Though the EU consultation of the much-debated Sustainable Finance Disclosure Regulation is set to conclude only in December, the outlines of what will be termed as SFDR 2.0 are gradually emerging.
What is evident is that there won’t be a comprehensive overhaul of this pivotal piece of European legislation that compelled the investment industry to embrace sustainability. The SFDR, initiated in March 2021, forced the sector to become more transparent and contribute to sustainability by encouraging the uptake of investments in firms that cut carbon emissions, combat climate change or promote social benefits for staff and clients.
Instead, EU lawmakers and regulators now endorse a broad, inclusive approach that considers the regulation’s interaction with other aspects of sustainable finance legislation such as the EU Taxonomy, the Corporate Sustainability Reporting Directive (CSRD), and accounting standards.
What’s more, regulators and the industry expect SFDR 2.0 will be in harmony with comparable regulations outside the EU to ensure its feasibility on a global scale. The UK’s financial regulator, the FCA, for instance, will unveil its own Sustainability Disclosure Requirements or SDR in the upcoming months. Feedback on those new rules is anticipated to contribute to the EU consultation.
‘They’ve learned from the mistakes made by the EU,” said Hortense Bioy, global director of sustainability research at Morningstar, speaking to Investment Officer. “They had a very clear objective, which was to create labels for retail investors, for the less sophisticated investors.”
Clear need for labels
Elaborating on its decision to initiate the SFDR review, the European Commission acknowledged that the market has adopted various fund classifications in a way that wasn’t intended. The market adopted the transparency articles as sustainability labels, with “Article 8”, often used as ‘light green’ or ‘sustainable’, and “Article 9” as ‘dark green’ or ‘most sustainable’.
Many asset managers began referencing these articles in their promotional materials as well, making the investment sector susceptible to greenwashing accusations and regulatory interventions. After all, these articles didn’t assure investors that their investments would genuinely align with sustainability goals.
“It was meant to be about transparency,” said EU Commissioner Mairead McGuinness during an SFDR webinar on Tuesday. “Instead, as you all know, it’s being used more as a labelling scheme. That was very much intentional, and with good reason – the regulation was negotiated to be flexible, to help market participants adapt to the new disclosures.”
Greenwashing and mis-selling
“But we do see that in practice, this lack of binding thresholds and strict definitions can lead to uncertainty,” she said. “Investors find it harder to know if the product they want to invest in is really sustainable. So based on how the regulation is being used, there is a risk of greenwashing and mis-selling.”
Upon the realisation of this unintended use in 2022, countless funds were subsequently re-categorised, demoted from ‘9’ to ‘8’. “That was extremely painful for many managers. And costly,” said Bioy. “They certainly don’t want (SFDR) to be completely revamped because that would have been a waste.”
“It has been a bit chaotic, and that is why the SFDR is being reviewed. It would have been a miracle if they had created something perfect right away,” said Bioy. “It’s obviously super complex, with a lot of trial and error.”
In the UK, the FCA has observed the unintended utilisation of the EU’s SFDR for labelling and now intends to implement a definitive, official labelling system as part of its SDR. The FCA has inquired with the industry about their thoughts on three sustainability labels: “Focus”, “Improvers”, and “Impact”.
Esma keeps retail investors in consideration
The EU’s financial regulatory community wishes to prioritise the interests of retail investors, ensuring that funds in which they invest genuinely fulfil their promises. Surveys conducted by the European Securities and Markets Authority (Esma) reveal that retail investors find it challenging to grasp the complex structure of the SFDR.
Esma chair Verena Ross pinpointed this as the primary challenge for SFDR 2.0, as part of a “holistic approach” ensuring that SFDR declarations are seamlessly integrated into materials like fund prospectuses and investor marketing information. Commissioner McGuinness supports this strategy.
Ross outlined four objectives for SFDR 2.0. Firstly, disclosure simplicity, adopting an investor’s perspective on information that is clear, uncomplicated, comprehensible, and comparable. Secondly, a comprehensive approach throughout the framework, which will also encompass the EU’s Retail Investor Strategy. Thirdly, a direct association with the EU taxonomy, including the impending social taxonomy.
Finally, Ross perceives a need to enhance expertise across the sustainable investment value chain, including among regulators. “For us as regulators, it’s exceedingly complex, and we need to quickly adapt and learn from our actions.”
‘From niche to the centre’
Although the EU’s legislative process might slow down next year due to elections in May, the SFDR reform will persist. Dutch MEP Paul Tang, of the social-democrats group, acknowledged that the initial SFDR iteration wasn’t flawless.
“Council and EP had very different opinions on what SFDR needed to look like but were urgently aware of the need to make the first step,” he told the SFDR webinar. “That was the starting gun for building a framework that will benefit people and planet.”
Tang said lawmakers were “overwhelmed” by the broad take-up of SFDR in the market. SFDR moved sustainable finance “from being a niche to the centre of capital markets, and that is very welcome. It’s worth the progress. We are fully aware of the need to improve.”
During the webinar, a poll with 634 participants revealed that 66% believed the SFDR introduced more confusion than clarity, elevating greenwashing risks. One-third are of the opinion that it has augmented transparency, enabling investors to make well-informed decisions.
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