Since its implementation in 2021, the Sustainable Finance Disclosure Regulation (SFDR) has become a fundamental component of the European Green Deal’s Sustainable Finance Action Plan, aiming to enhance transparency and accountability across financial institutions. However, the implementation of the SFDR introduces complexities, particularly in the interpretation and application of "good governance" standards for classifying financial products. Challenges such as keeping pace with regulatory developments and guidelines from authorities, coupled with ambiguous definitions and unclear criteria under the SFDR, significantly impact many financial market participants, particularly private equity investment firms. These complexities increase the risk of non-compliance and heighten the potential for accusations of "greenwashing." This article addresses common issues and provides practical guidance for them.

THIS ARTICLE IS WRITTEN BY SUZANNE DE BOER ([email protected]) AND SEFA GECIKLI ([email protected]). SUZANNE AND SEFA ARE BOTH PART OF RSM NETHERLANDS BUSINESS CONSULTING SERVICES WITH A SPECIFIC FOCUS ON SUSTAINABILITY.  

Background of the SFDR and Good Governance Assessment 

The SFDR came into effect in 2021 and stands as a core pillar of the European Green Deal’s Sustainable Finance Action Plan.  It facilitates transparency and comparability among financial institutions and their financial products by requiring disclosures of relevant sustainability information. The SFDR sets out the framework principles reflecting the key obligations, which is commonly referred to as a ‘Level 1’ Regulation. The SFDR thus contains different delegations to the European Commission to flesh out the technical implementing details in so-called ‘Level 2’ Delegated Acts, based on the advice of the European Supervisory Authorities (‘ESAs’). In this context, the framework for obligations, interpretation, and implementation of the SFDR is structured around three main components:

  • Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector (SFDR)
  • Commission Delegated Regulation (EU) 2022/1288 of 6 April 2022 supplementing Regulation (EU) 2019/2088 of the European Parliament and of the Council regarding regulatory technical standards
  • Consolidated questions and answers (Q&A) by ESAs on the SFDR (Regulation (EU) 2019/2088) and the SFDR Delegated Regulation (Commission Delegated Regulation (EU) 2022/1288)

We observe that many financial market participants and financial advisors have based their policies and compliance strategies solely on the Level 1 Regulation, failing to keep up with subsequent regulatory developments (Level 2) and the guidelines of the authorities. This oversight poses significant risks of non-compliance. In the Regulation, a key distinction made in transparency requirements is the separation of entity level disclosures from product level disclosures. Under this regime, the SFDR distinguishes between: 

  • financial products with environmental or social characteristics (falling under Article 8), 
  • financial products that aim for sustainable investments (falling under Article 9), and 
  • funds that do not have sustainable characteristics (based on the obligations under Article 6 and no additional requirements apply). 

The separate product categories are important in determining which transparency obligations must be met. 
For financial market participants, particularly private equities aiming to classify their funds under Article 8 and 9, in addition to the other criterion, there is another requirement: their investee companies must follow good governance practices.

This represents one of the aforementioned complexities:  the criteria for “good governance” are somewhat ambiguous as the SFDR does not explicitly define the term. This lack of clarity leads entities to struggle with compliance, potentially exposing them to the risk of unintentional "greenwashing" allegations. Reflecting this risk, regulatory bodies have raised concerns; for example, the Dutch Authority for the Financial Markets (AFM) has conducted thorough survey and noted that the information provided under Articles 8 and 9 often lacks depth and specificity. To address these challenges and ensure compliance, in-scope entities should have a clear understanding of all components of this regulatory framework.

Pathway to compliance

As stated in the Q&A document by ESAs, there is no definite criteria for “good governance assessment”. ESAs states that the SFDR does not explicitly define nor set out minimum requirements that qualify concepts such as contribution or good governance. However, the SFDR provides examples within the context of "sustainable investment" that can guide the criteria for good governance: “the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.” Financial market participants must carry out their own assessment for each investment and disclose their underlying assumptions.

The complexity then is how to assess these four fundamental components of good governance. ESAs provide some guidance here, suggesting that UN Global Compact, OECD or ILO principles, which is not prescribed in the Regulation, could form part of the “policy to assess” the management structures, employee relations, remuneration of staff and tax compliance.

Based on these guidelines, in-scope entities should develop a policy to assess the good governance practices of their investee companies. This assessment should at least cover the four components exemplified in the Regulation. To define concrete criteria for this assessment, entities may benefit from incorporating principles from the UN Global Compact, OECD, or ILO. When crafting the policy, it is crucial to consider the size, geographical location, and risk appetite of the investment portfolio to ensure the policy is appropriately tailored. Additionally, as part of their pre-contractual disclosure obligations, entities should publish this policy. The policy must strike a balance: criteria that are too lenient may lead to allegations of greenwashing, whereas overly stringent criteria without consideration of the portfolio's size and nature may make achieving Article 8-9 classification impossible.

Addressing another complexity, it is mandatory for the in-scope entities to consistently apply this policy and demonstrate how investee entities meet the established criteria under it properly. Furthermore, the recitals of the SFDR imply that the assessment of these criteria should be integrated at the point of making investment decisions. Thus, investee entities must comply with the criteria outlined in the policy for assessing good governance practices at the time of acquisition or investment to qualify for classification under Article 8 or 9. Otherwise, financial market participants should classify entities that fail to meet the criteria under SFDR Article 6. Subsequently, they could secure commitments from investee entities to meet the criteria over time, facilitating this through an engagement policy. Once these criteria are met, the products could be reclassified as Article 8 in periodic disclosures. These critical requirements are often overlooked, as indicated by our observations; in such cases, the investee entity is classified under Article 8 at the time of investment-decision, with the expectation that it will fulfil the accompanying obligations over time.

Forward Thinking

Looking ahead, financial market participants, particularly in sectors like private equity, must ensure that their policies set up under the SFDR are dynamically adapted to the evolving regulatory landscape and the specific characteristics of their investment portfolios. Regular engagement with regulatory bodies and participation in industry discussions can help entities stay informed of best practices and emerging expectations.

As the market evolves, the role of disclosures will become increasingly central in mitigating risks such as greenwashing. Entities must therefore be proactive in demonstrating their compliance through clear policies and transparent and detailed reporting. This approach will not only safeguard them against potential non-compliance and reputational risks but will also enhance their capacity to contribute meaningfully to the broader objectives of the European Green Deal.

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