Navigating EU Sustainable Finance Legislation: A Focus on the SFDR and the CSRD

Author: Rebecca Galea

The European Green Deal is a suite of policies and legislation designed to put the European Union on a path towards green transition. Key components of the Green Deal include, inter alia, the Sustainable Finance Disclosure Regulation (the ‘SFDR’) and the Corporate Sustainable Reporting Directive (the ‘CSRD’)[1] which will build on the existing Non-Financial Reporting Directive (the ‘NFRD’). While SFDR and CSRD share common environmental, social, and governance (ESG) goals, they have different scopes, objectives, and requirements.

Scope, Objectives, Requirements and Penalties of the SFDR and the CSRD

The SFDR obliges Financial Market Participants (‘FMPs’)[2] and Financial Advisers (‘FAs’)[3] to disclose how they incorporate sustainability risks into their investment decisions and investment / insurance advice, their approach to the way they consider negative sustainability impacts and whether a financial product promotes environmental or social characteristics, both at entity level and at product level. This ensures that investors are well-informed about the sustainability risks affecting the value of their investments and the ESG impact of those investments. Such disclosures under the SFDR are to be made both at the precontractual stage and during the ongoing relationship of the investors with the FMPs and FAs.

The CSRD has extended the reporting obligations under the NFRD to ‘large companies’[4] and listed small and medium-sized enterprises (‘SMEs’) within the EU. The goal is to improve and standardize corporate sustainability reporting by requiring the companies that fall within the scope of the directive to disclose information on their environmental and social impacts, as well as governance practices. Together with the European Sustainability Reporting Standards (the ‘ESRS’)[5], the CSRD enhances the consistency, comparability and transparency of the sustainability disclosures of companies. These standards allow entities covered to be benchmarked against each other, making it easier to assess the quality of their sustainability reporting.

As the CSRD is an EU Directive and not an EU Regulation such as the SFDR, it needs to be transposed by all the EU Member States and thus discrepancies in the laws of EU member states are likely to arise due to different interpretations.

It is interesting to note that the penalties under the CSRD and SFDR differ in scope and enforcement.  Whilst SFDR penalties focus on breaches related to the transparency of information in financial products and services such as not disclosing how sustainability risks are integrated into investment decisions and not providing clear information about sustainable investment objectives (“greenwashing”), CSRD penalties target companies that fail to report required sustainability information, which report inaccurate or misleading information and companies that fail to adhere to the ESRS.

On a separate note, the provisional political agreement between the Council and Parliament on ESG rating activities marks an important step towards implementing the ESG Rating Regulation. This initiative seeks to enhance the transparency, reliability, and consistency of ESG ratings. By mandating that ESG rating providers (ERPs) be authorized and supervised by the European Securities and Markets Authority (ESMA), and that they disclose their methodologies, data sources, and the reasoning behind their ratings, the regulation will offer companies and investors greater clarity on how ESG scores are determined. This is especially relevant given that a positive ESG rating may in turn result in better financing opportunities, lower borrowing costs, and increased investment interest from ESG-focused funds, enhancing a company’s reputation and market competitiveness.

It is important to recognize that the SFDR and CSRD are complementary rather than mutually exclusive, as they both aim to provide investors with the necessary data to make well-informed investment decisions.

Ultimately, the overlap between the CSRD and SFDR creates potential issues due to inconsistencies in definitions, terminology, and reporting standards. This misalignment may lead to data gaps and discrepancies between the two frameworks, potentially resulting in a lack of overall compliance and undermining the effectiveness of the EU’s sustainable finance objectives.

Summary Report of the Open and Targeted Consultations on the SFDR Assessment

To this end, the EU Commission conducted a consultation between September 14th and 22nd December 2023, to identify issues with the SFDR’s implementation. The report highlighted challenges in aligning SFDR and CSRD, particularly due to the differing terminology and definitions. Respondents also noted significant ESG data gaps, especially for entities which were not covered by the CSRD at the time.

The report highlights ongoing debates regarding Principle Adverse Impact (PAI) reporting, with concerns over the misalignment between the SFDR and ESRS frameworks, which complicates implementation and increases costs. Some advocate for simplifying and aligning entity-level disclosures to avoid duplication, while others question whether all financial products should be subject to the same disclosure requirements. There is growing support for an EU Categorization System to help investors better understand and compare sustainability claims, addressing concerns over inconsistent and burdensome reporting standards.

It will be interesting to observe how this chain of events unfolds, particularly in relation the   identification and prevention of greenwashing claims by the designated regulatory authorities in each Member State. As regulatory frameworks and market practices continue to evolve, it will also be intriguing to assess how the transposition of these new standards is implemented across Member States, shaping the future of ESG reporting across the EU.

[1] Deadline for transposition into Maltese law was 6 July 2024.

[2] ‘financial market participant’ means: (a) an insurance undertaking which makes available an insurance‐based investment product (IBIP); (b) an investment firm which provides portfolio management; (c) an institution for occupational retirement provision (IORP); (d) a manufacturer of a pension product; (e) an alternative investment fund manager (AIFM); (f) a pan‐European personal pension product (PEPP) provider; (g) a manager of a qualifying venture capital fund registered in accordance with Article 14 of Regulation (EU) No 345/2013;

(h) a manager of a qualifying social entrepreneurship fund registered in accordance with Article 15 of Regulation (EU) No 346/2013; (i) a management company of an undertaking for collective investment in transferable securities (UCITS management company); or (j) a credit institution which provides portfolio management.

[3] ‘financial adviser’ means: (a) an insurance intermediary which provides insurance advice with regard to IBIPs;

(b) an insurance undertaking which provides insurance advice with regard to IBIPs; (c) a credit institution which provides investment advice; (d) an investment firm which provides investment advice; (e) an AIFM which provides investment advice in accordance with point (b)(i) of Article 6(4) of Directive 2011/61/EU; or (f) a UCITS management company which provides investment advice in accordance with point (b)(i) of Article 6(3) of Directive 2009/65/EC.

[4] A ‘large company’ is one that meets at least two of the following criteria: a balance-sheet total of more than €20 million; a net turnover of more than €40 million; and more than 250 employees in the financial year.

[5] These are standards developed under the CSRD to standardize how companies in the EU disclose info related to ESG factors.