QUO VADIS SFDR? EUROPEAN COMMISSION LAUNCHES TWO NEW CONSULTATIONS

The European Commission has launched two new consultations which seek feedback on the main concerns of market participants under the current SFDR regime and ask for input on potential amendments to the SFDR, including a new product labelling framework.

1. WHAT ARE THE LATEST SFDR-RELATED CONSULTATIONS?

On 14 September 2023, the European Commission (Commission) launched two new consultations to seek feedback on the Sustainable Finance Disclosure Regulation (SFDR). The consultations follow the announcement by Commissioner Mairead McGuinness in December 2022 of a comprehensive assessment of the SFDR framework to assess potential shortcomings.

The consultations seek to review what progress has been made with respect to the implementation of the SFDR since coming into force in March 2021 and to identify how the SFDR framework could be improved to enhance legal certainty, useability and its ability to tackle greenwashing.

The first consultation is addressed to any stakeholder with general knowledge of the SFDR (Public Consultation), whereas the second consultation is targeted at public bodies and stakeholders who are more familiar with the SFDR and the EU's sustainable finance framework as a whole (Targeted Consultation).

Both the Public Consultation and the Targeted Consultation consider:

• the functioning of the current regime with a focus on clarity and usefulness of disclosures, costs, data and estimates (section 1); and
• SFDR's interoperability and alignment with other EU sustainable finance legislation, including the EU Taxonomy, the EU Climate Benchmarks, the Corporate Sustainability Reporting Directive (CSRD) and European Sustainability Reporting Standards (ESRS), sustainability preferences under the current Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD), and key information documents for retail investors under the Packaged Retail and Insurance-based Investment Products Regulation (PRIIPs) (section 2).

The Targeted Consultation also considers:

• the utility and appropriateness of entity and product level disclosures and the current form of presentation and publication of disclosures (section 3); and
• the possibility of establishing a product categorisation or labelling regime for financial products and the form this may take (section 4).

2. WHY ARE THE CONSULTATIONS IMPORTANT?

The SFDR has been in force for two and a half years, yet several concepts remain unclear and/or unworkable in practice. While the consultations are therefore likely to rouse strong criticism of the regulation, they are also an important opportunity for stakeholders to seek much-needed clarification.

In fact, such clarification may not be so far-off. The way the Commission has framed its consultation questions, especially those in the Targeted Consultation, allows us to draw some conclusions as to how the SFDR regime may change going forward. These questions relate to (i) the current status of and potential improvements to the SFDR and (ii) the potential introduction of a product labelling regime based on or in parallel to the SFDR.

3. WHAT ARE THE MAIN CONCERNS UNDER THE CURRENT SFDR REGIME?

3.1 More clarity is needed on SFDR concepts, including "sustainable investment"

Various questions in the Targeted Consultation ask stakeholders to provide feedback on whether the current requirements and concepts under the SFDR are sufficiently clear and performing their intended function.

One of the biggest "unresolved mysteries" of the SFDR has been the concept of "sustainable investment" under Article 2(17) of the SFDR for which the Commission provided helpful guidance on 6 April 2023. Question 1.6 of the Targeted Consultation picks up on this discussion and asks respondents to indicate whether they think certain legal requirements and concepts in the SFDR, including "sustainable investment", are sufficiently clear.

Question 1.7 of the Targeted Consultation further questions whether a lack of clarity of this and other legal concepts creates legal uncertainty, risk of greenwashing and mis-selling, reputational and other risks for financial market participants (FMPs) and financial advisers (FAs). Subject to the responses received, we would expect the Commission to provide further clarification on these topics.

3.2 Use of the principal adverse impacts (PAI) concept and indicators

Explaining the different use cases for PAI and PAI indicators under the SFDR is a key challenge. PAI can be considered at entity and product level, taken into account with respect to specific sustainable investments or used as part of a voluntary investment strategy – and not all of these use cases are coherently connected. It is therefore no surprise that the Targeted Consultation asks (i) whether methodological challenges arise when PAI indicators are used for "do not significantly harm" (DNSH) assessments under Article 2a of SFDR, and (ii) if it is clear how PAI disclosures at product level under Article 7 SFDR interact with the disclosure requirements under Article 8 and 9 of SFDR (question 1.9).

When speaking about PAI, FMPs have regularly criticised the requirement to use a set of pre-defined and, to a large extent, prescribed PAI indicators which do not adequately reflect the topics ad themes that are material for the investment strategy of the respective product. Although the concept of materiality is generally on the rise (e.g., in the context of the ESRS under which all topical disclosures are made subject to materiality, even those linked to PAI indicators that are mandatory under the SFDR), the SFDR currently relies on a rather simplistic "one size fits all" approach. It is therefore interesting that the Targeted Consultation now asks whether the current approach is appropriate or whether respondents would find it more appropriate for all PAI indicators to either always be considered material or to universally be subject to a materiality assessment by the relevant FMP (question 1.8). Requiring a reasonable materiality assessment with respect to all PAI indicators could not only help to make PAI disclosures more nuanced and meaningful, but also help to align SFDR with the CSRD/ESRS regime (see question 2.3).

3.3 Interoperability between SFDR and other EU sustainability regulation

In line with the Commission's general aim to ensure interoperability between different pieces of EU legislation (which sometimes leads to lengthy references to numerous points of obscure EU legislation), the Targeted Consultation also addresses whether the SFDR works in tandem with other EU sustainability regulation. One point of focus is the framework established by the EU Taxonomy Regulation and its implementing acts (EU Taxonomy). For example, question 2.1 enquires whether the recently introduced "safe harbour" for Taxonomy-aligned investments (under which Taxonomy-aligned investments are now deemed to be sustainable investments under the SFDR in certain circumstances) is sufficient.

The Commission is also enquiring if the relationship between the EU Climate Benchmarks and the SFDR is sufficiently clear, following the issuance of its guidance on 6 April 2023 (question 2.2), as well as whether the SFDR is aligned with the CSRD/ESRS (question 2.3). The latter question is one which most FMPs are likely to answer in the negative due to the mismatch between the rigid SFDR PAI regime and the materiality-based topical disclosures under the ESRS. Although the Commission's guidance clarified that PAI indicators not reported under the ESRS can be considered "immaterial", this has not fully resolved this inconsistency between the different pieces of legislation. For example, it remains unclear whether this means that the PAI value for the quantitative PAI indicators, such as GHG emissions, non-renewable energy consumption/production, emissions to water or hazardous waste, should be recorded as zero although the reporting company may still generate emissions, consume/produce non-renewable energy or produce waste.

Questions 2.4 to 2.6 deal with the alignment between the SFDR and the sustainability preferences under MiFID II and IDD. This is another challenging concept as it is not apparent to most industry participants why the SFDR disclosure categories do not match the sustainability preferences under MiFID II and IDD – counter-intuitively, many an Article 8 SFDR financial products are not eligible under any of the sustainability preferences categories although they are considered as "more sustainable" products.

3.4 Standardised sustainability disclosures for all financial products

Since coming into force, FMPs have struggled to understand the differences between the different financial product categories under SFDR (Articles 6, 8 and 9 SFDR) and the resulting disclosure. The dividing line between Article 6 and 8 SFDR is very thin and there is also not much difference between an Article 8 SFDR product with a high share of sustainable investments and an Article 9 SFDR product. Accordingly, we see that in many instances more time is being spent on allocating financial products to the right "SFDR buckets" than on preparing and making sustainability-related disclosures.

It is therefore not surprising that question 3.2.1 of the Targeted Consultation openly asks whether uniform disclosure requirements should be introduced for all financial products offered in the EU, regardless of their sustainability-related claims or any other consideration. Questions 3.2.1(a) and (b) elaborate on the idea of uniform disclosures and ask for feedback on specific information across all financial products (limited set of PAI indicators, EU Taxonomy, engagement strategies, exclusions and ESG integration). These categories are referred to in several questions (including in the context of the labelling regime, see section 4 below) and, interestingly, circle back to the early days of socially responsible investment (SRI) approaches that have now become increasingly popular again (e.g. in the context of the Self-regulation of the Swiss Asset Management Association (AMAS) or as labels under the upcoming Sustainability Disclosure Regime (SDR) in the UK). Question 3.2.2 raises the point on whether only financial products above a certain threshold should be required to make the relevant disclosures (an approach similar to that under the French Energy and Climate Law, which sets a threshold of EUR 500 million threshold for fund level disclosures).

Another interesting discussion point is introduced by question 3.2.9, which asks whether the sustainability of a financial product could be determined by reference to a scale (similar to risk profile scales, such as synthetic risk and reward indicators (SRRI) and SRI for retail funds) rather than by fixed categories such as Article 6, 8 and 9 of the SFDR. For many strategies, it will, however, be very difficult to determine which strategy is "more sustainable" or more "impactful" than the other. In the end, using a scale will also require to put financial products into specific "baskets", for which a clear labelling regime is likely more suitable.

3.5 Benefit of stand-alone or aggregated entity-level disclosures

We note that the Targeted Consultation also asks whether entity-level disclosures under Article 3, 4 and 5 of the SFDR are useful (question 3.1), whether the SFDR is the right place to include entity-level disclosures (question 3.1.3), and whether there is room for streamlining sustainability-related entity-level requirements across different pieces of EU legislation. Given that sustainability risk management (Article 3 of SFDR) and remuneration policies (Article 5 of SFDR) are also regulated by other pieces of EU legislation (e.g. the Alternative Investment Fund Managers Directive (AIFMD) or MiFID II) and the usefulness of entity-level PAI disclosures (Article 4 of SFDR) as aggregated across many different products is very limited, these questions are not surprising.

3.6 Relevance of SFDR for professional investors

Another main point of criticism of the SFDR has been its uniform application across professional and retail investor products. In the context of EU financial services, it is very unusual for disclosure obligations tailored to retail investor products to also bindingly apply to professional investors which do not require the same level of protection. Accordingly, both question 3.2.10, which asks about the sources of sustainability information used by professional investors, and question 3.2.11, which queries the usefulness of SFDR disclosures for professional investors, seem to insinuate that the Commission is reconsidering the relevance of the SFDR for professional investors.

3.7 The need for public disclosures and the split of sustainability information across various documents

Another topic that has been continuously discussed with respect to professional investor products has been the binding obligation to make product-related disclosures under the SFDR available publicly on websites (Article 10 of SFDR). Having to make information on dedicated financial products or financial products reserved for professional investors available to the public has led to many confidentiality and marketing rules issues and has been a constant point of concern for FMPs. Many national regulators have now allowed sustainability-related disclosures on professional investor products to be limited to the product's investors. Question 3.2.6 picks up on this discussion and asks whether confidentiality aspects should be considered and whether sustainability information should only be made publicly available where the product information itself must be made publicly available (e.g. for retail funds).

The Commission also recognizes that the split of sustainability product information across various disclosures (precontractual, periodic and website) may not meet investor demand for a unified, comprehensive disclosure and therefore asks if the current breakdown should be maintained (questions 3.2.4 and 3.2.5).

4. WHAT DOES THE COMMISSION THINK (AND ASK) ABOUT A NEW PRODUCT LABELLING SCHEME?

Although not intended to be used in this manner, Article 8 and 9 of the SFDR have been used as de facto product labels. In the Targeted Consultation, the Commission recognises that this fact alongside the proliferation of national ESG labels suggests there is market demand for a labelling scheme for financial products by ESG or sustainability performance. On this basis, the Commission sets out a number of questions which help to understand how a future labelling scheme at EU level could look like.

4.1 How a labelling regime could be built

Question 4.1.2 puts forward two suggested approaches:

• to convert Articles 8 and 9 of SFDR into formal product categories, and clarifying and adding criteria to underpin the existing concepts of environmental or social characteristics, sustainable investment, DNSH, etc.; or
• to split the proposed product categories in a different way, e.g., by focusing on the type of investment strategy of the financial product (an approach similar to the that taken in the UK under the upcoming SDR regime).

4.2 Possible product categories outside of SFDR

In relation to the second option above, the Targeted Consultation also asks for feedback on the thematic categories that could be used (question 4.1.4), as well as the minimum criteria to be applied to each category (questions 4.1.10 and 4.1.11). The suggested thematic categories are loosely associated with known responsible investing approaches but (likely deliberately) use different terms:

• Category A includes "products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability related problems that affect people and/or the planet", which sounds like a mix of the current concept of "sustainable investments", impact terminology and the United Nations Sustainable Development Goals.
• Category B is dedicated to products meeting "credible sustainability standards" or adhering to "specific sustainability-related themes", which seems to sit across the concept of "sustainable investment" and more advanced ESG integration strategies that use ESG standards or scorings/ratings.
• Category C includes products excluding negative externalities – which is slightly surprising since basic exclusions are generally no longer considered to be sufficient to render a product sustainable.
• Category D is dedicated to transition products – the Commission's new favourite investment category following the issue of the Commission's Recommendations on Transition Finance published on 13 June 2023.
  . Question 4.1.8 asks whether the categories should be exclusive (meaning that financial products must be allocated to only one of these categories) which, given the breadth of investment approaches in the market, will be very difficult or even impossible to maintain.

4.3 Rules on product names

There has been a seemingly endless debate between the Commission, the European Securities and Markets Authority (ESMA) and several national regulators about whether further rules on ESG and sustainability-related fund names are required to protect investors in addition to SFDR. The ESMA consultation on guidelines on funds' names using ESG or sustainability-related terms that ended in February 2023 has not yet led to a final guideline and various national regulators, including the German BaFin, currently apply their own fund naming rules. It is therefore not surprising that the Commission now asks whether the use of certain product names should be regulated to increase clarity with respect to categorisation (question 4.4.1).

4.4 How this fits with the upcoming UK SDR regime

It is worth noting, that although the approach of denominating categories by reference to the investment strategy of the product base mirrors the UK's SDR regime, the categories mentioned in the Targeted Consultation are quite different to those of the SDR. The "Sustainable Improvers" label proposed by the FCA will likely overlap with the transition category (Category D) being considered by the Commission. However, the "Sustainable Focus" and "Sustainable Impact" labels are unlikely to map across cleanly, and will like straddle Categories A and B being considered by the Commission.

5. WHAT TO EXPECT NEXT

The consultations will be accompanied by a series of workshops that will kick off on 10 October. Stakeholders are invited to respond to consultations by 15 December 2023 and the Commission intends to adopt a report on SFDR in Q2 2024.

For more information on what FMPs and FAs can expect next on the EU Sustainable Finance framework please see our comprehensive implementation timeline available here.