What will SFDR 2.0 look like according to the regulators that matter? Joint ESAs opinion on the assessment of the SFDR

On 18 June 2024, in the context of the ongoing review of the sustainability disclosures framework, the European Supervisory Authorities (EBA, EIOPA and ESMA) published a joint opinion on the assessment of the Sustainable Finance Disclosure Regulation (SFDR).

The ESAs' opinion includes a number of propositions and recommendations to the European Commission in the context of the review of the SFDR. One of the ESAs' key concerns is the complexity of current SFDR disclosures. They acknowledge that current investor disclosures is complex in nature and difficult to understand, in particular for retail investors (as shown by recent consumer testing exercises). They therefore suggest simplifying the current disclosure requirements and encourage the European Commission to undertake consumer testing prior to changing the regulatory framework.

The timing of the revision of the SFDR framework still remains unclear.

The ESAs recommendations include the following:

I. Product Classification System

The ESAs are in favour of the introduction of a product classification system to combat greenwashing arising from the misuse of disclosures under articles 8 and 9 of the SFDR, and to improve clarity for (retail) investors.

They suggest two new product categories consisting of minimum criteria (instead of labels of excellence of "best in class" products), which should replace the current categorisation of article 8 and 9 of the SFDR:

1) Sustainable Product Category

This category would comprise products investing in economic activities or assets which are already environmentally and/or socially sustainable.

Given the differences between environmental and social topics (and in particular the lack of a social taxonomy), the ESAs suggest either combining "sustainable products" in one category or splitting them into two different categories - environmental and social.

The ESAs further suggest that sustainable products should have to comply with a minimum "sustainability threshold".

For environmentally sustainable products, the threshold should be based on investments in taxonomy-aligned economic activities and should evolve over time as taxonomy-aligned activities grow. The part of the investment which is not taxonomy-aligned should at least respect the do no significant harm (DNSH) principle for environmental and social objectives and good governance requirements (provided that these concepts are more precisely defined).

2) Transition Product Category

The second category would be for products investing in economic activities/assets which are not yet sustainable, but which improve their sustainability over time to become environmentally or socially sustainable.

In the opinion of the ESAs, the investment strategies of such products could build on a mix of EU- Taxonomy KPIs to reflect the progressive improvement of environmental performance, transition plans disclosed by underlying assets and their analysis, product decarbonisation trajectories, and mitigation of principal adverse indicators (PAIs) at product level. However, in respect of PAI mitigation, the ESAs require that specific and relevant indicators are designed and that a minimum level of mitigation is set out in the regulation. Further, this product category could consider appropriate exclusions and criteria for credible transition plans.

The transparency obligations should ensure that investors are provided with clarity on the level of ambition and performance in the short and long term (including quantitative targets and intermediate milestones) and how the investment strategy delivers on that ambition. It would not be necessary to apply the DNSH principle to all investments to support investments in activities that are currently harmful, but which are following a transitioning trajectory. This could be demonstrated by measurable transition plans by companies engaged in such harmful activities.

The ESAs further suggest creating a sub-category for "investor's impact" for financial products investing in economic activities or assets that aim to offer solutions to sustainability-related problems together with a financial return. Alternatively, they suggest using such category as a cross-cutting indicator for all categories. However, they highlight that any "impact" sub-category needs to be sufficiently clear for retail investors to understand.

Disclosures and marketing for products inside and outside the categories

In respect of marketing documents, the ESAs differentiate between financial products that fall under one of the proposed new categories and those that do not. For the latter products, a differentiation should be made between products having sustainability features and those not having such features.

According to the ESAs, the current disclosures under article 6(1) of the SFDR in respect of the integration of sustainability risks into investment decisions should remain relevant for all financial products.

II. Sustainability Indicators

Another proposal concerns the introduction of a sustainability indicator for all financial products covering environmental and/or social sustainability.

Consumer testing and feedback from consumer associations has shown that consumers struggle to understand the different sustainability objectives of financial products and the distinction between different objectives as they are disclosed under the current SFDR framework.

Therefore, the ESAs suggest, subject to prior consumer testing, introducing a sustainability indicator using a grading scale with letters (in a nutri-score like system or similar to the energy certificate) or colours.

The ESAs highlight the importance of such sustainability indicator being based on clear and objective criteria to ensure that the scope of each category of the indicator is clearly defined. These criteria could for example relate to the EU-Taxonomy, decarbonisation targets or indicators such as fossil fuel exposures or GHG intensity.

The ESAs have suggested to the European Commission the need to test the following three scenarios:

• Using only the product categories;
• Using a mandatory single sustainability indicator; or
• Using a combination of product categories and a sustainability indicator, whereas such indicator could either work separately within each product category or outside these categories.

III. Sustainable Investment Definition

Consumer testing has shown that consumers find the distinction between the concepts of "taxonomy-aligned" and "sustainable" investments challenging, artificial and difficult to grasp. In consumer testing, "sustainable investments" are perceived to be more sustainable than taxonomy-aligned investments despite the efforts by the ESAs to explain the differences in the explanatory boxes in the technical standards.

In addition, the fact that the key elements of the definition of "sustainable investments" in article 2(17) of the SFDR are principles-based has given financial market participants flexibility but resulted in vast differences in the application. Therefore, the ESAs suggest that the European Commission should consider making the key parameters of this definition prescriptive. Depending on how the criteria for the suggested categorisation system and/or sustainability indicators are developed and/or whether the EU-Taxonomy will in future also cover social sustainability, the European Commission could even revisit the need for a sustainable investment definition, according to the ESAs.

At a minimum the European Commission should clarify the relationship between "sustainable investments" and investments in taxonomy-aligned activities and complete the EU-Taxonomy for (a) all activities that can substantially contribute to environmental sustainability and (b) social sustainability. In the interim, the Commission could amend the current definition in article 2(17) of the SFDR to rely on the EU-Taxonomy for disclosures on environmental sustainability and to use appropriate sustainability metrics for other economic activities (i.e., non-eligible economic activities and social sustainability).

IV. Relevant Documentation for Product Disclosures

The ESAs suggest that sustainability disclosure obligations should cater for the targeted investor group and market – resulting in very simple disclosures (presented in a simple and understandable manner) for retail investors and more comprehensive (and technical) information for more sophisticated investors. 

The format of the disclosures should also be adapted to reflect the increased digital consumption of information.

V. Extension of Scope

The ESAs propose that the European Commission should contemplate introducing appropriate disclosures for products currently outside the scope of SFDR - including structured products issued under a Euro Medium Term Note programme and some categories of investment options offered in multi-option products - to harmonise sustainability disclosures across financial products. According to the ESAs, the absence of SFDR-like disclosures for structured products could give rise to greenwashing, as current sustainability assessments are at the discretion of the manufacturer.

The ESAs go on to say that any sustainability disclosure requirements for structured products should ensure that such disclosure does not mislead investors about sustainability features, and should be comparable to SFDR disclosures made for other products. The ESAs also highlight that, as structured products can be MiFID financial instruments, they may be distributed to clients displaying sustainability preferences. This raises interpretation issues that may need to be addressed, as it is not clear whether "sustainability" should be assessed at Issuer level, or at asset/index level. 

VI. Transparency of Adverse Sustainability Impacts

The ESAs see merit in differentiating between "consideration" of PAIs and "information" on PAIs. While "consideration" includes the disclosure and mitigation of PAIs of investment decisions on sustainability factors, "information" on PAIs could exclude the obligation to mitigate PAIs, thus only covering the obligation to provide useful information to investors. 

The ESAs suggest that the "consideration" of PAIs of investment decisions on sustainability factors based on Annex I of the SFDR Delegated Regulation should be mandatory for products qualifying for the new sustainability product category, whereas the "information" on PAIs should become an obligation for products in the new transition category. 

In addition, some minimal disclosures (including information on a number of selected "key" PAIs) should become mandatory for all financial products.

Finally, the ESAs recommend further amendments and clarifications concerning the disclosures under article 7 of the SFDR as well as concerning the overlap with the disclosure obligation under the CSRD.

Ashurst comment

There can be no doubt in anyone's mind that SFDR as it is currently in force will be reformed in almost its entirety.  The ESA opinion is the best indication to date of the likely direction of travel.  It builds on the European Commission consultation on SFDR reform (which we covered in our briefing here).  

The ESAs' proposals would create a more understandable and streamlined system, focused more on climate transition but surprisingly keeping some elements such as PAIs, which have been difficult for some parts of the industry. 

What the ESA opinion does not address, however, is how the industry would expect to transition (no pun intended) to the new SFDR2.0 regime.  But financial market participants should have no doubt that such a significant change to the regime will require significant work, throughout all stages of the sustainable investment lifecycle.  2025 and beyond will continue to be busy for the sustainable finance market.

Authors: Lorraine Johnston, Partner; Detmar Loff, Partner; Hubert Blanc-Jouvan, Partner; Antonios Nezeritis, Partner; Arnaud Julien, Partner; and Marc Hirtz, Counsel.