SFDR 2: will 2024 open the age of maturity for sustainable finance regulations?
The year 2023 ended with the closing of a European Commission consultation on SFDR of unprecedented importance, that could open the age of sustainable finance regulations maturity. Released in September 2023, it covered all aspects of SFDR, from current experience of financial market participants with SFDR to potential future developments envisaged by the Commission. It is ambitious enough to tackle all the design and operational issues raised by the implementation of the regulation: SFDR’s potential successes, shortcomings and inadequate definitions, but also markets’ needs unveiled through the misuse of SFDR articles 6, 8 and 9 as a labelling system. In particular, the EU Commission is considering the possibility to develop a proper funds classification system.
With such fundamental and structuring ambitions, the consultation has aroused justified interest on the part of asset managers and other financial market participants concerned by SFDR, fueled by mixed feelings. While the clarification and potential fixes to SFDR flaws have been eagerly awaited, tackling implementation problems that could not be solved through mere Q&A will necessitate not least than the reopening of the original Regulation  through a lengthy, complex and potentially very impacting legislative process. Raising concerns as to the potential deconstruction of all the efforts deployed by investment managers to comply with the current SFDR.
In this respect, this consultation marks the end of a phase. That of the foundations of the EU sustainable finance regulation, that started with the first reports of the High-Level Expert Group (HLEG) in 2018 that enshrined all the ensuing sustainable finance regulatory big-bang, as ambitious and structuring as it was intense and chaotic. The time has now come for the first assessments and adjustments to this founding regulatory edifice, SFDR in the first place, to ensure that it responds as effectively as possible to its initial objective: channel much needed capital towards financing a sustainable economy, compatible with the Paris agreement. Stakes are double for SFDR: revamping the transparency regime and establishing – finally- a robust sustainability classification system.
The transparency regime of SFDR is the core purpose of the Regulation, with its primary objective being “Providing investors with transparency on sustainability to reorientate capital flows”, as recalled by the Commission in its consultation. Often overlooked, these disclosure provisions have proven quite weak in practice, but their principle remains extremely relevant and worth a careful revision.
At product-level, SFDR disclosures provide information mainly on sustainability risks management processes. All in all, they could be more concrete, granular and based on exposure to most sensitive sectors. Several avenues could be considered to define a common minimum base for product disclosure requirements that could apply to all products to ensure true comparability, including between vanilla and sustainability-oriented products: information on sustainability opportunities and taxonomy alignment, exposure to main sustainability sensitive sectors (both in terms of risks and opportunities), disclosure of PAIs at product-level with additional changes to be considered to make them really insightful for end-investors, among others. All product-related information could be gathered in a single information document.
Disclosures at entity-level suffers the same flaws, not providing a consolidated vision of the level of sustainability-integration across products. Our investors partners surveyed all confirmed these disclosures are never requested by their clients in the calls for tenders. However, important information is missing for end-investors, such as the percentage of investment in articles 6, 8 and 9 or other sustainability classification, taxonomy alignment of AuM, voting and engagement policies. Successfully revising the disclosure regime of SFDR is key to the credibility of the European Sustainable Finance regulatory package as a decision tool.
The classification regime also obviously requires a revamping. Regulators’ willingness to combat greenwashing with articles 6, 8 and 9 has deviated SFDR from its initial policy objective, leading to its misuse by the market as a labelling system. Raising concerns over the Regulation robustness and risks of greenwashing, hampering comparability and generating confusion, but also mainstreaming ESG and sustainability overnight.
The SFDR categories, despite unclear definitions of article 8 “consider ESG characteristics” and article 9 “sustainable investment as an objective”, have sketched out a simple and clear hierarchy of products based on their level of sustainability ambition– and not based on the industry’s complex practices. The market needed it to evaluate and qualify its approach to sustainability. Should it elaborate on articles 6, 8, 9 or renamed, this hierarchy needs to be maintained and deepened to distinguish the different levels of ambition of products and ensure a clear and comprehensible organization of the market for the end investor.
This has proven all the more a tour de force that, with the obligation for all products to disclose against one category or another, this hierarchy has reclassified the entire market and mainstreamed sustainability. It has given sustainable investment an unprecedented outreach and visibility, making these concepts strong enough to contribute to reorganize the investment market. Making SFDR articles a reference with international outreach outside the EU, and deeply transforming asset managers’ approach to clarify from the beginning their sustainability approach for each fund developed.
"If SFDR categories keep classifying the entire market of investment funds, they cannot hardly be thought as golden standard or labels, but rather as minimum operational requirements, based on self-assessment with potential light external verification or controls"
These strengths have led many Financial Markets Participants to speak out in favor of the existing categories, urging regulators not to “throw the baby out with the bath water”. This could have important implications on the architecture of a future potential classification. If SFDR categories keep classifying the entire market of investment funds, they cannot hardly be thought as golden standard or labels, but rather as minimum operational requirements, based on self-assessment with potential light external verification or controls.
A number of additional leads and clarifications could prove decisive for the success of SFDR 2 potential funds classification. Some structuring elements for investment managers (such as the notion of impact, or the specificities of the different financial products and asset classes considered) remain surprisingly absent and unaddressed in the consultation. Taking them into account, refining definitions, would contribute to better connect the EU Regulation with the conceptual and operational features of investment markets.
If maintained, the definition of Sustainable investment will imply to further clarify the link with the EU Taxonomy Regulation (TR). That seems inevitable for eligible activities included in the TR and located in the EU. For non-eligible, non-EU and/or social activities, regulators could/should leave substantial margin of manoeuver to assets managers where no regulatory text exists. Reconsidering the 100% sustainable investment for article 9 funds, at least for the most complex asset classes sensitive to risks diversification, could facilitate the acceptability of a taxonomy stronger reference. Another important idea has been introduced by the consultation with the definition of a “transition” category, that seems today indispensable to accompany the most polluting industries set to remain part of tomorrow’s economy. This would require robust criteria not to open the gate to greenwashing or mere decarbonization improvements not matching the actual challenges of the transition. Last but not least, a clarification of the role of exclusions and their role in funds classification (not sufficient to define an ESG strategy? But necessary to set a minimum level of quality for and ESG strategy?) will also be indispensable to create consensus, as demonstrated by the recent vivid debate on the update of the French Sustainable and Responsible Investment (SRI) label.
SFDR level 1 reform is key to the credibility of the EU sustainable finance package, but it should be done in articulation with additional developments. It could benefit from an orderly regulatory calendar: while the ESAs have been mandated and have proposed updates to modify the list of PAIs, stabilizing in the level 1 text the principles that make such indicators useful should be a priority, before validating any major changes. Clarifying the links between ESMA’s work on funds names guidelines and the SFDR classification is also needed. Complementary evolutions, such as the extension of the EU taxonomy to social or to the definition of transition pathways, would also support the efficiency of the SFDR provisions and the robustness of the overall EU system.
In all cases, the capacity to reform will remain dependent on the political developments to come in 2024, against a backdrop of multiple uncertainties. The stakes are high for the Commission, which aims to rectify on SFDR the trial and error process that have been the rule in the extremely ambitious implementation of the sustainable finance package since 2018. While the results of the consultation are not yet known, the political orientation and priorities of the Commission to be elected in June will decide whether -or not - and how to use them, with political options that should clarify by end 2024 / early 2025. While the fear of greenwashing and pending ESG fatigue and backlash have dominated regulators’ agenda in 2023, let’s hope that the EU will be in a position to consolidate and streamline the body of legislation that has made it the global pioneer regulator of sustainable finance.