The European Commission has issued a Targeted Consultation and a Public Consultation on the implementation of the Sustainable Finance Disclosure Regulation (SFDR). The Consultations include a series of questions on the practical functioning of the SFDR and its possible reform. The EU appears to have recognised that the SFDR is not as user-friendly as it had hoped and is seeking to assess its potential shortcomings and explore potential changes.
Direction of travel
Although the Consultations do not include any concrete proposals, the questions do provide some indication of the EU's thinking and the key areas where reform is being considered. In particular, the Targeted Consultation discusses the following:
- A potential categorisation system for financial products which may be based on the current Articles 8 and 9 of the SFDR or on brand new categories. If the latter, Articles 8 and 9 may disappear entirely, which would represent a material change for the industry.
- The possibility of product level disclosure requirements for all financial products offered in the EU, including those which do not make any sustainability related claims (e.g., so-called "Article 6 products").
- A reworking of the SFDR disclosure requirements – which may or may not lead to additional disclosure requirements.
Overall the Consultations indicate a shift in the EU's approach - potentially more closely aligning with the FCA's Sustainability Disclosure Regime (discussed here: FCA consultation on new UK sustainability disclosure regime and investment labels).
The Consultations are the first step in the European Commission's so-called "fundamental review" of the SFDR but no new rules are expected until after the new European Commission is in place at the end of 2024.
The Consultations both close on 15 December 2023. The Targeted Consultation is aimed at stakeholders who are more familiar with the SFDR and the EU's sustainable finance framework and the Public Consultation (which includes just a sub-set of the questions in the Targeted Consultation) is aimed at a broader range of stakeholders. Industry associations have already started to make representations and no doubt firms will want to engage with the Consultations through their representative bodies, expert groups, Public Affairs functions or consultants.
We have set out below a high-level overview of the Consultations and some initial thoughts.
General questions on the functioning of the SFDR
Both the Targeted Consultation and the Public Consultation ask whether market participants feel that the SFDR is meeting its stated objectives and whether there are any issues with the implementation of the SFDR. The Consultations also ask whether firms have increased their share of products which make sustainability claims since the SFDR started to apply and, if so, whether that has been driven by the SFDR or other factors such as investor interest.
In particular, the Consultations seek views on whether the required disclosures are useful to investors, whether concepts such as "sustainable investment" are sufficiently clear and whether the current framework adequately captures transition investments.
There are also a number of questions around the Principal Adverse Impact (PAI) disclosures including whether all indicators should always be considered material for entity level disclosures and whether the requirement to take account of PAI indicators for the "do no significant harm" assessment creates methodological challenges at product level.
There are also several questions on data gaps and the use of estimates as well as the costs of the SFDR disclosure requirements.
One section of the Consultations focuses on the interaction of the SFDR with other EU sustainable finance legislation, such as the Taxonomy Regulation and the Corporate Sustainability Reporting Directive (CSRD), including whether the approaches under different pieces of legislation are consistent.
The European Commission has not, at this stage, indicated what (if any) changes it is seeking to make to the specific provisions of the SFDR, but it seems clear from the questions asked that the Commission sees that there is room for improvement in the functioning of the SFDR and is open to the possibility of making changes to nearly all aspects of the SFDR.
Potential changes to disclosure requirements
Questions on potential changes to disclosure requirements are included in the Targeted Consultation. There is also an acknowledgement that, while the SFDR was designed as a disclosure regime, it is in practice being used as a labelling regime.
The Targeted Consultation asks whether the EU should impose uniform product level disclosure requirements for all financial products offered in the EU regardless of whether they make sustainability related claims or not. This is likely to be a particular concern to those firms which have avoided making sustainability claims in order to minimise the requirements applicable to them under EU sustainable finance legislation (i.e., so-called "Article 6 products").
It also includes questions about the usefulness of existing disclosures under the SFDR, including whether it is appropriate to have information across three places (i.e. pre-contractual, periodic and website disclosures); whether it is useful that product level disclosures are "publicly" available; and whether some product level disclosures should be expressed on a scale (e.g. if the disclosure results for similar products were put on a scale, in which decile would the product fall).
Again, the type of questions being asked suggests that the European Commission considers that the current requirements may need to be tweaked in some way both at entity and at product level. Many market participants may be concerned that this may lead to more, and not less, complexity (such as the proposals to introduce scaled product level disclosures) and therefore any developments will need to be monitored closely.
Potential categorisation system for financial products
The Targeted Consultation also includes questions on a potential voluntary categorisation system for financial products. The European Commission is of the view that "Articles 8 and 9 of the SFDR are being used as de-facto product labels" and considers that the proliferation of national-level sustainability labels suggests that there is a market demand for such tools. If adopted, a product categorisation system would represent a significant move away from the EU's position to date that the SFDR is a disclosure regime and not a labelling regime.
Although the Commission states that it is only consulting at this stage, the Commission outlines two alternative options, which suggests a relatively advanced level of thinking on this.
Option 1 would be a number of new categories which are not based on Articles 8 and 9 of the SFDR and which would distinguish between products based on the type of investment strategy the product pursues (such as the promise of a positive contribution to certain sustainability objectives or a transition focus). This approach could include a distinction between:
- Products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability related problems (e.g. renewable energy or companies building social housing).
- Products aiming to meet credible sustainability standards or adhering to a specific sustainability related theme (e.g. investments in companies with strong representation of women in decision making).
- Products that exclude activities and/or investees involved in activities with negative effects on people and/or the planet.
- Products with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in.
The European Commission states that if this option were adopted then concepts such as environmental/social characteristics or sustainable investment and the distinction between Articles 8 and 9 of the SFDR may disappear altogether from the transparency framework. This would represent a highly significant change to the current EU sustainability regime and potentially align the SFDR more closely with the FCA's proposed Sustainability Disclosure Regime.
Option 2 would be to establish a new categorisation system based on the existing Articles 8 and 9 of the SFDR. As part of this the Targeted Consultation asks questions about whether the current SFDR concepts are fit for that purpose and what the minimum criteria be for each element of the "sustainable investment" definition should be.
The Commission also asks whether a minimum proportion of Taxonomy aligned investments would be needed for a product to fall into a particular category and, if so, what those minimum proportions should be.
For both options, the Targeted Consultation also asks whether there should be mandatory third-party verification of product categories or, instead, self-declaration by the product manufacturer.
The Targeted Consultation also asks whether the use of particular terms (such as "sustainable", "ESG", "SDG", "green", "responsible" and "net zero") should be prohibited for products that do not fall into one of the relevant product categories and whether certain terms should be reserved for certain specific product categories.
Travers Smith has extensive experience of advising on both UK and EU ESG matters and we will be tracking the progress of the Consultations and any future proposals closely. We will continue to engage extensively with industry associations and clients are very welcome to get in touch with us if they would like to share any thoughts or views on the Consultations more widely.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.