Decoding SFDR 2.0: Navigating The European Commission's Proposed ESG Reforms (Podcast)

On this Ropes & Gray podcast, Michael Littenberg, corporate partner and global head of the firm's ESG, CSR & Business and Human Rights compliance practice, and asset management partner Eve Ellis break down the European Commission's proposed SFDR 2.0 revisions. They discuss new product labels, streamlined disclosure requirements, and the removal of certain compliance pain points. The episode explores operational implications for asset managers, cross-border challenges, and the impact on fund strategies, offering practical advice for navigating the evolving EU ESG regulatory landscape and preparing for upcoming changes.

For more detail on SFDR 2.0 and its impact on asset managers, please see SFDR 2.0 – The Impact for Asset Managers.

Transcript:

Michael Littenberg: Hello everyone, and thank you for listening in to our podcast on SFDR 2.0. I am Michael Littenberg, the global head of Ropes & Gray's ESG, CSR and Business and Human Rights compliance practice. I'm pleased to be here with my asset management partner, Eve Ellis, to talk about this important topic.

Eve, thank you for taking time out of your busy schedule to discuss the European Commission's SFDR 2.0 proposal. I know that you and your team have been working around the clock fielding questions on this one, and I'm really thrilled to get your perspective today since you're one of the very small group of lawyers that's the real OG in the SFDR space.

The Sustainable Finance Disclosure Regulation was adopted way back in 2019, and it started to take effect in 2021. To set the scene, what is the Commission's proposal trying to solve for or fix in the current SFDR?

Eve Ellis: Thanks, Michael. As you say, SFDR was introduced back in 2019 and came into force in 2021. The EU was really the first mover when it came to ESG regulatory disclosure regimes. It was designed to help transparency, investor decision-making, and to help mitigate greenwashing.

For multiple reasons, it didn't quite hit the mark in terms of its objectives. That was partly down to the fact that the industry used it as a labeling regime when it was intended to be a disclosure regime. So SFDR has been reviewed considerably, with a long consultation process, and we finally saw the outcome of that by the European Commission publishing the draft last Thursday.

The clear objectives here are to try and simplify things, again, make things helpful for investors when they're making their investment decisions, and also to help mitigate greenwashing, so going back to the original principles of SFDR.

It has been long awaited. There's still a fair way to go in terms of what the final rules will look like and some time still before it gets implemented. But at least we now have a pretty good idea of the direction of travel of SFDR 2.0.

Michael Littenberg: At a high level, what are the key changes that are being proposed under SFDR 2.0?

Eve Ellis: So the key changes are the introduction of new labels. There are three new labels for product categories: sustainable, transition, and ESG basics. They've also introduced a concept for impact-focused products, which is new, and we haven't seen that previously.

In addition, there is a simplification of both the product-level website disclosures and the manager-level disclosures, and also some of the concepts that we've lived with under SFDR 1.0 in terms of sustainable investments, do no significant harm, and good governance are no longer specifically referred to in the legislation. So it is a clear rewrite of SFDR 1.0. It's hard to follow, because the way that European legislation is amended is that you need to read it alongside SFDR 1.0 in order to see what the changes are. However, these are the key changes at a high level.

Michael Littenberg: You mentioned product categorization. How will these new categories work?

Eve Ellis: So as I say, there's three new categories: sustainable, which is still referred to as Article 9, these are products that have sustainable outcomes. You then have transition products—that is new Article 7. These are products that will invest in investments that have a clear and measurable transition plan. And then there's ESG basics—this is the category that most closely aligns to the existing Article 8 framework, and these are funds where investments take into account sustainability factors. Such factors must go beyond merely taking sustainability risk considerations into account, so, more than just taking into account ESG risks for the purposes of risk management.

Key elements to the labeling regime are that the investments need to meet a 70% threshold. So there's one key pillar there. The other one is exclusion criteria. And each of the different categories have different exclusions that need to be met in relation to those products.

So in effect, there is more of a shaping around what it is you are going to be investing in and an impact on the investment universe, which previously wasn't the case, particularly for Article 8 funds. In relation to the 70%, interestingly, it's been acknowledged that there may need to be a ramp-up period. So the rules now allow for what's called a phase-in period, within which you have to meet that 70% threshold. You need to disclose what the phase-in period end date is, and then you need to meet the 70% threshold by the end of that phase-in period.

Michael Littenberg: What about non-categorized funds? How will those be addressed?

Eve Ellis: So non-categorized funds will have to make certain disclosures, but the key thing from a non-categorized fund perspective is that there will be limits in terms of the statements that you can make around sustainability and ESG claims.

You will not be able to overstate those claims. They need to be neutral and balanced, and they need to be very much secondary to the main investment strategy. There's a percentage that's given in the rules such that sustainability claims should be limited to 10%. And there are also restrictions on including references to sustainability claims in your marketing communications. So just because you don't use a label doesn't mean that you can then say whatever you'd like to say from an ESG perspective. There will be limits in relation to what you can say.

Michael Littenberg: And manager-level disclosures? Will these change as well?

Eve Ellis: They are going to change. I think people will be very happy that the concept of the principal adverse impact is being removed from the manager-level disclosures, so that is good news. And, also, the remuneration disclosures (how you integrate sustainability considerations into the remuneration policies and procedures) have also been removed. But other than that, the manager-level disclosures will stay.

Michael Littenberg: I'm going to shift gears a bit. The current requirements relating to good governance, do no significant harm, and principal adverse impacts are a very significant compliance pain point for many managers. You and I have spent a lot of time with clients on these topics over the last few years. You mentioned PAIs a little bit, but how would all of these requirements change under the proposals?

Eve Ellis: Great question, and I think you're completely right. These have definitely been pain points for many sponsors when they've been grappling with how to implement SFDR. So the concepts of do no significant harm and good governance have come out. That's mainly because the definition of sustainable investments has been removed from SFDR. So those concepts were very much tied to sustainable investments and tied to Article 8 and 9 funds. In one way that is helpful. However, they've been replaced by the exclusions.

So in terms of demonstrating no significant harm and also the good governance, that is now being done by way of exclusions such as exclusions in relation to the Paris-Aligned benchmark and the Climate Transition benchmark. They're not exactly the same exclusions for each type of label or category, but that's, I think, is how the Commission have achieved similar concepts but in a more standardized way.

In relation to the concept of principal adverse impact, as I mentioned, that's come out at the manager-level disclosure, but it is still relevant at the product level, particularly for the transition and sustainable funds. The level of indicators will be determined in the Level 2 regulation, which we haven't yet seen.

As such it is something that hasn't disappeared completely, although it looks like that whether managers need to actually comply with the PAI will be on a more voluntary basis. And so it will be interesting to see what the Level 2 guidelines look like.

Michael Littenberg: Earlier you briefly mentioned impact investing. That's something that is explicitly addressed in the proposal, which I believe is a change from the current SFDR. Can you go into a little more detail on what the Commission is proposing here?

Eve Ellis: So they've created this concept of sustainability-related products with impact. And these are products where the investment strategy and objective of the fund is to have a very much predetermined impact from a social or an environmental aspect.

And there are some additional disclosure requirements that will apply if you are an impact fund and it will only be funds that are classified under that product that can use the word "impact" in their name. So there will be some consideration as to whether or not you are able to use the word impact when you're launching your fund, and there are some additional requirements and disclosure obligations that will apply.

Michael Littenberg: We haven't yet talked about EU Taxonomy requirements. I almost hate to go there because it's one of those dry and technical topics that nobody likes to talk about, but it's an important topic. Does the proposal alter how managers are going to need to assess and address Taxonomy alignment?

Eve Ellis: It doesn't change the taxonomy, but what it does do is it brings more references into SFDR from the taxonomy. So certain concepts and types of investments, if they meet taxonomy alignment, would automatically qualify for certain investments under the different labels. So it brings the two closer together than it previously did, which I think in some ways is helpful but in others less so, because obviously the bar to becoming taxonomy aligned in relation to investments is certainly a high bar.

Michael Littenberg: For this next question, I want to do a compare and contrast. A draft proposal was leaked a couple of weeks before the official Commission proposal came out. When that leaked draft came out, I know that many clients were eagerly tearing into it and reached out to you for help understanding the draft. How does the official proposal differ from the leaked draft?

Eve Ellis: A lot of it is pretty similar. The key difference is the leaked draft did have an ability for managers to opt out of SFDR 2.0 if their fund only has professional investors in it. Professional investors is a European concept of investors that meet certain requirements.

And whilst I think we may well have seen investors drive sponsors to choose and opt in to a label, I do think having that flexibility would have been helpful. But that is the key difference between the leaked draft and the version that we have today.

Michael Littenberg: So for the last part of our chat today, I want to focus on what all this means for managers. What do you see as being the biggest operational implications for managers coming out of the SFDR 2.0 proposal?

Eve Ellis: So I think the biggest changes are going to be how you manage funds that were originally operating under Article 8. And whilst SFDR was by no means perfect, I think people had got to grips with the different concepts.

These new labels will raise the bar, particularly for funds that are existing Article 8 funds. As I mentioned earlier, they're going to be looking to shape the investment universe and apply exclusions, and not all Article 8 funds did that. So I think one of the biggest issues is going to be operationalizing exclusions and also working out, particularly for the Article 8 funds (ESG basics), what it is you're going to commit to. Is that going to be enough to meet the hurdle to continue to be the new Article 8 fund going forward?

Michael Littenberg: How should managers be thinking about global product ranges and cross-border distribution?

Eve Ellis: I think that's a really interesting question, and I do think the key point here is probably the exclusion criteria that is going to be mandatory going forward. As you know, one of the biggest issues that you and I talk about all the time and how we're sort of guiding sponsors is how you thread that needle between the European regime and, in particular, the U.S. regimes, particularly the views that certain red-state investors have in relation to their approach to these topics.

And exclusions can be challenging. So how you manage that and thread the needle when you have to apply those from an SFDR perspective, because they're mandatory, I think, is going to be challenging for sponsors. It may well lead to more separate investment strategies between funds in the same complex so that you will only apply certain elements, for example the exclusions, to a Luxembourg parallel fund, for example. But I do think the key is that sponsors need to be thinking about these issues at an early stage in the fund life or the fund design process.

Michael Littenberg: Another question that is already starting to come up from many clients is whether there are any grandfathering arrangements for existing funds and compliance programs. How should managers think about these changes in conjunction with everything they already have out there?

Eve Ellis: So no, no grandfathering, which is certainly unhelpful. However, there is an opt-out for closed-ended funds that have been distributed before the application date of SFDR 2.0. So if you've got an existing fund that's closed-ended, you will be able to opt out of SFDR 2.0, so that is helpful.

For evergreen funds, you're going to have to transition to the new regime. So if you're thinking of launching an evergreen fund now, even though SFDR 2.0 isn't in force, I think it is worthwhile thinking about how you may deal with the current proposals as we have them at the moment.

Michael Littenberg: As we get toward the end of our time today, I think we'd be remiss if we didn't talk about timing and uncertainty. I feel like that is being glossed over in a lot of the commentary out there, which suggests that SFDR 2.0 is a done deal and is going to be adopted imminently.

As we have been living through with the EU's Corporate Sustainability Reporting Directive, Corporate Sustainability Due Diligence Directive and Deforestation Regulation, among others, EU regulatory reform can be a really messy and lengthy process. For example, in the case of CSRD and CSDDD Omnibus I, we're now roughly nine months after the Commission proposal and the Parliament just recently finally approved its negotiating position—after a lot of drama—and trilogues have finally begun. EUDR was postponed once, then it was scaled back by the Commission, and now looks like it's going to be pushed back again by another year.

Managers are continuing to launch funds. Many are also still building out aspects of their SFDR 1.0 compliance. How should they be approaching SFDR in the interim? And, before you answer, a related observation and question: in connection with these other regulatory mandates that I mentioned, we've seen that the center-right European People's Party and the further-right parties have advocated for changes that have significantly deviated from the Commission's proposals, and we've seen movement from those proposals. It's still very early days, but what's the chatter in Brussels about the Commission's SFDR 2.0 proposal, and how might this all spool out?

Eve Ellis: Yes, you're completely right, Michael. We have SFDR 2.0 from the commission, but things may well change. It needs to go through that legislative process and be agreed by the Parliament and the Council. And that can take time. And, as you say, there may well be movement.

It's a topic that people have very different views on, so it may well be that we still have amendments to come. So what we have at the moment isn't necessarily the final draft. And I think, as you said, it's really important that people remember that.

In terms of timing, in any event, you know, it's got to get agreed through that process. It then gets published in the official journal, and then it will take effect a period after that. So, you know, we are not going to be dealing with SFDR 2.0 for at least a couple of years.

And so I think it's important to bear that in mind. But as I say, managers will be launching funds between now and then. If they're closed-ended funds, there will be an opt-out, so that is helpful. I think if you do have evergreen products that you're launching now, I do think, as I mentioned earlier, it's important just to think through SFDR, even though it may change, and how you may deal with certain issues like exclusions, for example.

Michael Littenberg: So, the bottom line: watch this space closely, there's going to be a lot more developments—and keep in close touch with Eve Ellis and her team.

Eve, finally, if you had to give three practical takeaways for managers now, what would those be?

Eve Ellis: As you say, Michael, first thing, just monitor the position, because things may well change. Secondly, I would be mindful of what the current draft says and how you may manage that in practice, particularly, as I mentioned, for evergreen products.

And lastly, I think, it's worth listening to your LPs and seeing if they're making any noises around sort of categories that they would expect managers to have. So, at the moment, I think we are still a little bit "wait and see". But there are certainly things that you can be doing just to see how you would be applying these things in practice as and when they become relevant.

Michael Littenberg: Eve, thank you so much for your time today. This has just been extremely informative. I really look forward to continuing to partner with you to help clients navigate the many, many compliance complexities and challenges of SFDR that we're going to be dealing with, I think for a long time coming.

Michael Littenberg: Eve, thank you so much for your time today. This has just been extremely informative. I really look forward to continuing to partner with you to help clients navigate the many, many compliance complexities and challenges of SFDR that we're going to be dealing with, I think for a long time coming.

And thank you to all of our listeners. You also can subscribe to the series wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you.

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