Different Means to Shared Ends
Asset managers should adopt an agile approach to UK and EU sustainable fund rules, says Tom Willman, Regulatory Lead at Clarity AI.
The UK’s Sustainability Disclosure Requirements (SDR) and the EU’s Sustainable Finance Disclosure Regulation (SFDR) are two of the most important sustainability regulations facing financial firms in Europe – but their limited alignment threatens compliance headaches for those operating in both markets.
And – despite some headwinds globally – make no mistake: these regulations matter. Investor interest in sustainable funds continues to grow rapidly. In the EU, the market share of Article 8 and Article 9 funds rose further to more than 60% of the funds (with Article 8 funds alone accounting for 56%), reaching €6 trillion in value by the third quarter of 2024.
However, as sustainable investing grows as a larger segment of the market, the time and resources spent on regulatory compliance are increasingly becoming a burden for asset managers. For these firms, it is crucial to minimise the diversion of resources to manage overlapping regulations. By doing so, they can better focus on driving investor returns and effectively channelling capital into companies and projects that support sustainability goals demanded by end-investors.
Conception and convergence
From conception, SDR and SFDR have taken a different approach. The European regulation primarily focuses on sustainability-related disclosures at the product level; it was not conceived as a labelling regime, though the market has taken to treating Article 6, 8 and 9 as de facto labels nonetheless.
By contrast, SDR, through its four sustainability labels, has taken a more prescriptive approach to sustainability labelling from the outset, perhaps in response to how SFDR was received.
Therefore, though conceptualised with different intentions, there appears to be a degree of convergence in how the market understands the regulations in practice. This may be formalised by the European Commission’s Level 1 Review of SFDR due to be published next year, but for now firms should be wary of over-conflating the two.
Differences in naming and marketing rules
In addition to SFDR, the European Securities and Markets Authority’s name rule imposes significant requirements on ‘green’ EU funds. The rules outline six categories of sustainability-related terms (sustainability, environmental, social, governance, impact, and transition) and funds must meet an 80% threshold of investments tied to the targeted sustainability characteristics or sustainable investment objectives. Depending on the term, they may also be required to apply the EU Paris-Aligned Benchmark (PAB) or the Climate Transition Benchmark (CTB) exclusion criteria.
Alongside its investment labels, the UK’s SDR contains its own naming and marketing rules. The rules suggest that funds using sustainability terms should ensure the products have sustainability characteristics and that the name accurately reflects those characteristics. In further guidance, the Financial Conduct Authority (FCA) suggests that 70% of assets should be used in line with the ESG term selected and mandates disclosure of reasons for not using a label. Unlike SFDR, SDR does not require PAB or CTB exclusion criteria. Therefore, though there is overlap, it cannot be assumed that funds meeting the requirements of one regulation will automatically fulfil the other.
From Article 8 and 9 to labels
Moreover, Article 8 and 9 classifications do not map neatly onto SDR labels. Although the FCA issued a comparison graphic in its policy statement designed to outline the requirements of both regulations, market feedback overwhelmingly pointed out that this has provided limited clarity.
Elsewhere, the FCA statement references the EU Taxonomy as one example of a robust, evidence-based standard that can be used as part of its Sustainability Focus label. While the statement provides a potential bridge between the EU and UK regimes, it also underscores another key difference between the UK and EU sustainable finance frameworks: that the UK is yet to publish its own Taxonomy. If and when it does so, it will be interesting to see how much it diverges from the EU Taxonomy.
There is hope that SFDR 2.0 could reduce regulatory divergence by aligning more closely with SDR, especially in how sustainability claims are labelled and disclosed. However, it is unclear whether both frameworks will fully converge or continue to evolve separately, leading to further challenges for cross-border firms.
Unreconciled differences
Several challenges remain for firms operating in both jurisdictions. For example, SFDR uses principal adverse impacts (PAIs), while the FCA’s SDR has fewer prescriptive metrics and KPIs. Thus, asset managers and financial institutions may have to gather different types of data for each regime, leading to increased costs and operational complexity.
There is a growing sense in the EU that the European approach – though ambitious and well-intentioned – has created confusion in the market and may not have realised its full potential in terms of redirecting capital to sustainable projects demanded by end investors. In some cases, it has led to an increased risk of greenwashing, as mentioned by incoming financial services EU Commissioner Maria Luis Albuquerque.
Which is not to say that the SDR’s early days have been without issues. Uptake of the labels has been slower than many expected, and market participants’ struggles to adhere to the new rules have led the FCA to grant limited temporary flexibility on naming and marketing rules, extending the deadline to April 2, 2025, in some cases.
This bumpy start has meant that some firms have opted for changes to product names, and some have even considered suspending the sale of sustainable finance products to new customers, in order to avoid falling foul of the new rules.
Differences in practice
To take a hypothetical example, let’s consider a thematic equity fund focused on renewable energy. Under SFDR, we can imagine that this might align with either Article 8 (promotes environmental or social characteristics but does not have a sustainable investment at its core), or Article 9 (has a sustainable investment objective at its core).
In both cases, the fund would need to provide detailed disclosures including specific data on environmental objectives, sustainability metrics, and alignment with EU Taxonomy criteria. Assuming its name contained a reference to renewable energy, it would also be required to apply relevant PAB exclusion criteria. PAI data would also need to be collected to support the entity’s obligation to report on the adverse impact of its investment decisions and/or demonstrate the product does no significant harm.
By contrast, SDR would enable the fund to class itself as one of four labels: sustainable focus, sustainable improver, sustainable impact, or sustainable mixed goals, or otherwise adhere to the FCA’s naming and marketing rules.
Therefore, the same fund may need to provide additional disclosures over and above SFDR. In the case of choosing the impact label, it would be required to demonstrate not only its impact in relation to a sustainability outcome but also the investor contribution to bringing about that impact. While much of the information provided in each context may be reusable in the other, the lack of a direct read-across will mean that going through both processes will require resources and time.
What now?
Firms operating in the UK and EU face a complex task of carefully mapping out the differences between SDR and SFDR, and how they apply to their products and activities. However, the story does not end there, and firms face the reality of the risk of moving goalposts.
Neither SDR nor SFDR can be guaranteed to stand still and static in the future, as regulators modify their frameworks according to market responses and a changing political environment. We know already that the Commission’s Level 1 Review of SFDR is due next year, and the Draghi recommendations may still lead to further changes.
And – if SDR and SFDR divergence was not complex enough – it should be remembered that these are only two regulatory frameworks of dozens worldwide that will be of interest to financial institutions.
Clarity is a moving target
Therefore, firms must adopt an agile approach to compliance with both EU and UK rulesets (and others). As regulatory frameworks continue to evolve, technology will play a crucial role in helping firms navigate the complex reporting requirements. In this context, tools such as AI can be a critical ally, supporting information flow and enabling insights to drive effective capital allocation with speed and precision that can’t be achieved with a manual, human-only approach.
Despite the frustrations, we should not be too quick to criticise the regulators. Both they and policymakers recognise that they are in the early stages of constructing effective rules to drive finance to shared environmental goals. Convergence is desirable but difficult, and while we hope to see greater alignment in the future to enhance investor confidence and sustainable outcomes, the reality of today is that firms must be diligent in minding the gap between them.
The post Different Means to Shared Ends appeared first on ESG Investor.