SFDR and Taxonomy Regulation: What fund managers and investors need to know

The European Union has adopted several relevant pieces of legislation to encourage greater integration of environmental, social and governance (ESG) factors into the financial market. Two of the main ones are the so-called SFDR (Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector) and the Taxonomy Regulation (Regulation (EU) 2020/852 on a classification system for sustainable economic activities).

These documents regulate how funds – whether investing in traditional financial instruments (e.g. stocks, bonds), real estate, or private equity projects – must disclose information about their approach to ESG risks and objectives.

Perhaps the most important step towards harmonizing sustainability requirements across the European Union is the SFDR . It stipulates that each financial product, before concluding a contract with an investor, must provide information on whether and how it integrates sustainability risks into investment decisions. Typically, this information is reflected in a prospectus or other document provided before concluding an investment contract. In addition, the SFDR requires that the fund subsequently, in periodic reports, update and clarify this information. This allows investors to monitor whether the declared sustainability measures have actually been applied, or whether the structure of the investment portfolio has changed, which may affect ESG risks.

The SFDR also requires a fund to clearly disclose which of several disclosure levels it falls into:

• If the investment objective is neither the promotion of environmental or social factors nor the pursuit of sustainable investment, such a product is generally considered to be an SFDR Article 6 product. The fund must then indicate whether (and how) it assesses sustainability risk or, if it considers it not relevant, specifically explain why.

• In the case of Article 8 of the SFDR ("light green product"), the fund already declares that it dedicates a certain part of its policy to promoting environmental or social aspects. Here, the disclosure requirements are broader: it is necessary to explain what these aspects are and how they are implemented in practice.

• Article 9 of the SFDR (‘dark green product’) refers to products with a clear sustainable investment objective. In this case, specific indicators must be specified, the means by which the fund achieves this objective must be described, and the principle of ‘doing no significant harm’ (DNSH) must be ensured. Furthermore, periodic reports must show the extent to which the declared sustainability objective has actually been achieved.

The second important piece of legislation, the Taxonomy Regulation , aims to create a single EU classification system for sustainable economic activities. It defines six environmental objectives (e.g. climate change mitigation, biodiversity protection, etc.) and sets out what it means to “significantly contribute” to them while not harming other objectives. If a fund claims that a certain proportion of its investments meet these criteria, it must provide a percentage and demonstrate compliance with the DNSH principle. If a fund does not contribute to environmental objectives at all, it must clearly state that the taxonomy does not apply and the compliance rate is 0%.

In order to properly comply with the SFDR requirements, a fund generally discloses in its prospectus (or other pre-contractual documents) and subsequent periodic reports:

1. The definition and relevance of sustainability risk , indicating what environmental, social and governance risks may affect its investments.

2. The expected impact on investment returns , explaining how significant ESG risks may be and how they are managed.

3. The status of the assessment of adverse sustainability impacts (ASI) , i.e. whether it is being assessed or not, and why.

4. Classification of the fund according to Article 6, 8 or 9 of the SFDR so that investors understand the extent of the sustainability commitments the fund is working with.

5. Link to the Taxonomy Regulation , if the fund declares that it partially or fully complies with the criteria for sustainable economic activity (or vice versa - 0% compliance).

Such transparent disclosure throughout the process – before the contract with the investor and later in periodic reports – enables investors to make better-informed decisions and monitor how the fund actually complies with the declared sustainability provisions.

Examples of different funds :

Traditional investment funds (investing in stocks and bonds) may emphasize that they use public ESG ratings or have an internal system that assesses whether companies comply with environmental requirements, how employees are treated, or whether there is a recorded risk of corruption.

Real estate funds often face risks related to extreme weather conditions that can affect buildings, as well as the risk of corruption in the area of building permits. They can reveal that they carefully check construction documentation, energy efficiency indicators and the views of local communities.

Private equity funds investing in private companies are usually more vocal about governance risks and the reputation of companies; in the prospectus (and later in reports) they explain what measures they use to mitigate these risks, how they participate in governance, and what standards they apply to the companies they acquire.

It is important to highlight that even Article 6 funds (which do not pursue ESG objectives) must clearly inform investors why they believe that sustainability risks will not have a material impact on returns, while Article 8 or 9 funds have an even broader range of obligations. In this way, the SFDR, together with the Taxonomy Regulation, ensures that every fund – whether it is focused on simple financial returns or on specific environmental or social objectives – should indicate the importance of ESG factors in its investment strategy, and that investors can clearly see what to expect both in the prospectus and in the annual reports.