFDR framework, as well as its specificity around data collection. The bottom line: SFDR is good news for those among us who are hoping for an end to greenwashing. But it’s going to take work.
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