Mastering SFDR: Strategies for Seamless Compliance

Welcome and introductions

Good morning and good afternoon, everyone. Thank you for joining today's webinar. Today we will be discussing how to master the EU's Sustainable Finance Disclosure Regulation, also known as SFDR. We'll talk about strategies for seamless compliance, deep diving into some of the nuances of SFDR, and really sharing insights and actionable strategies to ensure that your organization is not just compliant but really ahead of the curve when it comes to this regulation.

Today's session is brought to you by Pulsora. We also are here with our guest speaker from Kirkland & Ellis. So I would like to start off today's webinar with just a brief introduction on who we have on today's call.

Today we have Rhys Davies from Kirkland & Ellis. Rhys is a partner in the ESG and impact practice group in the London office of Kirkland & Ellis. You can see by his background he's based in London. Thanks so much for joining us today, Rhys. Rhys has more than 15 years experience in ESG, including advising private equity firms, public companies, and project sponsors in relation to the design and implementation of ESG strategies. So great to have him here today and really give us some insight into SFDR.

We are also joined by Maddie Foote. Maddie leads our global sustainability regulation practice here at Pulsora. She's a really critical member of the team that helps build out our platform to ensure our partners and our customers are compliant with the regulation, but also makes sure that the product is built out to comply with these regulations.

My name is Nicole Peerless. I run Business Engagement at Pulsora and I'm a member of the leadership team. I have about 15 years of private markets practice, so super interested in today's discussions, looking at how these private capital market companies are addressing SFDR.

SFDR 101: what the regulation is

Let's get started. Rhys, perhaps at the top of the call we could start with a little bit of what I would call an SFDR 101.

Certainly. Thanks, Nicole. Happy to, and thanks for having me on the session today. The SFDR, the EU's Sustainable Finance Disclosure Regulation, forms part of the EU's ambitious sustainability and sustainable finance agenda and serves a number of objectives.

First, and perhaps foremost, it is focused on strengthening the protection of end-investors and ensuring that there is transparency and full disclosure as to the particular characteristics of individual financial products. That's equally targeted towards both individual or sophisticated investors, but also retail investors as well. We can get a little bit more into the mechanics of that later in the session.

It's not all about transparency, though. It's not all about disclosure. SFDR forms part of an aggressive, if I can call it that, agenda on the part of the European Union to really green the economy, a key part of which is driving capital towards sustainable investments, and investments that are promoting broader environmental and social objectives aligned with the bloc's objectives and its agenda through to 2030 and beyond.

Equally, there are some measures embedded in SFDR which are targeted towards the specific way in which fund managers operate, ensuring not just transparency but a degree of consistency in approach, and a base set of requirements in relation to the sorts of things that are taken into account in governance, in risk management, in remuneration. So really greening, if you like, some of the inner operations of fund managers as well.

Disclosure architecture: firm level and product level

In terms of some of the mechanics of SFDR, for those who aren't familiar with it, there are primarily two distinct categories of disclosures: those which apply to fund managers in certain circumstances, and those which apply to the individual financial products, the funds themselves.

It's important to note at the outset that, strictly speaking, SFDR applies only to fund managers and funds who enter the European market by specific mechanisms. In relation to products, for example, it's applying only to those funds that are marketed into Europe in a particular way. Equally from a firm-level perspective, particularly if you are a non-EU manager, it is only if you enter the European market in a particular way that you are potentially within the ambit of those disclosures.

If we put those technicalities to one side, in terms of the architecture, what we have at the firm level are three core requirements. The first is to describe the way in which sustainability risks are integrated into the investment process. Sustainability risks is a particular term of art under SFDR, but it essentially translates to the more common concept of ESG risks, so risks related to environmental, social, and governance matters which have the potential to have a financial impact. So it's that quite traditional formulation of ESG risk we're thinking about there.

SFDR is ultimately a disclosure regime, so it won't tell you what to do. You don't have to necessarily take sustainability risks into account in a particular way. What you do have to do is explain how you do it. It's analogous to a number of other regimes we see in the corporate governance and regulatory worlds where it's effectively a comply-or-explain mechanism. If you think, for whatever reason, that you don't need to take sustainability risks into account, perhaps you can't, then there's a need to explain why that's the case.

The second item relates to another term of art under SFDR, which is principal adverse impacts. That essentially refers to a particular set of negative externalities. If as a firm you take those into account, there's a requirement to disclose those in a particular way and disclose associated quantitative and qualitative metrics.

The final piece relates to remuneration policies. That largely relates to fund managers specifically, but that is another key component in those firm-level disclosures.

Article 6, 8, and 9 explained

The ones that then seem to get a bit more attention are the product-level disclosures. For those who are at all familiar with SFDR, you'll know that there are three categories, if I can call them that. The European regulators have been very clear that these are not labels. They are simply disclosure categories.

In addition to the numbers of the particular provisions that feature in SFDR, Article 8, Article 9, and Article 6, you will sometimes hear the language of light green and dark green attributed to those products. That's been discouraged by regulators and certainly is not the sort of thing we would encourage funds to use in marketing materials. But you will see those reported in news articles, used in public discourse, so it's helpful to understand exactly what those references are.

Just in terms of those three categories: funds that disclose under Article 6 are funds or products that are only considering sustainability risks. So they're taking ESG into account in a fairly conventional way. They could be applying quite light-touch ESG integration measures, or more expansive ESG integration measures. Again, SFDR won't tell you what to do, but it's very much that conception of approaching ESG factors with reference to potential financial impacts and disclosing the approach.

If we look at Article 8, this is where we start to get into products which actively promote environmental and social characteristics. SFDR is very strategy-agnostic. The different sorts of strategies that might be employed include an exclusion mechanism, a screening mechanism, positive or negative. A theme might be employed. Individual environmental and social attributes might be identified. There's no one way to do it, and the regulation doesn't prescribe that. But if that is part of the approach, there's a requirement to disclose exactly what those characteristics are, exactly how they're measured, both at inception and on an ongoing basis, and to disclose some of the methodology and the other binding measures around that.

The third piece, Article 9, is products that have a sustainable investment objective. Here we're thinking of products and funds that are pursuing a particular environmental or social outcome, and they're doing so in a way that they're making a commitment that their investments will have no negative externalities in addition to contributing to an environmental or social objective.

There tends to be perhaps a misconception that an impact fund, for example, should always be in Article 9. That's certainly not true. Impact funds can sit in either Article 8 or 9 depending on their approach. The sorts of things we tend to commonly see at the moment in Article 9, in certain segments at least, are funds in the pure-play renewable space, where there's quite an easy narrative to say, "We are mitigating climate change through investments in renewable energy projects and associated assets." That's the sort of thing that fits quite neatly into Article 9.

Q&A: examples of Article 6, 8, and 9 products

Thank you, Rhys. We've got an active audience, so we have a question in the Q&A from Maria. The first question is: there is news that the EU is considering the current product-level disclosures. Can you comment on that?

Yeah, absolutely. We will be covering this in a bit more detail a little later in the session. Suffice to say that SFDR has been the subject of a number of different consultations, even over the course of the past 12 months. For those that have been watching the news, they might have seen most recently that the European Commission has published a survey, a targeted and public consultation, in relation to a number of measures around SFDR, including whether the disclosure categories should remain as they are. There was prior consultation in relation to the form of the disclosures. We'll tackle that point pretty comprehensively a little bit later on. But yes, it certainly continues to be a fluid environment.

Great. Another question came up in the chat: can you provide some specific examples of products that fall under Article 6, 8, and 9?

Sure, happy to. The first thing I'd say is, we always need to keep in the back of our mind that this is a disclosure regulation, and it in no way, shape, or form dictates the strategy. So the starting point is always to say, "If I have a fund, what is my existing strategy? Does it focus on ESG solely for risk management purposes in the financial sense? Do we focus on one or two elements in a way that is intentional and additional? Do we have an overarching objective that sits over all of our investments and is very much integrated into the investment objective?"

Those are the sorts of questions we would usually ask to try and get a sense of, based on the ESG strategies you've just described, you would most likely disclose under 6, 8, or 9. It's important not to start with the category in mind. You first say what the strategy is and then match it to the disclosure category.

Article 6 is anything that's taking ESG risk into account in any way and integrating it into the decision-making process, but doesn't go so far as to think about additionality and intentionality. Article 8 might be a buyout fund that had an additional emphasis on reduction of greenhouse gas emissions across the portfolio, and encouraged portfolio companies to reduce their greenhouse gas emissions over the course of the hold period. Or they could do the same with criteria in relation to a range of social factors.

Article 9 could be the example I mentioned before: a pure-play renewable strategy, or a high-ambition impact fund. The key distinguishing characteristic there is that singular sustainable investment objective that sits alongside the financial objectives, and that will apply across the board to all investments.

It's different in Article 8, where you can have a couple of characteristics and apply them to any proportion of the investments. You might say, "We are a buyout fund and we will commit to a minimum 50% of our portfolio trying to bring down their greenhouse gas emissions over the course of the hold period." You can do that in Article 8. If you're doing 100%, then maybe you should be thinking about Article 9.

Healthcare investments and category selection

That dovetails to the latest question in the chat, which was: can funds that are investing in healthcare only, in brackets, social impact, be categorized as Article 9 funds?

Healthcare is one of those sectors that can be quite challenging. It has inherent social attributes, but actually when you look at the mechanics of the ESG strategy, it can sit in any of 6, 8, or 9. It very much depends on what you are doing in the sector and how you're measuring it. Are you trying to think about patient outcomes in a particular way? Are you trying to bring down the cost of a certain product? Are you trying to enhance access to products? So it's really drilling down to that level of detail that gives you these sorts of answers as to whether you should be in 6, 8, or 9.

Principal Adverse Impact indicators

SFDR incorporates this concept of principal adverse impact indicators, and broadly speaking, that is an SFDR term which refers to a range of potential negative externalities. There is quite a long list, separated out into three tables of particular principal adverse indicators that SFDR is interested in.

If you think back to those firm-level disclosures, if you are a firm that is active in Europe in a particular way and you've elected to disclose externalities, then these are the sorts of indicators you would use. There's a need to disclose scope 1, 2, 3 greenhouse gas emissions, energy consumption, a number of these attributes across the portfolio. The ambit of the portfolio depends again on the way in which that particular manager has gone to market in Europe.

Equally, these principal adverse impact indicators can be adopted at the fund level. It's voluntary, not mandatory to do so. But if you do, then again there's a particular set of metrics.

One thing I would say about these, and I think it segues to one of the questions that was asked in the Q&A: there is a requirement for all funds disclosing under Article 9 to make only sustainable investments, and one of the ways in which you get comfortable that an investment is a sustainable investment is to query each of these data points in relation to the proposed investment and form a view. So you need to get an understanding of the greenhouse gas emissions footprint, for example, and then form a view about whether the emissions from that particular investment fall afoul of what SFDR refers to as doing significant harm. Might those greenhouse gas emissions do significant harm to the climate change objective, for example?

SFDR itself is not prescriptive about where that threshold sits, but what it does say is you need to interrogate these data points, go to potential investments, ask them for that data to be able to form a view, as a fund manager, as a GP, as to whether or not this investment is a sustainable investment, and therefore is within scope of the fund.

Interaction with other EU sustainability regulations

Maddie, over to you. We do have a question in the chat, but I believe it's preempting this slide, talking about the interaction with other EU sustainability regulations.

Thanks, Rhys, for explaining what is a fairly technical piece of legislation so concisely and clearly. I think another good piece of context for SFDR is the way that it interacts with other EU sustainability regulations. On this slide we have three examples: the CSRD, which is the Corporate Sustainability Reporting Directive; the CSDDD, the Corporate Sustainability Due Diligence Directive; and the EU Taxonomy. I'll take the first two and then I'll hand it over to Rhys to handle the EU Taxonomy piece.

CSRD: the Corporate Sustainability Reporting Directive

Starting with CSRD, this is a piece of legislation, fairly sweeping legislation, that came into effect in January of this year. Why CSRD is important is that it really broadens the scope of companies who will be reporting sustainability information. Whereas SFDR applies to the financial sector and financial market participants, CSRD really targets companies and corporations.

The predecessor to CSRD was the NFRD, the Non-Financial Reporting Directive, and that impacted approximately 11,000 companies. CSRD really broadens the number of companies that will be impacted, and the figure is estimated at roughly 50,000 organizations. That includes companies both in the EU and those outside the EU who may have significant revenue streams from within the European Union.

Why this is important for SFDR is that, currently, financial market participants will ask their investee companies for certain sustainability-related information. Those companies that exist below these managers generally aren't subject to any regulation that requires them to report or collect this information. For that reason, it creates effectively a data gap between what the financial market participants need to report and what is actually being collected and reported at a company level.

Under CSRD, the legislation requires that companies report against the ESRSs, the European Sustainability Reporting Standards. There are 12 of these standards. They cover environmental matters, social matters, and governance matters, as well as two standards that are cross-cutting or general.

The thinking is that once CSRD starts rolling out and these companies start getting up to speed and really coming to grips with setting up processes and controls to collect this data, and finally reporting it, that will hopefully close the gap. When their financial owners reach out for this information, it will be more readily available. Of course, the first companies will be reporting in 2025, and then there's a phase-in approach with, for example, non-EU companies reporting in 2029. So there will still be a few years under SFDR where this data gap will still exist.

CSDDD: the Corporate Sustainability Due Diligence Directive

The next piece of legislation here, CSDDD, CS3D, whatever you'd like to call it, is currently in negotiation between the European Parliament and the European Council. We do have a proposed rule in place, but it's possible that it may change in the coming years. We're expecting this to come into place in potentially 2025 or 2026.

In effect, the idea behind CSDDD is to mandate certain companies, again meeting certain revenue thresholds or headcount, to undertake due diligence on their operations and supply chain with respect to environmental and social matters. Where that will complement SFDR is by requiring these corporations underneath the financial sector, and I'll add that it's likely that the financial sector will be carved out of CSDDD, so this will likely just apply to corporations.

That means the financial market participants subject to SFDR will be able to call down to certain companies that they are invested in, and have a more ready response to questions like, "What are the negative externalities of your activities and your company's operations?" These two pieces of legislation will likely complement SFDR in that way and hopefully assist this disclosure regime. It's yet to be seen how this will work in practice and there might be a few iterations to really get to the point where we want it, but I think that is the ultimate goal of the European Union in setting out these regulations.

EU Taxonomy

I'll hand it over to Rhys to discuss the EU Taxonomy, because that's also a meaty subject.

Thanks, Maddie. The EU Taxonomy is certainly an integral part of this exercise. For those unfamiliar with it, the EU Taxonomy is the Union's attempt to establish a set of environmental, and ultimately social, objectives, and then identify economic activities that are aligned with those objectives, and the specific criteria by which a business activity or economic activity would be determined to be aligned.

In terms of the environmental objectives, they include, for example, climate change mitigation and climate change adaptation. What the taxonomy does is it goes through a range of different economic activities and says, "In order for this particular economic activity to be treated as aligned with an objective like climate change mitigation, it must do three things."

The first is make a substantial contribution to that objective, and the taxonomy sets out technical criteria as to what constitutes a substantial contribution. The second component is that it does no significant harm to the remaining environmental objectives, and again there are specific criteria as to what would constitute doing significant harm. The third piece is that the economic activity is aligned with what the taxonomy calls minimum safeguards. Minimum safeguards is a term primarily focused on social risk, and specifically refers to activities being aligned with two key international instruments. One is the UN Guiding Principles on Business and Human Rights, and the second is the OECD Guidelines for Multinational Enterprises.

An economic activity that satisfies all three of those criteria will be taxonomy-aligned. That is significant for a range of different participants in the economy. For financial institutions, for example, it factors into calculations as to green asset ratios. In the context of SFDR, individual financial products have to disclose their degree of alignment with the EU Taxonomy in certain circumstances. The CSRD incorporates a requirement that corporates or issuers within scope of that directive will also have to report on EU Taxonomy alignment of their activities.

You can see how these pieces interact. We have all participants in the ecosystem forming a view about the extent to which their activities are aligned with these particular environmental objectives. You have corporates disclosing the extent of their alignment. You have financial institutions disclosing the extent of the alignment in their portfolio. In the private markets context, you have funds doing the same. That is how that ecosystem is intended to fit together. We only have environmental objectives at the moment, but it is contemplated in the fullness of time that there will also be a social taxonomy to accompany that.

Sustainable investments vs taxonomy alignment

Just to touch on the question that was asked in the Q&A as to whether a sustainable investment according to SFDR does not need to be taxonomy-aligned: that's right. A sustainable investment under SFDR and taxonomy alignment, or what the taxonomy calls an environmentally sustainable investment, are two related but distinct concepts.

One way to think about that: you can certainly have a sustainable investment that isn't taxonomy-aligned. There is recent guidance that confirms, by and large, taxonomy-aligned activities will be sustainable investments. You sometimes hear people talk about the taxonomy as a gold standard in that context. A sustainable investment can contribute to a particular objective, can be free of negative externalities, but might not rise to the level of being taxonomy-aligned. A taxonomy-aligned investment, however, will almost always be a sustainable investment.

Case study: Pulsora and Kirkland & Ellis workflow

Thank you so much for that insight, Rhys, and for directly answering that question in the Q&A. For those participants, please do feel free to put your questions in the Q&A function. Happy to hear from you and keep this interactive.

We're going to move on to a case study now. I really find this is where the rubber hits the road. Kirkland & Ellis has been a great and incredible partner to Pulsora in helping us build out our platforms for our joint clients. At Pulsora, we work with a lot of funds that are subject to SFDR, and so they're collecting their data on Pulsora, a SaaS platform that helps companies do their data collection and reporting, improve their sustainability performance, and be compliant. I want to pass over to Maddie to walk us through a case study.

Thanks, Nicole. You're exactly right. I think the best way to discuss SFDR, once we have the basics, is to walk through how this operates in practice. Because Kirkland & Ellis and Pulsora work together advising this one particular client on SFDR matters, it seemed natural to use them as an illustrative example.

For background, this is a large firm that has about $130 billion in assets under management and operates globally. They use Pulsora for many of their ESG reporting and data collection requirements. In this case today we'll just be covering SFDR. And of course they use Kirkland & Ellis for a range of legal matters, again focusing on SFDR today.

Compliance workflow in practice

How does the interaction work between this client, Kirkland & Ellis, and Pulsora? You have the manager looking to collect information from their portfolio. To do so, they'll set up a request for information that has, for example, questions on whether the investee companies are performing against the PAI indicators, what their good governance practices are, any outward impacts that might go towards the do no significant harm test.

This request is generated. It's created in Pulsora and then through Pulsora it's sent down to all of the applicable portfolio companies. As part of the firm's license, which is standard, the portcos have access to Pulsora, so they'll receive notification of this request by email. They'll log on to Pulsora, they'll submit their responses and any additional evidence.

Instead of that information then directly routing back to Pulsora or the manager, there's an additional layer whereby those responses then go to the lawyers at Kirkland & Ellis. K&E will take a look at all of the information that the portcos have provided, check for any errors, anything that might require further clarification. To the extent there are errors or a need for more information, they'll add comments, send those back to the portcos to revise as necessary. If the data's in a good place, K&E will approve that information. It'll go back into Pulsora where it's stored, and the asset manager has access to this. Come reporting time, they can simply push all of this information stored in Pulsora into any reports or templates configured to meet the SFDR reporting requirements.

There could be any number of changes or configurations, but this workflow with the approval from an outside third party in the form of Kirkland & Ellis is quite standard. The same workflow can be used in the context of due diligence for prospective investments. Instead of existing portfolio companies receiving these requests, you would have the target company receive the request. That's reviewed by, for example, lawyers at K&E, and then to the extent the deal is successful and the company is acquired, that target company converts to a portfolio company, exists within the portfolio, and you can hold that information on throughout the ownership period, all stored in the software.

Rhys, I know you're very close to this process, so just wanted to see if you had anything else to add.

Thanks, Maddie. That's a good description of the workflow. Just to contextualize this for the audience and those who may be less familiar: ultimately what we're doing in this context is, if you have a financial product that has an ESG strategy that's been disclosed through SFDR, one of the requirements is that all the statements and commitments made in there are binding. They should be binding in any event as they're incorporated into the fund strategy. But if you are saying, for example, that this is a financial product that discloses under Article 9, you will, among other things, need to be able to demonstrate that each investment is a sustainable investment. In order to do that, there's a range of individual data points that need to be collected and a view needs to be reached as to whether an investment falls on the right side of relevant criteria. The concept of good governance that Maddie alluded to is something that underpins all investments in products disclosing under Article 8 or 9, and needs to be diligenced both at the point of making an investment decision and on an ongoing basis.

The SFDR architecture, particularly at the product level, has two key requirements. The first is that you make a pre-contractual disclosure. You disclose to prospective investors exactly what the characteristics are, the environmental and social characteristics or objective, and how that will be measured. That's measured on an annual basis for the life of the fund. So being able to demonstrate that those characteristics or objectives have been assessed on an ongoing basis, that they've been measured, and then being able to generate the reports to comply with SFDR's reporting obligations, is the legal architecture that sits behind or on top of the workflow Maddie described.

Beyond SFDR: LP requests and annual reporting

Maddie, when you talked about the workflow you talked about using Pulsora to comply with SFDR regulations. You also talked about how you do this through due diligence. Can you also report, for example, on your LP requests or do your general reporting in terms of your annual report?

Yeah, absolutely. Pulsora is set up to support any sort of ESG reporting requirements. We would have, for example, a repository of all of the ESG metrics or disclosure requirements that a certain customer is looking to report against. That would all exist in the same place in Pulsora. We have systems set up such that if you are only focused on getting requests from portcos on SFDR, you can carve that out and send those requests out, and do the same with questions from LPs, information that you're looking to report in your annual sustainability reporting, or whatever integrated report you're putting together. Certainly set up to support all of those data collection and reporting needs.

Regulatory Technical Standards: the ongoing consultations

As we hit the tail end of the conversation, perhaps we should pivot over to RTS. Again, if you have any questions, please feel free to put them in the Q&A function.

As you probably picked up just from hearing us discuss SFDR and the associated delegated regulation, or the Regulatory Technical Standards, which are appended to SFDR, this is a very novel piece of legislation. It's quite new, having come into effect in March 2021. But it's also not been without teething problems. Rhys alluded to this at the beginning of the discussion, but there have been a number of pieces of guidance released from the European Commission, for example, based on feedback from those subject to SFDR, that some of the legal technicalities and the practicalities of disclosing against SFDR have created some issues, or it's challenging in some respects.

To that end, already, although I haven't included it on this chronology here, we have seen, for example, the European Commission update the principal adverse impact indicators already. Right now, we are currently in a position where we have two open and ongoing consultations.

The ESAs consultation

The first, with the orange bars, is the one being run by the European Supervisory Authorities. That's the three financial bodies within the European Union charged with overseeing and reviewing this legislation. They received a mandate from the European Commission in July of last year to look into SFDR specifically. In April of this year, after that period of time, they came out with a consultation paper with a number of questions asking for feedback, and they also added a draft amended Regulatory Technical Standard. I'll go into a bit more what exactly the subject of this consultation was and what these suggested amendments were. We're expecting the final report to come out in October, so in the next few weeks in essence.

What exactly are these consultations looking at? If we look at the report the ESAs have prepared, there were a number of issues they looked into. The first three bullets form part of the mandate that the European Commission gave them. It was to look at extending the list of PAIs to increase the number of social indicators, to refine the content of indicators including definitions and methodologies, basically just dealing with any inconsistencies or lack of clarity there, and to introduce a disclosure around GHG emissions reduction targets. Currently there is none at the moment, although there is a requirement that you disclose your scope 1, 2, and 3 greenhouse gas emissions.

The ESAs took the opportunity to review SFDR and actually increased the scope and added a few more points to the bottom three bullets on the left-hand side. They looked into the Do No Significant Harm disclosure, simplifying the pre-contractual and periodic reporting templates, and finally looked at a few other technical adjustments.

The European Commission consultation

In addition to that consultation, we're also in this consultation period being run by the European Commission. Rhys mentioned this at the start. The European Commission, in effect, has two consultations: a targeted consultation aimed for those who are closer to SFDR and might be reporting against it or looking to report against it, and a public consultation, looking for feedback from any members of the public. If you look at the two different consultations though, you'll see that the questions are more or less identical. That opened in September, and the consultation period will end in December, with the report to follow in 2024.

The Commission's consultation looked into a number of other issues. There's some overlap, but effectively they're calling for feedback on these points: whether SFDR has actually been effective in meeting its objectives, any issues surrounding the data gaps we've made reference to throughout this discussion, comments on PAI indicators, the Do No Significant Harm assessment, asking for information on what the actual cost of disclosing against SFDR is, recognizing that the financial burden is quite high in some instances. And the last point, raised by a member of our audience earlier on, is about Article 8 and Article 9 product categorization.

Article 8 and Article 9 reclassification trends

Rhys already gave a great intro to this, bringing up the fact that SFDR is a disclosure regime and not a labeling regime. However, in practice, given that there is no strict criteria or methodology for meeting Article 8 and Article 9 product categories, this has led to some confusion, I would say, or challenges among financial market participants.

Just to give a real-life example: SFDR came into effect in March of 2021. In June of 2021, recognizing that some participants had issues with this Article 8 and Article 9 categorization, the European Commission released new guidance, just giving a bit more information on what exactly they're looking for. As a result of that guidance, about 300 funds reclassified from Article 9 to Article 8.

Morningstar is looking into these issues and following these trends. They recently reported that some of those funds that reclassified from 9 to 8 have actually reverted back to 9. You can see there is some inconsistency, or differences in understanding of how SFDR works. The point of these consultations is to arrive at a place where we can address those issues and have a much more streamlined regulation.

Avoided emissions and sustainable investment

I'll move from this slide onto general recommendations for SFDR. Yeah, that works well. There was a question in the chat for Rhys based on a comment he made earlier with regards to substantial contribution. Rhys, can you see the question or would you like me to read it?

I can see that and very happy to answer. Just to be clear: sustainable investments and taxonomy-aligned investments are two separate concepts. Substantial contribution is the language and the test used in the context of the taxonomy. If we're thinking about sustainable investments, the test is a little lighter. It's just contribution, contribution to an environmental or social objective. Whereas the taxonomy is very prescriptive as to what constitutes a substantial contribution, that is not the case for sustainable investment.

If you have a sustainable investment that makes a contribution to an environmental objective, it is within the domain and the discretion of the sponsor of the product to determine how they will measure that contribution. To the question specifically, for the benefit of everyone: can detailed quantitative Scope 4 avoided emission calculations work in this context? Yes, there is nothing in SFDR that says you could not use avoided emissions potentially as a basis for formulating a contribution to sustainable investment.

I would say it would need to be in concert with other metrics, so you'd still need to have a sense of the Scope 1, 2, and 3 emissions, for example, bearing in mind that a sustainable investment must do no significant harm to other environmental and social objectives. What is very fundamental to a sustainable investment is that it's holistic in nature. It can't just excel at one attribute and not address the others. But if avoided emissions is a key metric, and that's taken into account, and the do no significant harm and other criteria are also taken into account, there's certainly no reason it can't form the basis of an approach to sustainable investment.

Recommendations for SFDR compliance

Thank you, Rhys. I do appreciate that we've run two minutes over. As we pivot into the recommendations for SFDR compliance led by Maddie, I just want to offer a final chance for anybody to put a question in the Q&A chat. We're also happy to hang on for a couple of minutes over.

Thanks, Nicole. A few points that people should keep in mind as they're looking to maybe comply with SFDR for the first time, or make sure that their current disclosures are in compliance with all of the changes coming down the pipeline.

I would say be prepared for the upcoming revisions following the open consultations. Take a look at the draft amended RTS that the ESAs put out in April, and look out for the final report they're going to release imminently.

We've made a few comments on the issues of data gaps and data availability for those disclosing against SFDR. If you look at the guidance being released by the European Commission generally, there is less and less tolerance for companies explaining that they can't disclose due to a lack of data availability. The expectation there is that there really is a push to collect this information and make sure it's of high quality.

That dovetails into this final point: under SFDR, the engagement of managers with their portfolio companies and investments is significantly higher than it previously ever was with respect to sustainability matters. So making sure that you are engaging with your portcos, bringing them up to speed on what ESG is, why it is necessary, why you're asking for this information from them, is key. Then helping them as well, or at least supporting them, in their controls and processes around collecting this information. They'll be particularly grateful for that leg up, especially if they ultimately become subject to legislation like CSRD. I'll stop there. Rhys, if you have any additional comments, it's all yours.

Nothing further to add. Nicole, I'll hand it back to you.

Closing

Wonderful. I just want to thank Rhys and Kirkland & Ellis for participating in today's session on how to master the EU's Sustainable Finance Disclosure Regulation, also known as SFDR. Thank you all for attending.

If you would like to hear more, please contact Pulsora. We're happy to help you simplify your SFDR data collection and disclosure obligations, and demo the platform for you at any time. If you'd like to be in contact with Kirkland & Ellis or Rhys, you can also contact us and we will make the introduction. After today's call, we will be sharing the recording. Once again, thank you all for your participation and your great questions.

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