As Europe seeks ways to address greenwashing, supervisors have proposed broad reforms to the Sustainable Finance Disclosure Regime (SFDR). To enhance transparency, they propose stricter labelling. Together with the addition of a transition investing category, these changes could redefine sustainable investing.
Concerns about how the SFDR can be misused for marketing purposes or even to facilitate greenwashing have been raised since it became law. As part of tackling these issues, a recent common position paper from Europe’s supervisory authorities, known as the ‘ESAs’, has proposed an approach to reforming the SFDR that could clarify and even extend what is possible to do when investing in the name of the environment.
Response to the ESA paper was positive from both industry and financial watchdog perspectives. Law firm Loyens & Loeff and retail investor lobby group Better Finance highlighted limitations and deficiencies in the first iteration of the legislation.
Complex
“ESAs acknowledged that the current framework seems to be quite complex and difficult to understand, in particular for retail investors,” Irina Stoliarova, counsel at the investment management practice at Loyens & Loeff Luxembourg, told Investment Officer.
Stoliarova has extensive experience advising asset managers, fund initiators and institutional investors in structuring and setting up Luxembourg-regulated and non-regulated investment fund structures. She advises fund managers and initiators on various regulatory and ESG matters.
“In order to potentially eliminate the risk of misuse of SFDR, the ESAs are of the view that a new categorisation system with simplified disclosures will empower retail investors to better understand the underlying sustainability profile of financial products,” she said.
The ESAs argue that moving away from a pure “disclosure” regime to a real classification system with specific requirements “would significantly reduce the current risk of greenwashing,” she explained.
Disclosures misused
While the SFDR was designed to enhance transparency around sustainability, “the ESAs have noted that, in practice, disclosures have been used by financial market participants to classify their financial products,” explained Majorie André, a Loyens & Loeff partner and attorney at law who is also part of the firm’s Luxembourg-based investment management practice group.
André is an alternative investment funds lawyer focusing on private equity, real estate and infrastructure funds, along with other types of liquid and illiquid investments.
She noted that the industry’s approach to using the SFDR led to the ESA’s approach “Since the regulation has been used as a labelling regime, it means there is a need for such labels, so why not create proper labelling categories, and not just disclosure ones?”
“We also noticed a tendency of ticking boxes just to fall within one or the other category, without necessarily generating a massive shift toward greener and more sustainable products,” observed Stoliarova. “In our view, that’s the reason why the current classification system should be moved away.”
Reform could be burdensome
While the Loyens & Loeff lawyers see benefits from these new requirements and rules, they concede this “might be quite burdensome and generate additional compliance fees.”
The general praise for the joint ESA paper echoed elements of the view from finance watchdog group Better Finance.
The group, which emphasises the importance of empowering retail investors, hailed the ESA’s recommendation to replace the existing ‘Article 8’ and ‘Article 9’ disclosure rules with appropriate categories better reflecting retail investor interest and understanding of sustainable financial products.
‘Transition’ as new category
One aspect of the proposal getting special praise from market participants was the ESAs joint proposal of a new “transition” category. This would allow investors to play a part in greening the brown economy, rather than simply reallocating investments between sustainable sectors, argued Better Finance.
Such a move could, argued the group, revolutionise sustainable investing by channeling efforts towards delivering tangible impacts on the real economy.
The finance watchdog also pointed to academic research into this kind of approach. US-based researchers at Yale University and Boston College published research in November 2023 highlighting how current practices in portfolio greening may inadvertently undermine broader economic stability efforts.
Transparency obligations important
The Loyens & Loeff lawyers agreed that this element is important. It “is a long-awaited solution to improve the carbon footprint of brown assets,” said André.
However, André emphasised that “we…would like to emphasise that transparency obligations for transition products should provide investors with clarity on the level of ambition and performance in the short and long term, including quantitative targets and intermediate milestones and on how the investment strategy delivers on the ambition.”
Proper monitoring and reporting would be needed to “ensure compliance and avoid greenwashing.”
Impact investing emphasised
The joint ESA opinion also emphasises the role of impact investment. The ESAs proposed multiple approaches the Commission could take. Under one variant, this would see “investor’s impact” as a sub-category under the transition category, for products having a positive measurable impact on an environmental or social objective.
Alternatively, this could be a cross-cutting indicator across all categories based on an “impact potential’ scoring.
The ESAs emphasised that “any ‘impact’ sub-category would have to be sufficiently clear for retail investors to understand their parameters and make an informed investment decision,” said André.
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