On September 14, the European Commission published a targeted consultation and a public consultation of the sustainable finance disclosure regulation (SFDR). The review of SFDR has been previously trailed but the extent of the scope of the questionnaire is surprising.

The consultation is open until December 15. It is likely that any significant reform will therefore take a number of years before entering into force but could amount to a significant regulatory change project (again).

The SFDR sets out how financial intermediaries, such as asset managers, have to communicate sustainability information to investors. It is designed to bring more transparency to the market and enable investors to make informed choices. However in practice it has been a heavy compliance burden in the face of significant areas of legal uncertainty since it came into force in March 2021.

The 45-page targeted consultation is split into four areas: (a) current requirements of the SFDR; (b) interaction with other sustainable finance legislation; (c) potential changes to the disclosure requirements for financial market participants; and (d) potential establishment of a categorisation system for financial products. The 18 page public consultation covers (a) and (b) only.

This article sets out below some of the more interesting requests for feedback from the European Commission.

Consultation highlights

The consultation:

• is extensive;
• considers whether SFDR achieves its basic objectives of increased transparency and reorientation of capital;
• acknowledges that there are fundamental flaws in SFDR which has led to legal and reputational risks and arguably greenwashing;
• considers whether sustainability information should be required for all products, including article 6;
• ruminates on a new labeling system, either built on top of article 8 and 9 or starting afresh; and
• considers what would be needed to transition to a new categorization system that was not built on SFDR.

Current requirements of the SFDR

Here the European Commission asks for feedback on whether the SFDR’s objectives are still relevant and whether it has achieved those objectives (increasing transparency of sustainability risks, increasing transparency towards end investors in relation to consideration of adverse sustainability impacts, strengthening protection for end investors, channelling capital towards sustainable investments, including transitional investments.

There are some additional questions on whether the costs of the regime are proportionate to the benefits (and we would eat our hats if the consensus on this comes out positive) and the effects of SFDR.

Question 1.7 is interesting as it clearly sets out some of the key criticisms of the regime and asks whether respondents agree that (amongst others):

• SFDR creates legal uncertainty;
• SFDR creates reputational risks;
• SFDR does not provide distributors with sufficient or enough knowledge of the sustainability profile of the products they distribute;
• SFDR creates a risk of greenwashing; and
• SFDR does not effectively capture investments in transition assets.

This section also seeks input on the effectiveness of principal adverse impacts and (a) whether PAIS create methodological challenges and (b) whether it is clear how PAIS should be used in do-no-significant-harm assessments. This section looks at the costs incurred by firms and requests significant breakdown of costs incurred. Finally the section seeks input on data challenges and the use of estimates under SFDR.

Interaction with other sustainable finance legislation

In this section the European Commission seeks feedback on whether some of the recent Q&A publications have provided sufficient clarity on certain issues, such as the classification of funds using PABs or CTBs or the interoperability of SFDR and CSRD, MiFID, IDD and PRIIPS KID.

Potential changes to the disclosure requirements for financial market participants

This section asks some existential questions about the SFDR, including whether the SFDR is the right place to include entity level disclosures and how sustainability information could be streamlined across different pieces of legislation.

It also looks at product level disclosures. Here the consultation acknowledges that “[t]he SFDR was designed as a disclosure regime but is being used as a labeling scheme, suggesting that there might be demand for establishing sustainability product categories”. The European Commission is quick to highlight that the questions analyzing the need for possible changes to disclosures, as well as potential link between product categories and disclosures, “does not pre-empt in any way a decision about how a potential categorization system and an updated disclosure regime’ would interact if these were established”.

The European Commission suggests it could also consider expanding the sustainability information to be provided by Article 6 products. It says, “providing proportionate information on the sustainability profile of a product which does not make sustainability claims could make it easier for some investors to understand products’ sustainability performance as they would get information also about products that are not designed to achieve any sustainability related outcome”.

Here they ask: Would uniform disclosure requirements for some financial products be a more appropriate approach, regardless of their sustainability-related claims (eg products whose assets under management, or equivalent, would exceed a certain threshold to be defined, products intended solely for retail investors…)? Disclosures suggested include taxonomy related disclosures, engagement strategies, exclusions, or information about how ESG related information is used in the investment process.

This section also questions whether current disclosures are made in the right place (ie precontractual documents, periodic reports and websites). Should scales be used to reflect different financial products? Should disclosures be standardized and digitized for better machine readability?

Potential establishment of a categorization system for financial products

Finally the questionnaire considers whether a classification system for financial products ought to be established. This is where the European Commission acknowledges that “Articles 8 and 9 of the SFDR are being used as de facto product labels together with the proliferation of national ESG/sustainability labels, suggests that there is a market demand for such tools in order to communicate the ESG / sustainability performance of financial products”.

“There are persistent concerns that the current market use of the SFDR as a labelling regime might lead to risks of greenwashing”, the European Commission acknowledges. The questions in this section presume that any such classification regime would be voluntary.

If the Commission was to propose the development of a product categorization system, it envisages two potential strategies:

• a product categorization system could build on and develop the distinction between articles 8 and 9 and the existing concepts embedded in them, complemented by additional (minimum) criteria that more clearly define the products falling within scope of each article; or
• a different approach is taken, for example, focused on the type of investment strategy based on criteria that do not necessarily relate to those existing concepts (in which case articles 8 and 9 would disappear).

The Commission also gives an early indication of the types of categories it could adopt which includes:

• products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability related problems that affect people and/or the planet;
• products aiming to meet credible sustainability standards or adhering to a specific sustainability-related theme;
• products that exclude activities and / or investees involved in activities with negative effects on people and/or the planet; and
• products with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in (eg companies with credible targets or plans to decarbonize).

The European Commission also queries whether there is merit to distinguishing between products with a social focus and an environmental focus. There are a significant number of questions around how a new categorization system could and should work, including the transition to such a regime and whether rules on naming and marketing communications would also be needed.

Overhaul of the SFDR framework

While the European Commission is at pains to emphasise that the questions do not reflect their preferred policy approach, the number and depth of the questions reflect a pressing need for significant overhaul of the SFDR framework. While the European Commission doesn’t put it in so many words, it looks as if they have at last accepted that the current regime is unworkable.

While responding to the questionnaire will be a significant task in itself it is important for all firms to shape the reforms that are likely to come out of this process. The alternative would be that we are looking at tinkering around the edges of SFDR, which no one wants.