SFDR Overhaul Signals More Uncertainty for Managers

Review could permit greater interoperability with fund-labelling, disclosure regimes in other jurisdictions. 

A wide-ranging review of the EU’s Sustainable Finance Disclosure Regulation (SFDR) has been welcomed for its recognition of the changing global landscape for sustainable investment, but risks near-term disruption for asset managers and their clients.

On 14 September, the European Commission published a long-anticipated consultation, which will close on 15 December, seeking feedback on the current requirements of SFDR, its interactions with other sustainable finance legislation, and potential changes to disclosure requirements for financial market participants.

“It is really pleasing to see the breadth and depth of the questions,” said Christine Phillips, Head of ESG Transactional and Advisory at law firm Fieldfisher.

“It’s absolutely right that the Commission is considering whether SFDR is fit for purpose and what needs to change.”

Although SFDR was first designed to be a disclosure regime, the consultation noted that it is being used as a labelling system, suggesting “there might be a demand for establishing sustainability product categories”.

There has been ongoing uncertainty among fund providers and users surrounding what constitutes an Article 8 (environmental and/or social characteristics) or 9 (environmental and/or social objective) fund, with the former serving as a ‘catch-all’ for a huge variety of products.

Funds that are classified as Article 8 currently range from those with very simple exclusions through to impact funds that don’t precisely meet Article 9 criteria, experts told ESG Investor.

Dr Anthony Kirby, Wealth and Asset Management Consulting Regulatory Intelligence Lead at Big Four accountancy firm EY, added that “a more explicit breakdown of the qualifying criteria acceptable to each national regulator” would also be helpful to market participants, as some European jurisdictions have adopted their own understanding of Article 8 and 9 thresholds.

Weighing the options 

In the consultation, the Commission has identified two possible strategies to transition the existing SFDR framework to a more precise product categorisation system.

The first would build on and better develop the distinctions between Articles 8 and 9, and the existing concepts embedded in them, introducing additional minimum criteria to more clearly define what kind of product can sit within each category.

Alternatively, the consultation has proposed a product categorisation system focused on the type of investment strategy, such as transition focus or promised contributions to certain environmental objectives.

If the latter option is carried forward, the consultation said concepts such as environmental and/or social characteristics/objectives, ‘sustainable investment’, and Article 8 and 9 “may disappear altogether from the transparency framework”.

Any prolonged lack of clarity over which direction the Commission will take is likely to cause “market uncertainty around how funds will be categorised and named going forward”, said Benjamin Maconick, Managing Associate in law firm Linklaters’ financial regulation group, adding that this could make it difficult for investors to design a sustainable product in the near term.

It is also currently unclear how the review will interact with ongoing assessments and proposals being carried out by the three European Supervisory Authorities (ESAs), which also aim to “refine and improve SFDR as it stands”, Maconick said.

These include the ESAs’ review of SFDR’s regulatory technical standards (RTS), and the European Securities and Markets Authority’s (ESMA) draft rules for sustainability and ESG fund labels.

Grappling with interoperability 

The SFDR review is nonetheless a welcome opportunity to assess the new landscape of disclosure and labelling rules for sustainable funds, according to Phillips from Fieldfisher.

“The landscape is very different from when SFDR first came into force, with the International Sustainability Standards Board (ISSB) issuing its standards and the European Sustainability Reporting Standards (ESRS) coming out.

“We’ve got to look at SFDR in light of these changes and identify the differences between disclosure regimes.

“Different systems in different places will confuse the market; we have to get to a place that is proportionate,” she said.

In particular, increased alignment with the UK Financial Conduct Authority’s (FCA) proposed Sustainability Disclosure Requirements (SDRs) could be a welcome move for investors, experts told ESG Investor.

Last year, the FCA introduced its proposal for three product labels in a bid to crackdown on greenwashing: ‘sustainable focus’ (funds investing in sustainable assets), ‘sustainable improver’ (funds investing in assets undergoing a sustainable transition), and ‘sustainable impact’ (funds targeting sustainable solutions).

The UK watchdog has delayed the publication of the SDR policy statement to Q4 of this year.

“The FCA has previously been able to hold back and review what the EU was doing and act with hindsight; the EU didn’t have anything to compare its work against,” said Maconick.

“If there is future alignment with the FCA SDRs, that will be great, but there is the risk that the EU goes for a more granular product categorisation system, which could actually reduce interoperability instead.”

The UK government has further introduced plans for its Sustainability Disclosure Standards (SDS), which will build on the ISSB’s standards.

On 20 September, the US Securities and Exchange Commission (SEC) published new rules to prevent misleading or deceptive use of ESG terms in fund names by modernising the existing Investment Company Act ‘Names Rule’.

The Names Rule, which requires funds with a name suggestive of a particular type of investment to invest at least 80% of its assets accordingly, has been extend to cover ESG investment strategies.

The final rule does not include a previously proposed section designed to prevent misleading labelling, in which funds that have considered ESG-related factors, but haven’t made this the objective of the fund, would not be allowed to use ‘ESG’ or a similar term in its product name.

Read more articles like this on Regulation Asia’s sister publication, ESG Investor.

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