The EU regulators are reviewing the Sustainable Finance Disclosure Regulation introduced in 2021, exploring the need for potential additional adjustments.
On 14 September 2023, the European Commission initiated a consultation on its sustainable financial disclosure practices, seeking feedback on Regulation (EU) 2019/2088 — the Sustainable Finance Disclosure Regulation (SFDR). The consultation surveys stakeholders’ experiences during the implementation of the SFDR and, in particular, solicits feedback on its interactions with the broader EU sustainable finance framework.
Background
The SFDR came into effect in March 2021 and sets out how financial market participants should communicate information to investors and make sustainability-related disclosures. One of the EU’s key aims in introducing the SFDR was to ensure transparency and create a level playing field for financial market participants and investors regarding sustainability risks, adverse sustainability impacts, and sustainability-related information in financial products.
The regulation sets out different requirements for sustainability-focused investment products depending on their focus. This includes so-called “Article 8 funds” promoting environmental or social characteristics, and “Article 9 funds” that have sustainable investment as their primary goal, as opposed to “Article 6 funds”, which are all other funds. While the EU did not intend for the SFDR to become a product labelling regime, it has been acknowledged that the Article 8 and Article 9 fund concepts have led certain market participants to use it as such.
Since the introduction of the SFDR, firms have faced implementation issues and difficulties in relation to the legal certainty and useability of the regulation’s framework.
The European Commission has previously sought to clarify the SFDR including through the Q&A process, and the European Supervisory Authorities’ issued a consultation in April 2023, which focused on potential amendments to the regulatory technical standards complementing the SFDR. However, the scrutiny and depth of the questions in this month’s consultation emphasises that the European Commission may be considering a significant overhaul of the SFDR rather than the incremental adjustments seen to date.
Consultation Structure
Two linked consultations have been launched:
- Targeted Consultation Paper: aimed at financial market participants, relevant public authorities, national regulators, and others that are subject directly or indirectly to the provisions of the SFDR
- Public Consultation Paper: aimed at individuals and organisations (e.g., interest groups) that have a general knowledge of the SFDR
The consultations will take place over three months, closing on 15 December 2023. Following this, the European Commission will collate responses to assess whether the SFDR is meeting investors’ needs and expectations, whether it is fit for purpose and how, if at all, it should be amended.
Consultation Focus Points
Labelling
The consultations seek to address operability issues of the current Article 6, 8, and 9 categories. In Section 4 of the Targeted Consultation, the European Commission outlines two possible alternate approaches envisaged:
- to build on and develop the distinction between Article 8 and 9 categories to “more clearly define the products falling within the scope of each article”; or
- to remove Articles 8 and 9 entirely and instead categorise products by type of investment strategy, for instance “promise of positive contribution to certain sustainability objectives”, or “transition focus”.
The above suggestions show an increased focus on the SFDR as a labelling, rather than a disclosure, regulation. In Section 3.2, the Targeted Consultation states “the SFDR was designed as a disclosure regime, but is being used as a labelling scheme, suggesting that there might be a demand for establishing sustainability product categories”, noting “the proliferation of national ESG/sustainability labels in order to communicate the ESG/sustainability performance of financial products”.
Greenwashing
The consultation also notes the risk of greenwashing under the current regime, given growing concerns among asset managers that the misuse of Articles 8 and 9 as product labels increases the potential risk of this issue. Section 4 of the Targeted Consultation notes that the existing concepts and definitions in the SFDR were not conceived as a labelling scheme, and suggests that developing specific and precise labelling criteria focusing on types of investment strategies would mitigate the risk of greenwashing.
Principal Adverse Impact (PAI) indicators
One requirement of the SFDR that certain market participants have found challenging to report on is PAI indicators, including those in relation to climate, social issues, human rights, and anti-corruption measures. Section 1.1 of the Targeted Consultation contains several PAI-related questions – Question 1.8 asks if the indicators in their current form are “always considered material” and Question 1.9 asks whether the requirement to take account of PAI indicators presents “methodological challenges”. This indicates a reassessment of whether PAI indicators are a useful metric, or whether an alternative approach should be taken.
Cost
Another area of focus for the European Commission is the financial cost incurred by firms in complying with the current requirements of the SFDR regime. Question 1.10 asks firms to provide an estimated breakdown of the “one-off and recurring annual costs associated with complying with the SFDR disclosure requirements” and Question 1.4 of the Targeted Consultation asks whether “the costs of disclosure under the SFDR framework are proportionate to the benefits it generates”.
Commonality With the UK’s Sustainable Disclosure Requirements (SDR)
The move towards a labelling, rather than a disclosure, regime would be more aligned with the approach taken by the Financial Conduct Authority (FCA) for the UK’s Sustainability Disclosure Requirements (see this Latham blog post). The European Commission’s new categorisation proposals in Section 4.1.4 of the Targeted Consultation more closely mirror the FCA’s sustainability proposals, consulted on in March 2023, compared to the existing SFDR regime. These categories include products:
- investing in assets that specifically strive to offer targeted, measurable solutions to sustainability-related problems;
- aiming to meet credible sustainability standards or adhering to a specific sustainability-related theme;
- that exclude activities and/or investees involved in activities with negative effect; and
- with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in.
The FCA is set to launch its Sustainable Disclosure Requirements regime later in 2023, emphasising that it serves as a labelling system, in contrast to the SFDR disclosure system currently in place as its European counterpart.
Next Steps
The deadline for responses to the consultations is 15 December 2023. Until then, the consultations will be complemented by workshops and roundtables to enable stakeholders to submit further input. An online workshop will be held on 10 October 2023 to open the discussions, focusing on ways to make disclosures more effective, as well as the potential introduction of product categories. Following the consultation period, the European Commission intends to publish a report on the SFDR in Q2 2024.
Latham & Watkins will continue to monitor developments in relation to the SFDR and the EU sustainability disclosure landscape more broadly.
