The Future of SFDR? ESAs Publish Opinion

20 Jun

Following the EU Commission’s consultation on the Future of Sustainable Finance Disclosure Regulation (SFDR) which was concluded in December 2023, we now have a glimpse into where this might head. The European Supervisory Authorities (ESAs) have published a joint opinion proposing changes to the SFDR. Key among the proposals is the introduction of new “Sustainable” and “Transition” labels for financial products.

Background

The European Commission initiated a review in 2023 of SFDR following greenwashing concerns stemming from the use of Article 8 and 9 classifications as de-facto labels. SFDR was originally conceived as a disclosure regime, but the classifications have widely been used as sustainability labels. The Commission was concerned this may be causing confusion for investors, which could lead to greenwashing. Their consultation asked questions such as whether product disclosures should be simplified, whether sustainability disclosures should be introduced for all financial products regardless of sustainability characteristics, and most importantly, whether the SFDR should introduce product labels.

Product Categorisation

The ESAs suggest two distinct product categories which would replace the current Article 8 and 9 framework, (thus no longer differentiating between those that promote environmental and social characteristics, and those that have sustainable investments / objectives). Proposed categories are (and this may sound familiar to those aware of the FCA’s SDR Product Labels):

“Sustainable”: products that invest in economic activities and assets that are already environmentally or socially sustainable.
“Transition”: products that invest in activities or assets that are not yet sustainable but are on a pathway to becoming so.

For the sustainable category, a minimum Taxonomy-aligned threshold would apply. Transition products could include a mixture of EU Taxonomy KPIs, transition plans, product decarbonisation trajectories and mitigation of PAIs at product level.

Additional disclosure requirements have also been proposed for products that do not qualify for the Sustainable or Transition categories but that contain “sustainability features”.

Other Proposals Include:

Sustainability Indicators: The introduction of indicators aimed at grading financial products and minimising the complexity of sustainable disclosures. This would include an indicator for products in the new categories, and beyond.

Sustainable Investment Definition: ESAs suggest a new prescriptive definition of “sustainable investment” such as the use of taxonomy-alignment, PIA or ESRS data points as applicable (something which we support as this moves away from a principles-based approach which has caused widespread confusion in the market).

Key Investor Document: Providing simplified disclosures for retail investors, with more complex information in separate documents.

Adverse Sustainability Impacts: Approach dependent on product categorisation:

“Sustainable” products would be required to consider and take action on adverse impacts
“Transition” products would only be required to inform investors of adverse impacts

What we think

This is the first indication we’ve had in relation to where SFDR may go next, and how it might change, and this is potentially very material for those already operating in the Article 6, 8 and 9 framework. In general, we are supportive of the concept of product classifications, if indeed they can be delivered with suitable levels of clarity, usability, comparability and applicability to all asset classes and products (we’re not asking for much!).

There are also many unanswered questions that we will be keen to understand:

How will financial market participants be expected to transition to the use of potential new product classifications?
What timeframe?
How will SFDR align to other sustainability frameworks and product labels such as the SDR’s Sustainable Focus, Sustainable Improvers and Sustainable Impact labels – will there be any effort to ensure convergence in operating frameworks across jurisdictions?
In what way will disclosure templates change and what will be expected by way of disclosure for products which do not adopt the classifications, whether or not they have sustainability features?
Will SFDR 2.0 help investors to truly understand how sustainable investment products are?

What next?

As the market digests these “opinions”, it’s important to remember it’s the EU Commission, not the ESAs who will make the final decision about whether to adopt these proposals, and we do not expect a final conclusion on that until 2025. The EU Commission will take this on board, but is not obliged to make the recommended changes.

It’s key in our opinion that the EU Commission gets this right, so as not to undermine the value and purpose of the SFDR as a whole. A first-mover in regulatory development is always a risky position to be in, but this is an opportunity to make SFDR really great and we remain hopeful.

We also remain committed to supporting our clients through this transition, when the time comes. Let us know if you’d like to discuss further.