SFDR and the EU Taxonomy: What Fund Managers and Investors Need to Know

The European Union, seeking to promote greater integration of environmental, social, and governance (ESG) factors in the financial market, has adopted several relevant legal acts. The two key ones are commonly referred to as the SFDR (Regulation (EU) 2019/2088 on sustainability‐related disclosures in the financial services sector) and the Taxonomy Regulation (Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment).

These two documents regulate how funds - whether investing in traditional financial instruments (such as shares or bonds), real estate, or private equity projects - must disclose information about their approach to ESG risks and objectives.

Perhaps the most crucial step toward aligning sustainability requirements across the European Union is the SFDR. It stipulates that every financial product, before entering into an agreement with an investor, must provide information on whether and how it integrates sustainability risks into investment decision-making. This information typically appears in the fund prospectus or another document made available prior to concluding the investment agreement. Moreover, the SFDR requires that later on, in periodic reports, the fund must update and refine this information. This allows investors to monitor whether the declared sustainability measures have actually been implemented and whether the composition of the investment portfolio has changed in ways that might affect ESG risk.

The SFDR also provides that a fund must clearly disclose which level of information disclosure it falls under:

• If an investment product does not aim to promote either environmental or social characteristics or pursue sustainable investment objectives, it is generally considered an SFDR Article 6 product. In that case, the fund must indicate whether (and how) it assesses sustainability risk, or if it deems the risk not relevant, it must specifically explain why.

• Under SFDR Article 8 (“light green” product), the fund already declares that it dedicates part of its policy to promoting environmental or social aspects. Here, the disclosure requirements are broader: the fund must detail which aspects it promotes and how they are practically implemented.

• SFDR Article 9 (“dark green” product) applies to products with a clear sustainable investment objective. In this scenario, the fund must specify its indicators and describe the measures by which it seeks to achieve this objective while ensuring the “do no significant harm” (DNSH) principle. In addition, periodic reports must demonstrate how much of the stated sustainability objective was actually achieved.

The second key legal act, the Taxonomy Regulation, aims to establish a unified EU classification system for sustainable economic activities. It identifies six environmental objectives (for instance, climate change mitigation, biodiversity protection, etc.) and defines what it means to “significantly contribute” to them without harming the other objectives. If a fund claims that a certain share of its investments meets these criteria, it must provide a percentage and prove that the DNSH principle is upheld. Should a fund not contribute to environmental objectives at all, it must clearly state that the Taxonomy Regulation does not apply and that its alignment is 0%.

In order to meet the SFDR requirements, a fund typically discloses the following in its prospectus (or other pre-contractual documents) and in subsequent periodic reports:

1. A definition of sustainability risk and its relevance, identifying which environmental, social, and governance risks may affect its investments.

2. The expected impact on investment returns, explaining how significant ESG risk may be and how it is managed.

3. The status of principal adverse impacts (PAI) - i.e., whether and why the fund does or does not assess any potential negative effects its investments might have on sustainability factors.

4. The fund’s classification under SFDR Articles 6, 8, or 9, so that investors understand the extent of the fund’s sustainability commitments.

5. Its relationship to the Taxonomy Regulation, if the fund claims partial or full alignment with sustainable economic activity criteria (or conversely, that alignment is 0%).

Such transparent disclosure throughout the process - before an agreement is made with an investor and later in periodic reports - enables investors to make more informed decisions and to monitor how the fund is actually adhering to the sustainability principles it has declared.

Examples of different types of funds:

Traditional funds (investing in shares or bonds) might highlight that they use public ESG ratings or have an internal system to assess whether companies meet environmental requirements, how they treat their employees, or whether there is any record of corruption risk.

Real estate funds often face risk related to extreme weather conditions that can affect buildings, as well as corruption risk in obtaining construction permits. In their disclosures, they may emphasize that they carefully examine construction documentation, energy efficiency ratings, and local community perspectives.

Private equity funds that invest in non-listed companies typically focus more on governance risk and corporate reputation; in the prospectus (and subsequently in reports), they explain what measures they use to reduce these risks, how they engage in corporate governance, and what standards they enforce in acquired companies.

It is important to note that even Article 6 funds (i.e., those that do not pursue ESG objectives) must clearly inform investors why they believe sustainability risk will not significantly affect returns, while Article 8 or Article 9 funds have much broader obligations. In this way, the SFDR, together with the Taxonomy Regulation, ensures that every fund - whether geared towards purely financial returns or focused on specific environmental or social goals - must state how important ESG factors are in its investment strategy. It also ensures that investors have a clear idea of what to expect both from the prospectus and from the annual reports that follow.