The European Commission (the Commission) has published two consultations to both evaluate and assess enhancements to the EU’s Sustainable Finance Disclosure Regulation (SFDR). Open until 15 December 2023, the Commission is asking for feedback on how the current SFDR framework is working in practice and— in recognition of the fact that the SFDR has been mistakenly applied as a labelling (instead of disclosure) regime and that there are inconsistent market interpretations—how it could be improved.

This is a welcome policy commitment to enhancing the EU sustainable finance legislative framework’s usability and its role in mitigating greenwashing. In our view, the industry would very much welcome regulatory consistency, legal certainty, simpler implementation and international co-operation – which we expect this evolution may well help facilitate.

The ‘targeted consultation’, in the form of a questionnaire, covers four topics, while the shorter ‘public consultation’ covers just the first two. 

In this alert, we set out the key elements of the topics to be assessed, along with our thoughts and comments. 

The establishment of a categorisation system will potentially create the biggest change, in particular the ability for transitional strategies to be recognised as sustainable. This would represent a fresh approach to current guidance - that Article 9 funds must be investing fully in investments that already qualify as sustainable, so for example a transitional strategy to move assets to become sustainable would only be disclosed under Article 9 when all the assets in the portfolio are sustainable and meet the relevant SFDR criteria.

The output from these consultations is expected in Q2 2024. This is an initial feedback process only, with complementary workshops and roundtables to follow. At the moment there is nothing substantive to illustrate what SFDR II (if any) may look like (for instance, legislative amendments or an outline roadmap of what to expect). Therefore, for the foreseeable future the current legislative framework remains in place.

Current Requirements of the SFDR

The Commission is seeking views, opinions, and explanations on the following:

• How efficient and effective the disclosure framework has been to date
• Potential issues around key concepts such as ‘sustainable investment’ (also relevant to the prospective establishment of a categorisation system, covered below)
• Market challenges and SFDR deficiencies— including data gaps, the SFDR’s use as a labelling and marketing tool instead of as the intended disclosure framework, and its failure to capture investments in transition assets
• The application, methodology, and appropriacy of the principal adverse impact (PAI) indicators at entity (Article 4) and product (Article 7) levels — in particular, how the relevant disclosures explain how the indicators for PAI have been taken into account for the ‘do not significant harm’ (DNSH) test at the product level
• Estimated one-off and recurring annual compliance costs (if possible, split between product-and-entity level disclosures), including third-party costs such as for data providers and advisers
• Issues in obtaining high-quality data and the SFDR’s flexibility to allow for the use of estimates
• Market data on the number of Article 8 and 9 products offered year-on-year since the SFDR took effect in March 2021

Interaction with other sustainable finance legislation

This possible overhaul would also affect related sustainable finance legislation, such as the Taxonomy Regulation (Taxonomy), Benchmarks Regulation, MiFID and AIFMD supplemental legislation, the Corporate Sustainability Reporting Directive (CSRD) (and its European Sustainability Reporting Standards) and the PRIIPs Regulation. As well as considering the extent to which the information to be reported on across the frameworks is consistent, streamlined and useful, focus areas in the questionnaire relate to whether there is sufficient clarity on two specific areas:

• How to treat Taxonomy-aligned investment (relating to the Commission’s recent FAQ confirming that investments in ‘environmentally sustainable economic activities’ pursuant to the Taxonomy automatically qualify as SFDR ‘sustainable investment’)
• The use of EU climate benchmarks in connection with products that have the reduction of carbon emissions as their objective (relating to Commission guidance  that funds that passively track an EU climate benchmark fall within Article 9(3) and are deemed to have sustainable investment as an investment objective, and that active funds that do not track a climate benchmark must explain how the carbon reduction objective is achieved)

Potential Changes to the Disclosure Requirements for Financial Market Participants

In addition to consideration of SFDR entity-level disclosures in general, and if there is scope for streamlining requirements with related legislation, the Commission is looking at various issues on product-level disclosures:

• Uniform disclosure requirements for all products, including with reference to a limited selection of PAI indicators, regardless of their sustainability claims — which would be a departure from specific disclosures required for only those that fall under SFDR Article 8 and 9 
• Uniform disclosure requirement for some products (as set out above) but based on a threshold test (e.g., AuM test, products available to retail investors), regardless of their sustainability claims
• Probing: (i) the need for disclosures in pre-contractual, website, and periodic reporting materials; (ii) the need for additional disclosures on sustainability claims; and (iii) how to address confidentiality issues in website disclosures
• The accessibility and usability of disclosures to end investors (tying in with the European Supervisory Authority (ESA)’s complementary proposals for machine readability criteria that are ready for digital use) and variables with different investor and product types

Potential Establishment of a Categorisation System for Financial Products

The Commission is open to suggestions but sets out its proposals (albeit with reminder that these are in the context of a non-committal consultation) for a voluntary sustainability product categorisation system. This could be achieved by discarding the existing Articles 8 and 9 categorisations and introducing a fresh approach focused on investment strategy (Approach 1). Alternatively, it could be achieved by converting Articles 8 and 9 into clearly defined formal product categories, which would involve building on the existing regime by clarifying and adding minimum criteria to underpin existing concepts (Approach 2). Below is an overview of the proposed labels under Approach 1 and how they may align with those proposed by the FCA under the UK’s Sustainability Disclosure Requirements (SDR) (as per the October 2022 consultation, with feedback and an FCA policy statement pending).

For Approach 1, input is requested on minimum criteria (and any process criteria to demonstrate the stringency) for each proposed product and whether or not the categories should be mutually-exclusive. Also the merits of distinguishing between products with a social and environmental focus.  For Approach 2, input is requested on whether or not key concepts (‘E and/or S characteristics’, ‘sustainable investment’, ‘contribution’, ‘DNSH’ and ‘investee companies’ good governance practices’) are fit for purpose and require any adaptations (eg good governance practices related to real estate investments). Also, on any specified minimum criteria and minimum proportions. For both approaches, comments are invited on the need for transitional support for a new regime and a governance system, including potential verification or supervision of the categorisations.

Knock-on impacts also require scrutiny — for instance, how a categorisation system would interact with EU benchmarks, PRIIPs KID disclosures, and sustainability assessments based on sustainability preferences under MiFID and the Insurance Distribution Directive. The Commission also wants more input on marketing communications, product names, and whether the SFDR should include additional rules on labelling and marketing communications. The ESMA consultation on guidelines on fund names using ESG or sustainability-related terms is not referenced in these consultations, but the feedback already provided on these guidelines will also be relevant here.

Final thoughts

Pending the outcome of this consultative process, there may be limited progress on the various other outputs still expected from the European legislators — for instance: (i) amendments to the SFDR Level 2 regulatory technical standards (RTS) amendments following the April 2023 consultation (see our client alert ESAs propose adjustments to the EU SFDR rules for more); (ii)  outcomes from the ESA’s call for evidence on greenwashing (a final report is expected by end of May 2024); and (iii) the development of a taxonomy for social investments. 

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