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How will the EU's SFDR sustainability rules work?

How will the EU's SFDR sustainability rules work?
Photo by Anton Klyuchnikov from Pexels

Europe’s action plan on sustainable finance will accelerate the mobilisation of green finance and reinforce EU leadership in this area by being an example for regulators across the world that are looking at a standardised approach.

Despite the challenges, the goal is to build a greener, more sustainable future, but it cannot be done without the weight of financial market participants being fully committed.

Today, country and corporate carbon reduction plans are still far short of the 1.5C target under the Paris agreement. There is a need for a further $1.6tn (£1.2tn) to $3.8tn a year to finance the energy transition.

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What’s more, Covid-19 has exacerbated socio-economic inequalities. Private investment is needed to fund the transition to a climate-neutral and fair economy, complementing capital already committed by governments.

But mobilisation of the financial sector is underway. Cop26 saw 450 financial institutions, representing $130tn in capital, committing to transforming the economy and achieving net zero by 2050.

Indeed, new sustainable finance legislations are proliferating. One is the 2018 EU action plan on sustainable finance; it aims to see the EU carbon neutral by 2050. The action plan applies to asset managers, pension funds, EU banks and insurers, among others.

Asset managers should welcome this initiative because it provides clarity and transparency on a range of sustainability measures to investors, financial institutions, businesses and issuers, helping them make informed decisions on sustainable investment.

Potential of the EU plan

The EU action plan is a series of policy building blocks that together build a favourable environment for sustainable investments. The building blocks, with different implementation deadlines, are:

1. EU taxonomy regulation

This determines which economic activities are environmentally sustainable. It helps investors, companies and policymakers identify activities that are deemed to make substantial contributions to environmental objectives and which help to finance the transition to a more sustainable economy.

The EU taxonomy defines criteria for a given activity to reach one environmentally sustainable objective, such as climate mitigation, but also to not significantly harm any other objective, such as the protection of biodiversity.   

2. The corporate sustainability reporting directive (CSRD)

This amends the existing non-financial reporting framework, extending the scope to all large companies and all listed companies, requiring additional third-party verification, and additional reporting requirements.

This is based on the 'double materiality' principle: a company shall disclose the environmental, social or governance factors that can materially impact its value and how the company impacts the environment, social matters or human rights.

3. The sustainable finance disclosure regulation

This supplements current rules governing the public disclosures of financial products. Managers have to disclose the sustainability risks of their investment process; the metrics used to assess ESG factors; the objective in terms of sustainable environmental and social investments; and how investment decisions reached these objectives and took into account the principal negative effects on sustainability factors.