Decoding the future of SFDR

The Sustainable Finance Disclosure Regulation (SFDR) has undoubtedly shaped the landscape of European sustainable investments, with Article 8 and 9 funds now encompassing 56% of total EU assets¹. Given this comprehensive coverage, the recent SFDR consultation offered financial market participants (FMPs), investors, national regulators, and others an opportunity to provide industry feedback on the regulation's practical implementation while considering its long-term effectiveness.

The feedback from the industry has highlighted some key areas that the regulator needs to address in the coming years. In this article, we will analyse this feedback and focus on five primary areas of discussion that offer interesting insights. These areas cover:

1. Current Market Opinion: perception of the SFDR’s progress and navigating its complexities
2. Categorisation labels: a shift from Articles 8 and 9 and a preference for new SFDR Product Categories
3. Transition Investments: navigating the ambiguity of Article 9 suitability in SFDR
4. EU Taxonomy: lack of issuer-level alignment data hampers reporting and opposition to minimum alignment thresholds

While there are topics that reveal divergent viewpoints, the overarching message from respondents is clear; there is a call for more guidance on the disclosure requirements to make sure that transparency and comparability in disclosures are achieved.

Additionally, and probably more importantly, the responses give an indication as to where changes may occur going forward.

With the completion of the first reporting cycle of the Sustainable Finance Disclosure Regulation (SFDR) and a year of observing disclosure and increased usage, a critical question arises: does the regulation's broader aim² to enhance transparency through sustainability-related disclosures in the financial services sector to support the EU's transition to a sustainable, climate-neutral economy still resonate with financial market participants?

At first instance, the answer seems to be yes, as 90% of respondents affirmed its relevance. Furthermore, 63% of the respondents believe that the SFDR has successfully integrated ESG considerations into investment and advisory processes. This indicates that ESG factors are increasingly being uniformly integrated into financial services.

However, as shown in Figure 1, opinions differ when it comes to the achievement of the SFDR’s specific objectives. Divergence is most pronounced in the confidence that the SFDR has improved transparency concerning sustainability risks and adverse impacts for end investors – only 18% of respondents agree that this is the case.

Half of the respondents remained neutral regarding the statement that the SFDR is effective in channelling capital towards investments with sustainability claims, indicating uncertainty.

Thus, while the overarching commitment to increase sustainability integration and disclosure is evident, the SFDR's implementation strategy requires sharpening to fulfil all its objectives.

In the consultation, respondents were asked to indicate how much they agreed with a set of predefined deficiencies and how much these deficiencies led to certain issues. The consultation listed potential deficiencies, such as unclear legal requirements and concepts (such as ‘sustainable investment’), data gaps that make disclosures difficult, the lack of a machine-readable format that makes data re-use problematic, and the misuse of SFDR as a labelling and marketing tool. All the deficiencies were agreed upon by more than 70% of the respondents.

The most common concern among respondents was that these deficiencies could lead to greenwashing and mis-selling, with 81% agreeing. Figure 2 provides a breakdown of the responses.

Despite the European Securities and Markets Authority's clarification of the EC's June 2021 Q&A that funds making Article 9 disclosures should hold only sustainable investments, except for cash and assets used for hedging purposes, the concept of ‘sustainable investment’ continues to be a challenge.

The difficulty of grasping the term could be due to there being no prescribed approach or minimum requirements for its key parameters (1) substantial contribution, (2) do not significant harm, and (3) good governance. With the lack of data and, at times, lack of technical knowledge of what constitutes sustainability for the sector, it may leave FMPs hesitant to use the term.

However, investors do show a preference for strategies with a commitment to sustainable investments, as evidenced by Article 8 Funds with No Commitment to Sustainable Investments experiencing the largest outflows³. So there appears to be a mismatch between investors' demands and FMPs' actions.

More than 60% of the respondents would like to have a form of product categories and thus could see the SFDR develop into a labelling scheme. Financial market participants, along with national authorities and regulators, show strong support for this idea.

Regarding the alternative pathways that product categories could take, the consultation provides two options.

The first option involved converting Articles 8 and 9 into formal product categories and clarifying and adding criteria to existing concepts. Opinions are split on this approach, with 27% agreement and 34% disagreement. Responses noted its resource-efficiency advantage as it can leverage the efforts already invested into working with the current system and may minimise additional costs. Yet, to make the existing concepts more effective would require further clarification and the potential introduction of minimum standards.

The second option proposes developing new categories that differ from existing SFDR concepts. This option garners 45% of respondents' support, such as those included under the UK’s Sustainable Disclosure Requirements and Investment Label regime⁴.

Respondents propose various new categories, such as a specific ‘impact’ category – endorsed by organizations like Impact Europe and SpainNAB – that differentiates between investments aiming to mitigate harm versus those actively creating solutions to environmental and social problems.

There are also calls for an ‘improver’ category to accommodate transition investments, echoing the importance of a clear framework for such strategies. Respondents emphasise the need for transparency and the importance that a new labelling system should avoid favouring one sustainable investment approach over another. The consultation put forward some potential categories’ labels, sustainability focus and transition were highly rated, indicating a preference for proactive approaches over traditional exclusion strategies, which, as one of the earliest ESG tools, now commonly complement rather than define sustainable investment practices as the market evolves.

The EU is estimating an additional €700 billion needed annually to decarbonize its economy by 2030⁵, the financial industry sees a growing demand for products that support this low-carbon transition. Indeed, the surge to $50 billion in AUM for global transition funds in 2023 underpins this trend⁶.

The SFDR aims to enable sustainable investments but its definition of ‘sustainable investments’ lacks clarity on classifying transition and improvement-focused investments. These investments tend to be disclosed under Article 8, colloquially referred to as 'light green', potentially misrepresenting the ambitious and substantial sustainability impact they have.

The real estate industry is a good example of the practical challenges of this: It is widely acknowledged that we need to retrofit the existing building stock (a position supported by EU policy) and that this is more sustainable than building new stock. Yet, under SFDR's current rules, there is confusion: New, green-certified buildings might fit neatly into Article 9 ('dark green' funds), whereas the status of retrofits is not as clear. They often fall under Article 8 ('light green' funds), even though their sustainability impact can be substantial, reflecting a disconnect in the SFDR's ability to fully recognise and categorise the nuances of such transition activities.

The feedback from the consultations reflects this disparity between the SFDR framework and the market's needs for transition finance. As 50% of respondents strongly agreed, and an additional 28% partially agreed, that the SFDR is not effectively capturing transition assets.

A dedicated transition label was well received, as 69% of respondents would find it useful.

The Principal Adverse Impacts (PAI) indicators have become a challenging aspect of the SFDR, the primary issue being the lack of robust data to report and the absence of clear and practical guidance from the EU.

Figure 4 illustrates respondents' views on PAI at the product level. The main concerns relate to the vague language around taking PAI into account for Do No Significant Harm (DNSH) assessments. This ambiguity creates methodological challenges for FMPs, leading to various interpretations and inconsistent approaches regarding how the DNSH test is applied and met.

70% of respondents feel that it is unclear how the disclosure requirements of Article 7 in relation to PAIs interact with the requirement to disclose information according to Article 8.

80% feel that the PAIs create methodological challenges with respect to product level disclosures. A similar percentage believe it is unclear how the materiality of PAIs should be applied.

Bloomberg, in their response, mentioned the challenge of applying materiality to PAIs. They found that asset managers are citing differences in thresholds set, which make it difficult to compare.

A common theme across responses was that product-level disclosures may be more valuable than mandatory entity-level reporting, as the latter does not always provide investors with useful information for decision-making and could even lead to unnecessary complexity or data collection burdens. It is suggested to define a reduced list of mandatory PAI and an extensive voluntary list that FMPs can disclose after a materiality assessment. Furthermore, respondents suggest this for FMPs that fall under the Corporate Sustainability Reporting Directive (CSRD).

The issue of data scarcity is also highlighted, especially for entities outside the scope of the Non-Financial Reporting Directive (NFRD) and are yet to be included in the CSRD scope (which expands the scope of the NFRD reporting requirements to include a broader range of companies and disclosure requirements). Utilising estimates or proxies for these entities is important, but it requires clarity in guidelines to ensure uniformity among data providers and asset managers. Morningstar echoes these concerns, emphasizing the methodological difficulty in accounting for PAIs in DNSH assessments and calling for explicit instructions on the use of estimates to address 'patchy' data, particularly for non-NFRD entities. They also questioned entity-level PAI reporting as it seems misaligned with user needs and decision-making in investing. In summary, the consultation reveals a strong opinion across the industry for clearer, more practical PAI guidance and the use of the CSRD as a key enabler to improve data quality and reporting efficacy.

The EU Taxonomy aims to set a standard at the asset level of what constitutes a green activity by setting clear benchmarks. FMPs can use this to robustly define 'sustainable investment' or environmental characteristics. Morningstar's Q4 2023 review of Article 8 and 9 Funds⁷ indicates that 94% of Article 8 funds and 72% of Article 9 funds reported zero percent taxonomy alignment. Only a fraction of Article 9 funds reported modest taxonomy-aligned investments, with few exceeding 60%.

A key barrier to higher alignment reporting under the SFDR is the absence of issuer-level taxonomy alignment data.

77% of respondents agreed that they struggled to find information on the proportion of taxonomy-aligned investments (see Figure 5).

There is resistance to mandating disclosure, 48% of participants disagreed with its mandatory introduction for all financial products. See figure 6 below.

The feedback received indicates that further efforts are needed to improve the reporting of portfolio companies before FMPs can fully adopt EU Taxonomy alignment reporting in the SFDR. The primary challenge currently faced is the lack of accessibility to required data. However, once this obstacle is overcome, we may witness an increase in the willingness to disclose expected % alignment in pre-contractual and actual alignment in period disclosures.

It is fair to say that the SFDR has had a significant impact on the sustainable investment landscape in Europe, it has provided some much-needed uniformity in how ESG factors are integrated into financial services and its resulting effects disclosed.

Yet, there is a journey ahead, and while there is agreement on its aim to enhance transparency, challenges persist.

The responses and details provided by FMPs show that they have been carefully thought through and that FMPs are well-versed in suggesting changes. The responses provided by the market are valuable in clearly demonstrating to regulators where challenges and opportunities lie. In particular, the need for a labelling scheme and challenges surrounding data availability will be interesting to follow.

The SFDR is a critical tool in promoting sustainable investment, and its continued evolution and improvement will be essential in supporting the EU's shift to a sustainable, climate-neutral economy. However, it requires tweaking to ensure it not only fulfils its objectives and prevents the risk of greenwashing but also facilitates the flow of capital towards sustainable activities and those that contribute to the green and just transition.

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¹ Morningstar SFDR Article 8 and Article 9 Funds: Q4 2023 in Review

² This Regulation aims to reduce information asymmetries in principle‐agent relationships with regard to the integration of sustainability risks, the consideration of adverse sustainability impacts, the promotion of environmental or social characteristics, and sustainable investment, by requiring financial market participants and financial advisers to make pre‐contractual and ongoing disclosures to end investors when they act as agents of those end investors (principals).

³ SFDR Article 8 and Article 9 Funds: Q3 2023 in Review Article 8 fund outflows continue, while Article 9 funds lose appeal amid market and regulatory turbulence.

⁴ PS23/16: Sustainability Disclosure Requirements (SDR) and investment labels (fca.org.uk)

⁵ https://finance.ec.europa.eu/system/files/2024-01/240129-sf-platform-report-market-practices-compendium-report_en.pdf

⁶ GS SUSTAIN SFDR, two years on - Trends and Anatomy of Article 8 & 9 funds in 2023 (goldmansachs.com)

⁷ SFDR Article 8 and Article 9 Funds: Q4 2023 in Review | Morningstar