The Sustainable Finance Disclosure Regulation (SFDR), established by the European Union in March 2021, is a key regulatory framework to promote transparency in sustainable investing. It sets strict guidelines for financial market participants to disclose information related to the environmental, social, and governance (ESG) characteristics of their financial products. The SFDR is integral in driving the shift towards more responsible and sustainable finance practices, as it provides investors with clear and comparable information to make informed decisions.  

Level 2 requirements, as outlined in the Sustainable Finance Disclosure Regulation (SFDR), are detailed provisions for disclosure and due diligence in financial markets. They mandate financial market participants to provide comprehensive information on how sustainability risks are integrated into their investment decision-making processes. Understanding them is crucial as they ensure companies meet transparency standards set by the SFDR, fostering trust and accountability in sustainable finance. Complying with these requirements aligns business practices with regulatory expectations and supports a sustainable financial ecosystem. 

In this article, we will explore the SFDR Level 2 requirements, key obligations for financial market participants, data collection and reporting standards, impacts on stakeholders, and provide case studies with practical examples of compliance. 

Understanding SFDR Level 2 Requirements 

Explanation of what Level 2 requirements entail 

Level 2 requirements under the Sustainable Finance Disclosure Regulation (SFDR) provide a more detailed and rigorous framework for transparency in the realm of sustainable finance. These requirements entail specific and technical standards for pre-contractual and periodic disclosures, designed to ensure that financial market participants thoroughly integrate and communicate sustainability considerations. Under Level 2, entities are obligated to disclose how sustainability risks are considered in their investment processes, the adverse impacts of investment decisions on sustainability factors, and how financial products align with sustainable objectives. 

The requirements aim to standardize sustainability reporting across the financial sector, promoting consistency and comparability. This involves providing detailed information on the methodologies used to assess the environmental and social characteristics of investments, as well as the governance practices in place to manage sustainability risks. By adhering to Level 2 requirements, financial institutions demonstrate a commitment to transparency and responsible investing, which is crucial for fostering investor confidence and facilitating the transition to a more sustainable economy.  

Purpose and scope of these requirements 

The purpose of Level 2 requirements is to enhance the understanding and transparency surrounding sustainable investments. They aim to foster a more responsible financial ecosystem by providing investors with relevant and reliable information on ESG factors. This enables them to make informed decisions that align with their values and contribute to achieving sustainability goals. 

These provisions apply to all financial market participants, including asset managers, financial advisors, and investment firms, who offer financial products in the EU. This includes both EU-based entities and third-country entities that market their products to EU investors. The scope of these requirements is broad, as they encompass all types of investments, from equity shares to bonds and real estate. 

Differentiation between Level 1 and Level 2 Requirements 

Aspect	Level 1 Requirements	Level 2 Requirements
Scope	Broad principles for sustainability	Detailed technical standards and methodologies for disclosure
Focus	High-level statements on sustainability	Specific and comprehensive integration of sustainability risks and factors
Disclosure	General disclosures	Detailed information on sustainability risk assessment, adverse impact, and alignment with sustainability objectives
Implementation	Initial framework	Stringent and standardized implementation across financial market participants
Compliance	First stage of compliance	Advanced and rigorous compliance requirements for deeper transparency
Target Audience	Investors and general public	Institutional investors, asset managers, financial advisors, and regulatory bodies
Regulatory Detail	Less prescriptive	Highly prescriptive with specific reporting formats and timelines

In summary, the key differences between Level 1 and Level 2 requirements under the SFDR are primarily centred around the scope, focus, and depth of disclosure. Level 1 requirements establish broad principles and high-level statements on sustainability, offering a general framework for sustainability disclosures. In contrast, Level 2 requirements are more detailed and prescriptive, mandating specific technical standards and methodologies to be used for comprehensive sustainability reporting. While Level 1 focuses on initial compliance with general disclosures, Level 2 necessitates advanced compliance with stringent and standardized implementation across financial market participants, ensuring deeper transparency and a more robust integration of sustainability risks and factors. 

Key Obligations under SFDR Level 2 Requirements 

In this section, we will delve into the specific responsibilities that financial institutions must fulfill, providing a clear roadmap for achieving the high standards set by the SFDR Level 2 requirements. 

Pre-contractual Disclosures 

Under the SFDR Level 2, financial market participants are required to provide pre-contractual disclosures that outline how sustainability risks are integrated into their investment processes and how they consider adverse impacts on sustainability factors. This includes a description of the due diligence procedures used to assess the environmental and social characteristics of investments, as well as information on how sustainability risks are integrated into the overall risk management framework. 

Periodic Disclosures 

In addition to pre-contractual disclosures, Level 2 requirements also mandate periodic disclosures on sustainability risks, adverse impacts, and alignment with sustainable objectives. These disclosures must be made at least annually and should include details on the methodologies used to assess sustainability factors and risks, as well as any changes to these methodologies. 

Financial market participants must also disclose the results of their sustainability assessment, including any significant negative impacts that arise from investments. They must also provide information on how they engage with investee companies to address any adverse impacts. Additionally, periodic disclosures should include a comparison of the performance of sustainable investments against their benchmarks. 

Transparency on Remuneration Policies 

SFDR Level 2 also requires financial market participants to disclose information on their remuneration policies and how they are in line with sustainability risks. This includes how variable remuneration is linked to the integration of sustainability risks and factors, as well as how this affects the overall risk profile of the entity. 

Publication of Sustainability Policies 

Under Level 2 requirements, financial market participants are expected to publish their policies on the integration of sustainability risks and adverse impacts. These policies should outline how they consider ESG factors in their investment decision-making processes and provide information on how they promote the sustainability of their investee companies. 

Impact on Stakeholders 

The SFDR Level 2 requirements will have a significant impact on various stakeholders in the financial industry. These include investors, asset managers, financial advisors, and regulatory bodies. 

Impact on Investors 

For investors, the SFDR Level 2 requirements provide a heightened level of transparency and detail, enabling more informed decision-making. Investors will have access to comprehensive pre-contractual and periodic disclosures that clearly outline how sustainability risks are integrated into investment strategies. This includes detailed assessments of environmental, social, and governance (ESG) factors, giving investors insight into the sustainability performance of their investments. 

Moreover, the mandated disclosure of sustainability policies and remuneration policies ensures that investors can evaluate how financial institutions align their incentives with sustainable practices. This level of transparency helps investors identify which financial products and institutions genuinely support sustainable development, allowing them to align their portfolios more effectively with their personal or institutional sustainability goals. 

Impact on Asset Managers 

For asset managers, the SFDR Level 2 requirements necessitate a robust integration of sustainability risks and ESG factors into their investment processes. This means that asset managers will need to adopt comprehensive due diligence procedures to evaluate the environmental, social, and governance characteristics of their investments. They must ensure that their investment strategies are aligned with the sustainability objectives outlined in the SFDR, and that these strategies are transparently communicated to investors through pre-contractual and periodic disclosures. 

Additionally, asset managers are required to regularly update and review their methodologies for assessing sustainability risks and impacts. This involves staying informed about the latest developments in sustainability standards and best practices, and ensuring that their evaluation criteria remain pertinent and effective. The periodic disclosures mandated by SFDR Level 2 provide an avenue for asset managers to demonstrate how they are addressing sustainability issues over time and the outcomes of their sustainability assessments. 

Impact on Financial Advisors 

For financial advisors, the SFDR Level 2 requirements introduce a need for enhanced knowledge and expertise in sustainability matters. Advisors must be well-versed in the sustainability risks and ESG factors that are integral to the investment products and financial instruments they recommend to clients. This includes understanding the detailed disclosures provided by asset managers and other financial market participants, enabling them to convey accurate and comprehensive information to investors. 

Financial advisors will need to adjust their advisory processes to ensure that they align with the enhanced transparency and reporting mandates. This involves incorporating sustainability considerations into client assessments and ensuring that the advice provided is consistent with each client’s sustainability preferences and investment objectives. By doing so, advisors can help clients make more informed and sustainable investment choices. 

Case Studies and Practical Examples 

Case Study 1: BlackRock’s Sustainability Integration 

BlackRock, one of the world’s largest asset managers, has been at the forefront of integrating sustainability risks and ESG factors into its investment processes. In response to SFDR Level 2 requirements, BlackRock has developed and published comprehensive policies on sustainability risk integration and adverse impacts. These policies are accessible to the public and detail the methodologies used to evaluate ESG factors, the engagement processes with investee companies, and how sustainability considerations are factored into investment decisions. 

As part of its periodic disclosures, BlackRock provides detailed reports on the sustainability performance of its funds, comparing them against appropriate benchmarks. The company also discloses significant negative impacts observed in its investments and outlines the corrective actions taken in collaboration with the investee companies. This level of transparency helps investors understand the effectiveness of BlackRock’s sustainability strategies and the real-world impact of its investments. 

Case Study 2: Allianz Global Investors’ ESG Reporting 

Allianz Global Investors (AGI) has embraced SFDR Level 2 by enhancing its ESG reporting and disclosure framework. AGI has implemented a detailed policy on integrating sustainability risks, which includes specific criteria for assessing environmental, social, and governance factors. This policy is regularly updated to reflect the latest industry standards and best practices in sustainability. 

AGI’s periodic disclosures are notable for their comprehensive nature, providing investors with in-depth information on the ESG performance of its investment portfolios. These reports include the methodologies used for ESG evaluation, the results of sustainability assessments, and how the investments align with the firm’s sustainability objectives. Additionally, AGI discloses information on its remuneration policies, highlighting how they encourage the integration of ESG factors into investment decision-making and risk management processes. 

Conclusion 

The SFDR Level 2 requirements represent a significant shift towards greater transparency and accountability in the financial industry. By mandating detailed disclosures on how sustainability risks and ESG factors are integrated into investment strategies, these regulations aid investors in making informed decisions that align with their sustainability goals. Asset managers and financial advisors must now adopt more rigorous procedures and enhance their expertise to comply with these requirements, ultimately fostering a more sustainable and responsible investment landscape. Through real-world examples like those of BlackRock and Allianz Global Investors, we see the potential for these regulations to drive meaningful progress in sustainability practices across the financial sector. 

 

Sources: 

[1] Preparing for Level 2 of SFDR 

[2] SFDR Level 2 enters into force: everything investors need to know