Background
The European Union’s (the EU) Sustainable Finance Disclosures Regulation (SFDR) came into force in March 2021 and has kept the industry busy (and sometimes frustrated) since then with myriad updates and guidance.
This landmark regime was designed as a transparency regulation, setting detailed disclosure requirements for financial market participants, financial advisers and financial products in relation to sustainability issues. However, the widespread market sentiment is that SFDR is not functioning as intended for many reasons.
Consequently, as SFDR approaches its third anniversary, the European Commission (the EC) has launched a comprehensive consultation process to assess the regulation's impact and determine its future trajectory.
On 14 September 2023, the EC published two consultations on the future of SFDR (together, the “Consultation”):
- A public consultation aimed at a broader range of stakeholders with a more general knowledge of SFDR (e.g. individual investors); and
- A targeted consultation aimed at those who are more familiar with the details of SFDR and the EU’s approach to sustainable finance more generally (e.g, fund houses)
We consider it crucially important that the EC has identified that the issues with SFDR impact such a broad range of stakeholders and welcome their intention to view changes through both lenses.
1. Purpose and scope of the Consultation
The Consultation is an ambitious initiative aimed at ensuring the continued relevance and effectiveness of SFDR in the rapidly evolving landscape of sustainable finance. It is designed to gather insights and experiences from a broad spectrum of stakeholders, including financial practitioners, non-governmental organisations (NGOs), national competent authorities (NCAs), professional and retail investors.
The central objective of the Consultation is to understand how SFDR has been applied in practice, and to identify any potential shortcomings, focussing on legal certainty, the useability of the regulation and its ability to play its part in tackling greenwashing. The Consultation will evaluate SFDR’s interaction with other components of the European sustainable finance framework, the interoperability with similar frameworks in other jurisdictions and explore potential avenues for improvement.
2. Key themes of the consultation
The Consultation is structured around several pivotal themes, each holding a crucial role in shaping the future of sustainable finance in the EU:
- What are the main issues with current SFDR implementation?
This section delves into the current state of SFDR, assessing its practical implementation to date and whether it has been effective in meeting its objectives. This gives an opportunity for the industry to be very clear on the challenges which have been faced. It tackles issues which have been recurring themes of concern, including:
- compliance costs;
- data challenges, including the use of data "estimates”;
- clarity and consistency of application of key legal terms (for example, the wide mandate given to the concept of “sustainable investments”);
- the different uses of PAIs, including their relevance for the compliance with the “do no significant harm” principle for products claiming to make “sustainable investments”; and
- overarching concerns around greenwashing
- How does SFDR interact with other EU sustainable finance legislation?
Understanding how SFDR interacts with other EU sustainable finance regulations is paramount for creating a cohesive and harmonised framework. This section explores the synergy between SFDR, and other legislation aimed at promoting sustainability in financial markets such as the Taxonomy Regulation[1], the Benchmark regulation[2] or the CSRD[3].
- What should happen with the current entity and product disclosures?
As part of an evolving regulatory framework, SFDR has room for improvement and the industry is well aware of the various ways in which the mandated SFDR disclosures are not always fit for purpose. This is true at both an entity level and product level and the EC are considering changes to each:
- Entity level
Linked to the interoperability point above, the Consultation queries whether SFDR is the right place for entity level disclosures, given the need for such disclosures under other legislation (e.g., CSRD).
The industry has queried the usefulness of the SFDR entity level disclosures for some time as in many cases the requirements do not provide for any meaningful information or comparability across houses, while being incredibly onerous to implement. Considering whether these are achieving the correct results or could be better assimilated elsewhere is a welcome question.
- Product level
In addition to the fundamental issue of introducing a classification regime, the Consultation also seeks feedback on the usefulness of the existing disclosures, which would no doubt be fundamentally changed if the transparency approach is in fact changed.
However, more specifically, the Consultation is questioning whether:
- it would be helpful to impose disclosures across all financial products, whether or not it makes sustainability related claims; and
- whether it is appropriate to have product related information (all of which is slightly different) in three places (pre-contractual, website, periodic).
No matter what happens with the introduction of a classification regime, a detailed look at the current product disclosure requirements is of crucial importance. The existing disclosures remain unfit for purpose on multiple levels, particularly considering the needs of retail and institutional investors, and their utility for different types of asset class.
- Potential establishment of a classification regime
The EC acknowledges the misuse of SFDR as a classification system, deviating the regulation from its initial purpose of enhancing transparency around sustainability claims in the investment funds industry. The increasing use of SFDR as a de facto product labelling tool shows the demand for labels to communicate the ESG and sustainability performance of financial products.
There are concerns that the current application of SFDR as a labelling regime may inadvertently lead to greenwashing, where sustainability claims are exaggerated or unsubstantiated. This concern arises because the existing concepts and definitions within SFDR were not initially designed for such labelling purposes. Instead, they were intended to encompass a broad spectrum of financial products, ensuring that sustainability claims were well-founded, credible and – simply – properly disclosed.
Looking forward, the EC is exploring potential options and is actively seeking input and insights from stakeholders across the financial industry and beyond to gauge the advantages of establishing sustainability product categories and to understand how such categories should function effectively. The Consultation therefore solicits specific proposals for categorisation, considering two broad approaches:
- The first approach would involve refining the existing distinction between Articles 8 and 9 of SFDR and their embedded concepts, supplemented by additional, well-defined criteria.
- The second approach could focus on the type of investment strategy employed, such as a commitment to positively contribute to specific sustainability objectives or a strong emphasis on transitioning to sustainable practices. In this scenario, existing concepts like environmental/social characteristics and sustainable investment, along with the distinction between Articles 8 and 9 of SFDR, may undergo significant revisions or even disappear from the transparency framework.
To avoid misleading terms related to a categorization system, the Consultation also suggests introducing rules on product communication. In particular terms such as “sustainable”, “ESG”, “green”, “responsible”, “net zero”, would be prohibited for products that do not fit into one of the proposed categories. This would echo the guidelines proposed by ESMA in relation to the naming of funds using ESG or sustainability-related terms[4], as well as the introduction of naming rules introduced by the SEC, which requires a fund’s investment portfolio to align to its’ marketed investment focus.
The introduction of a labelling or categorisation regime would bring SFDR closer to the proposed sustainable finance regulatory framework that is being developed in the UK, the Sustainability Disclosure Requirements (SDR). SDR is designed as a labelling regime and prescribes detailed criteria market participants must meet in order to use the proposed investment labels. The UK’s Financial Conduct Authority is expected to publish the final rules on the SDR by the end of 2023.
It is important to note that any envisaged categorisation system would likely be voluntary, considering the strong demand for sustainable financial products in the market. It is essential to emphasize that the EC is currently in the consultative phase and has not endorsed any specific policy approach at this stage.
3. Targeted and public consultations
While both the targeted and public consultations share the overarching goal of improving SFDR, they take distinct approaches:
(a) Targeted consultation: this consultation is tailored to engage asset managers, investors, and relevant stakeholders, and invites feedback on a range of specific areas, including:
- Categorisation: determining whether Article 6, 8, and 9 products should be revamped or serve as the basis for new categories;
- PAIs indicators: assessing the utility and appropriateness of PAIs, with options for making them mandatory;
- Uniform disclosures: exploring the potential for standardised product disclosures, including Taxonomy-related disclosures, engagement strategies, exclusions and more; and
- Website disclosures: discussing the challenges of making website disclosures public.
The Targeted consultation also includes questions aimed specifically at professional investors, addressing their sources of sustainability information, the impact of SFDR requirements and the potential benefits of sustainability product categories.
(b) Public consultation: this broader consultation seeks feedback on SFDR's general effectiveness, with a particular focus on the use of estimates, greenwashing considerations, data challenges and implementation costs. It welcomes input from a wide array of stakeholders, including financial practitioners, NGOs, NCAs, professional and retail investors, and other interested parties.
Responses to the public consultation are solicited through an online questionnaire, providing a structured platform for stakeholders to share their experiences, concerns, and suggestions related to SFDR. The input gathered from this consultation will help make future regulatory decisions, contribute to refining SFDR and enhance its effectiveness in promoting sustainability, transparency, and responsible finance within the EU.
4. Timeline and participation
Stakeholders are encouraged to actively participate in this consultation process, as their insights and expertise are instrumental in driving positive change in the European sustainable finance landscape. The deadline for feedback is 15 December 2023, providing ample time for meaningful contributions. Respondents are urged to examine the entire questionnaire to provide holistic feedback and adjust their responses accordingly.
Conclusion: all stakeholders are needed to shape the future of sustainable finance
The EC's dual approach to consultation, through both the public and targeted consultations, reflects its commitment to creating a sustainable finance framework that is not only robust but also reflective of the stakeholders’ diverse needs and perspectives. By actively engaging with a wide range of voices, from industry professionals to NGOs and investors, the EC aims at fostering transparency, effectiveness, and sustainability within the European financial sector. The Consultation provides a platform for collective input and serves as a testament to the collaborative effort required to shape the future of sustainable finance in the EU. Finally, with interoperability across jurisdictions being a significant concern for financial market participants, suggestions of alignment with the UK regime will be extremely welcome in the hope that it may somewhat alleviate the burden of complying with multiple regimes across jurisdictions.
[1] Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088, PE/20/2020/INIT.
[2] Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds and amending Directives 2008/48/EC and 2014/17/EU and Regulation (EU) No 596/2014.
[3] Directive (EU) 2022/2464 of the European Parliament and of the Council of 14 December 2022 amending Regulation (EU) No 537/2014, Directive 2004/109/EC, Directive 2006/43/EC and Directive 2013/34/EU, as regards corporate sustainability reporting.
[4] https://www.esma.europa.eu/press-news/consultations/consultation-guidelines-funds%E2%80%99-names-using-esg-or-sustainability-related
