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EU Sustainable Finance Disclosure Regulation: The integration of Environmental, Social and Corporate Governance

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The European Parliament and the Council of the European Union has implemented, from 10th March 2021, the Sustainable Finance Disclosure Regulation (“SFDR”) with direct effect on the Member States. The SFDR introduces the key requirements on Environmental, Social and Governance (“ESG”) and lays down harmonized rules with regard to the integration of sustainability risks, such as an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment. Moreover, it takes into consideration adverse sustainability impacts in their process and the provision of sustainability-related information with respect to financial products. ESG factors can have impact on the planet, be people-related elements and/or corporate governance issues, such as bribery and corruption. The investment services and asset management have a direct impact and must comply with the provisions of the SFDR regulation as these are analysed in simple terms in the present article.

When we are referring to a sustainable investment it means an investment in an economic activity that contributes to an environmental objective as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, as well as on the production of waste and greenhouse gas emissions, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices. Financial market participants and advisers include, among others, investment firms and investment funds.

As per the provisions of Article 3 of SFDR, financial market participants and advisers must publish, on their websites, information about their policies on the integration of sustainability risks in the investment decision-making process and in their investment advice. Article 4 of SFDR lays down the requirements of transparency of adverse sustainability impacts at entity level. Financial market participants, such as Cyprus Investment Firms (CIFs) providing portfolio management, Alternative Investment Fund Manager (AIFM), or the management company of an undertaking, for collective investment in transferable securities (UCITS management company), must publish and maintain, on their websites, statements on due diligence policies with respect to adverse impacts of investment decisions on sustainability factors (i.e. environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters). Such statements must take into account the size, nature and scale of their activities as well as the types of financial products they make available. Financial products may include a portfolio managed by a CIF, an Alternative Investment Fund (“AIF”) or a UCITS. Such information must include at least the following:

  • Information about the financial market participants’ policies on the identification and prioritisation of principal adverse sustainability impacts and indicators;
  • A description of the principal adverse sustainability impacts and of any actions in relation thereto taken or, where relevant, planned;
  • Brief summaries of engagement policies in accordance with Article 3g of Directive 2007/36/EC, where applicable;
  • A reference to the financial market participants’ adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement adopted under the United Nations Framework Convention on Climate Change which was entered into force on 04th November 2016.

In the event financial market participants, as defined previously, do not consider adverse impacts of investment decisions on sustainability factors, they should publish and maintain, on their websites, clear reasons for not doing so.

Financial advisers such as CIFs/AIFM/UCITS providing investment advice, must publish and maintain, on their website, information as to whether they consider in their investment advice the principal adverse impacts on sustainability factors, taking into account their size, nature and scale of their activities and the types of financial products on which they advise. In the event the financial advisers, as defined above, do not consider adverse impacts of investment decisions on sustainability factors in their investment advice, they shall publish, on their website, information for why they do not do so, including information as to whether and when they intend to consider such adverse impacts, where relevant.

According to Article 5 of the SFDR, financial market participants and financial advisers must include in their remuneration policies information on how those policies are consistent with the integration of sustainability risks and shall publish that specific information on their websites. Article 6 of the SFDR lays down the transparency of the integration of sustainability risks. Financial market participants shall include, in pre-contractual disclosures descriptions,  the manner in which sustainability risks are integrated into their investment decisions as well as the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available. In the event a financial market participant deems sustainability risks not to be relevant, then they shall include descriptions as to the reasons that such risks are deemed irrelevant. The same also applies to financial advisers. Financial advisers must include, in pre-contractual disclosures, the manner in which sustainability risks are integrated into their investment advice as well as the result of the assessment of the likely impacts of sustainability risks on the returns of the financial products on which they advise. In the event the financial advisers deem sustainability risks not to be relevant, then such descriptions must be disclosed explaining the reasons thereof.

The information to be disclosed, as referred above, must be disclosed to the investors in accordance with the provisions of the applicable laws. For example, in the event where the financial market participant and/or financial adviser is an AIFM, the AIFM for each of the EU AIFs they manage and for each of the AIFs they market in the European Union must make available to the AIF investors, the said disclosures before they invest in the AIF. UCITS management companies for example, either acting as a financial market participant or as a financial adviser, must disclose such information in their prospectus.

 Article 7 of the SFDR law applies more analytical requirements on financial market participants. By December 2022 financial market participants will have disclosed information for each financial product they make available. Such information must include clear and reasoned explanation of how a financial product considers principal adverse impacts on sustainability factors. In addition, a statement that information on principal adverse impacts on sustainability factors is to be made available in the information to be disclosed on the financial market participants’ annual or periodic reports as per the provisions of the applicable laws. The reporting obligations will apply from 1st January 2022.  The financial market participant must include a statement with the reasons, where it does not consider the adverse impacts of investment decisions on sustainability factors, for each financial product they make available.

The risks and impacts of the climate change as well as other ESG factors pose risks to the financial sector and to financial stability. Responsible investments have a significant impact in improving environmental degradation and social inequality, which in effect contributes to achieving long-term financial and economic activity. The financial industry will face challenges as the incorporation of ESG factors into the asset selection and risk management process requires relevant expertise, analytical capabilities and data availability. Financial market participants and/or financial advisers might not be able to appreciate the impact of responsible investments to their long-term performance or might not have access to reliable and comparable ESG related data. ESMA and the competent authorities must educate the affected parties and provide the required feed for the ESG implementation.

The content of this article is valid as at the date of its first publication. It is intended to provide a general guide to the subject matter and does not constitute legal advice. We recommend that you seek professional advice on your specific matter before acting on any information provided. For further information or advice, please contact Stephanos Ayiomamitis, Senior Associate at Tel: 25 363685 or via email at stephanos.ayiomamitis@kyprianou.com