‘SFDR 2.0’ – what's the latest?

The Sustainable Finance Disclosure Regulation (SFDR) is a cornerstone of the EU's strategy to integrate sustainability into the financial markets. However, the regime is complex and implementation has been challenging. Just over two and a half years since it first became effective, there are mixed views on whether SFDR remains fit for purpose.

On 4 December the Joint Committee of the European Supervisory Authorities (ESAs) published a Final Report containing proposed amendments to Level 2 SFDR, reflecting a further step towards “SFDR 2.0”. The proposed amendments include: (i) changes to the list of PAI indicators and the PAI reporting framework; (ii) changes to the way in which firms disclose their approach to the ‘do no significant harm’ test; (iii) a new set of disclosures for funds with greenhouse gas emission reduction targets; and (iv) revisions to the layout for the pre-contractual and periodic disclosure templates.

It's likely that these proposed changes will take effect well in advance of the proposed more significant overhaul of SFDR (described by the market as “SFDR 2.0”). 

This briefing considers how the European environmental, social and governance (ESG) regulatory landscape applicable to asset managers has changed throughout 2023, the potential impact on sponsors and managers and what’s next on the horizon.

The ‘Great Reclassification’

On 1 January 2023 the SFDR Level 2 Regulation became effective. From a regulatory perspective, this introduced requirements on the detailed product-level disclosures including pre-contractual, website and periodic disclosures.

There had been uncertainty around the meaning of ‘sustainable investments’ and the methodology that should be used to assess relevant investments for some time. Towards the end of 2022, the European Securities and Markets Authority (ESMA) clarified that Article 9 funds should only hold ‘sustainable investments’ (except for cash and assets used for hedging). As a result, the market saw a significant number of funds positioned as Article 9, ‘reclassify’ to Article 8 prior to 1 January.

Based on Morningstar’s latest market report (SFDR Article 8 and Article 9 Funds: Q3 2023 in Review), between the last quarter of 2022 and first quarter of 2023, around 350 Article 9 funds were repositioned to disclose under Article 8 SFDR.

However, in April 2023, the European Commission (EC) published further guidance which clarified that sponsors and managers should set their own methodology for assessing whether investments are ‘sustainable investments’ and disclose the underlying assumptions.

Even with this clarification, there remains uncertainty in the market. This is likely fuelled by a number of factors including the economic conditions, increased focus on greenwashing claims and ever-changing regulatory landscape.

What can we expect from SFDR 2?

In 2023, there have been published consultations in relation to both Level 1 and Level 2 SFDR. 

Level 2 – in April 2023, the ESAs published a consultation of SFDR Level 2, in accordance with a mandate given by the EC. The consultation focussed on a review of the principal adverse impact (PAI) indicators, ‘sustainable investments’ definition and the mandatory disclosure templates. Given that the consultation was published only four months after the introduction of the Level 2 requirements, the proposed significant changes were potentially unwelcome – at least in terms of timing.

As noted above, following the consultation, in December 2023, the ESAs published their final report setting out the proposed changes to the Level 2 requirements. In more detail, these include:

• Amendments relating to PAI – including additions to the list of mandatory and opt-in social PAI indicators; technical adjustments to Table 3 PAI indicators; changes to environmental PAI indicators; and technical amendments to the PAI framework such as changes to formulae;

• Updates to the Do No Significant Harm (DNSH) disclosures - in particular including a requirement to disclose the criteria for the PAI indicators taken into account for the purposes of DNSH, as well as ‘safe harbour’ for taxonomy-aligned investments;

• New disclosures relating to GHG emissions reduction targets - applicable to products having GHG emissions reduction as their sustainable investment objective, including products that passively track EU climate benchmarks;

• Other amendments to the Level 2 framework - including catering for financial products with investment options and simplifying the pre-contractual and periodic disclosure templates.

The EC now has 3 months to review these changes and decide whether to endorse it in whole, make amendments or delete certain of the proposed amendments.

Once adopted, the draft Level 2 regulation will be forwarded to the European Parliament and the Council for their scrutiny, typically within 2 to 4 months. It will likely still be some time before these changes are effective and market expectation suggests it will not be before 1 January 2025.

Level 1 – in September 2023, the EC launched an extensive consultation (including both a public consultation and a targeted consultation) to seek feedback on how SFDR is working in practice. In terms of potential future changes to SFDR, at a high level, the consultation focuses on the following topics:

• Entity-level disclosures: the EC has queried the usefulness and appropriateness of entity-level disclosures. The Consultation explores whether SFDR is the correct platform for entity-level disclosures, especially since other EU legislation also mandates such disclosures (e.g., CSRD). This is especially relevant for investment managers who must consider both entity-level and fund-level compliance.

• Product-level disclosures: the consultation queries whether standardised product disclosures should apply to all products, regardless of their ESG claims.

• Introduction of categorisation / labelling: the EC suggests a product categorisation / labelling system. Given that other key jurisdictions like the UK and the US are also developing their own sustainable finance frameworks, a major concern for investment managers would be ensuring that any potential labelling regime is carefully designed to be interoperable with the investment labels or sustainable finance frameworks of other key jurisdictions. This would be needed in order to limit confusion as well as reduce the associated compliance burdens for investment managers which may be required to comply with multiple labelling regimes.

The consultation will close on 15 December and the outcome could be ‘SFDR 2’ which would have far reaching consequences for sponsors, managers and their portfolios. This is particularly unwelcome now that managers and sponsors have spent the last three years getting up to speed on SFDR and expending time, money and resource to implement policies, processes and procedures that are aligned with the regulatory requirements. Therefore, it is reasonable to expect a frustrated response from market participants. The proposed changes to both Level 1 and Level 2, if implemented, would likely result in a significant overhaul of disclosures, internal procedures and even investment strategy and process in some cases.

That said, there are clearly challenges with the current regime and an (almost) complete re-write could be an opportunity to bring SFDR into alignment with the now more developed sustainable finance framework in Europe (Taxonomy, CSRD and CSDDD). In addition, it appears that the EC’s proposals draw on the UK’s Sustainability Disclosure Regime and this could result in greater alignment between the UK and EU’s approach (resulting in longer-term efficiencies) which may help those managers that manage funds offered in both the UK and the EU.

Whatever happens, in our view it will be important that the revised regime allows for flexibility and adaptability so that it can move with the times.

Other developments

There have been other notable developments this year including:

• PAI Report – the ESAs’ annual report on the extent of voluntary disclosure of PAI (PAI Report) was published in September. PAI disclosures at entity level are optional for most managers / sponsors (except the largest). The PAI report noted that there is still significant variation in the extent of compliance with the voluntary disclosures across different jurisdictions and financial market participants. However, the results of the survey showed an overall improvement in the application of voluntary disclosures, and in the accessibility of disclosures on websites (when compared with last year’s results).
  
  Areas for improvement flagged in the PAI Report relate to explanations of non-consideration of PAI (which the ESAs considered to be incomplete) and disclosures on the degree of alignment with the Paris Agreement (which the ESAs considered to be vaguely formulated).

• Commentary from National Regulators – certain national regulators have expressed views on the success of SFDR and areas for improvement. For example, the French regulator (AMF) published a paper in February which proposed minimum environmental standards for Article 8 and 9 funds. Also, the Dutch regulator (AFM) published a paper in November which proposes the use of investment labels (in a similar way to the UK’s proposals) and minimum disclosures for all products.

• ESMA article on fund naming – in October 2023, ESMA published a Trends, Risks and Vulnerabilities Risk Analysis entitled “ESG names and claims in the EU fund industry” (Article). The Article focuses on EU investment funds and considers data obtained from 36,000 funds and more than 100,000 documents available at the end of 2022.
  
  The findings reported in the Article are not surprising: ESMA found that funds increasingly use ESG-related language in their names, investors consistently prefer funds with ESG-related words in their names, and the fund industry adapts the language it uses depending on the type of communication or document (i.e., regulated or unregulated) particularly in relation to funds sold to retail investors.

• Fund naming guidelines – in December 2023, ESMA published updated guidelines on funds’ names using ESG or sustainability-related terms. Sustainability-related terms in funds’ names should be used where the fund (1) applies a minimum of 80% of its investments in order to meet the sustainability characteristics or objectives, (2) applies the Paris-aligned Benchmark (PAB) exclusions, e.g., in respect of fossil fuels, controversial weapons and tobacco and (3) invests meaningfully in sustainable investments. Funds using impact or transition-related terms in their names should ensure that investments are (1) made with the intention of generating a positive, measurable social or environmental impact alongside a financial return or (2) on a clear and measurable path to social or environmental transition. ESMA intends to adopt the guidelines as amended following completion of the review of AIFMD and the UCITS Directive.

• Other developments – given the fast pace of regulatory change, there are continual developments in the EU, UK and worldwide. In the EU, ESMA has recently published three explanatory notes covering key topics relevant to SFDR (sustainable investments; do no significant harm; and use of estimates). In the UK, the FCA has just finalised its rules and guidance on the UK’s investment labelling and disclosure regime (see our client briefing on the UK SDR).

Conclusion

Whilst 2023 started with the implementation of Level 2 SFDR, it is clear that the dust has not settled yet. In 2024, we can expect the EU regime to evolve, and we will also see the introduction of the new UK regime. The data shows that there is some uncertainty in the market, which is not surprising. Morningstar reported that Q3 of 2023 saw the lowest level of subscriptions for Article 9 funds since the introduction of SFDR, as well as a decline in newly launched Article 8 and Article 9 funds. However, the data also shows that Article 9 funds (and more ambitious Article 8 Funds which make sustainable investments) are faring better with investors (from a net inflow perspective).

Even though changes to the regime may be frustrating and costly in the short term, they will hopefully result in longer-term gains such as increased clarity and certainty of requirements, cost and resource efficiencies, interoperability with other international regimes, and flexibility with a future-proofed approach. With over €5 trillion of assets now sitting in Article 8 and 9 Funds, the regime must already be seen as a success by some metrics. So long as investors retain confidence in SFDR/SFDR 2, the cost and effort of compliance will be well worth it for sponsors.