ESAs Add More Ideas into SFDR Mix
In a bid to simplify the regime, the European Supervisory Authorities run the risk of adding complexity, regulatory specialists say.
The European Supervisory Authorities’ (ESAs) proposal for a revamped Sustainable Finance Disclosure Regulation (SFDR) may seek to clarify the regime, but lawyers are concerned it could make it diverge from other jurisdictional rules, creating disruption for fund managers.
The European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), and European Securities and Markets Authority (ESMA) proposed this week two voluntary product categories and a sustainability scale to grade financial products.
This follows the European Commission’s three-month 2023 consultation, which collated feedback on the effectiveness of SFDR over the past three years. It proposed either designing and implementing new criteria that would more closely align with the UK’s Sustainability Disclosure Requirements (SDR) fund labels, or formalising Article 8 and 9 as product categories.
In May, the commission published a summary report outlining feedback to the consultation, identifying no clear consensus on which option would work best.
“It is interesting that the ESAs have chosen now to release this opinion, when the commission has already consulted and following a massive shake-up to the EU legislature,” Marta Gajos, Associate for Financial Services at law firm Eversheds Sutherland, told ESG Investor.
The ESAs have proposed the implementation of a sustainability-focused scale of indicators covering environmental sustainability. This would work in a similar way to energy performance certificates for buildings. It would also help consumers and asset owners assessing funds to more easily understand a product’s degree of sustainability focus, the ESAs argue.
The sustainability indicators could either replace product categorisations under SFDR altogether or be designed to incorporate product categories.
Premlata Fagan, Managing Associate for the Financial Regulation Practice at law firm Linklaters, argued that the use of a rating scale was a more user-friendly way for consumers to grasp a product’s sustainability.
“However, developing a single generic scale is a challenging prospect,” she said. “The commission would have its work cut out in developing criteria that are objective and precise enough to give the necessary clarity to investors, while also preventing any risk of misunderstanding and factoring in a variety of topics and indicators – such as greenhouse gas intensity and decarbonisation targets.”
The commission would also need to guard against the risk that a grading system could make transition-focused products less desirable than sustainable ones, Fagan added.
Subsequently, the amended SFDR would need to set out a very clear scope and criteria to make the scale easy to understand.
“Any ambiguity or overlap between different rating levels could potentially lead to greenhushing, where products either downgrade their characteristics in fear of non-compliance or upgrade it,” warned Phil Spyropoulos, Partner in Financial Services at Eversheds Sutherland.
New categories
Any categories listed under SFDR require clear objective criteria or thresholds, the ESAs mentioned in the report. As such, they suggested establishing two new product categories – one for sustainable products, and the other for transition products.
All sustainable products would need to comply with a minimum sustainability threshold for their investments, such as investing in a percentage of EU Taxonomy-aligned activities. However, the ESAs noted that social-focused funds may instead need to be separated from environmental funds into their own category due to the comparative lack of a social-focused taxonomy and established social metrics.
Investment strategies that qualify for the transition category could build on taxonomy key performance indicators (KPIs) to reflect environmental performance improvements, transition plans disclosed by underlying assets, product decarbonisation trajectories, and appropriate exclusions. The transition category could also be extended to include a sub-category for impact investments targeting assets offering solutions to sustainability-related problems.
Meanwhile, products that fail to qualify for either of the proposed categories, but which have sustainability features, would be subject to some disclosure requirements, the ESAs further suggested.
Although several lawyers welcomed the introduction of a transition category, they cited concerns that the ESAs’ suggestions could increase the risk of stranded funds that were SFDR-compliant under the old framework.
“The existing body of Article 8 and 9 funds does not necessarily map to the new categories,” Spyropoulos noted. “This could be incredibly disruptive for funds and their investors.”
In addition, it is currently not clear how the proposed categories and rating scale would align with other fund-labelling regimes, such as the UK’s SDR.
“While SFDR and SDR are two very different regimes, we are seeing that UK funds have been able to identify common concepts between both and that their previous SFDR disclosure has helped their SDR analysis,” Spyropoulos added. “It appears that they would not be able to do the same under the categorisation system proposed by the ESAs.”
In addition, the ESAs have encouraged the commission to revisit the two parallel definitions of ‘sustainable investment’ as defined under SFDR and the taxonomy.
“The ambiguity in the definition of sustainable investment was originally one of the greatest uncertainties in the first version of the SFDR regime,” said Gajos. “However, changing the definition now, after firms have landed on their own positions, risks creating a lot of market disruption.”
The ESAs have been tasked with supporting the development of SFDR throughout the regulation’s existence, including the issuance of several sets of draft Regulatory Technical Standards (RTS). They have also developed practical application guidance for SFDR and supervised related disclosures.
Meanwhile, the commission is still in the process of assessing stakeholders’ responses to its review consultation.
“The ESAs stand ready to support the commission in providing any necessary additional technical assistance related to the disclosure elements in SFDR within the appropriate timeframe,” the authorities said.
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