The EU’s Sustainable Finance Disclosure Regulation (SFDR) level 2 rules are set to go into effect from 1 January 2023, but there is still much confusion in the market.
- The SFDR level 2 rules, which strengthen the reporting requirements for sustainable and ESG-labelled financial products, go into effect on 1 January 2023.
- There are concerns over their alignment with the EU taxonomy, reporting of Scope 3 emissions, and the reporting of Principal Adverse Impact Statements.
- Several fund companies have reclassified their funds, opting for less stringent disclosure requirements, to reduce the risk of greenwash claims.
What is the SFDR?
The European Commission views the Sustainable Finance Disclosures Regulation (SFDR) as a building block of the European Sustainable Finance Agenda. SFDR sets the sustainability-related disclosure requirements for financial market participants, financial advisers and financial products.
It also seeks to bring accountability and discipline to sustainability claims made by manufacturers of financial products and financial advisers. The SFDR was first published in the official journal of the European Union in November 2019.
The primary scope of the regulation is to improve sustainability-related disclosures to enable comparability of the disclosures for end investors. This, it was hoped, would reduce the occurrence of adverse sustainability impacts and greenwash.
A further aim was to improve the quality and comparability of information on the sustainability-related performance of the makers of financial products, financial advisers and the financial products themselves.
Why is the EU strengthening its sustainability reporting requirements?
The EU’s technical standards for disclosing sustainability-related information under the SFDR were adopted on 6 April 2022. These rules are designed to improve the quality and comparability of information provided by investment managers about the sustainability performance of their financial products.
The EU believes that compliance with sustainability-related disclosures will help protect investors and reduce greenwash, with the ultimate aim of enabling the financial system to support the EU’s transition towards a more sustainable economy.
Funds using ESG and sustainable tags have come under scrutiny as deadlines to meet reporting compliance loom under the SFDR. Morningstar told Bloomberg that almost a quarter of the Article 8 listed funds did not meet the required reporting or listing criteria.
SFDR and Article 6, Article 8 and Article 9
Level 1 of the SFDR went into effect in March 2021, with the scope of classifying financial products into separate categories, based on their investment into and their claims regarding sustainability. As a result, financial products such as investment funds and ETFs were classified as Article 6, Article 8 or Article 9.
An Article 6 SFDR fund requires asset managers to disclose the level of integration of sustainability in their funds, regardless of how they are labelled. Funds that have some form of ESG, green or sustainability labelling then go on to be classified as Article 8 or 9.
Article 8 funds are those that promote environmental or social characteristics but do not have them as a core investment objective.
Article 9 funds are those that have sustainability as their core investment objective, and require comprehensive and understandable related disclosures.
Notable sustainability disclosure requirements in the SFDR
The rules relating to the SFDR apply to financial services in two ways: at the firm or entity level, and at the product level.
SFDR entity-level disclosure
At the entity level, a firm must provide transparency on the adverse sustainability impacts of its investment decisions. This has to be published and maintained on the firm’s website. If they do not provide this transparency, they have to specify the reason for not doing so, and whether and when they intend to consider such adverse impacts.
SFDR product-level disclosure
Adverse sustainability impact statements also have to be made at the product level and maintained on the provider’s website. If no adverse impacts are not considered, once again, reasons as to why are required.
Disclosures are required for Article 8 and 9 funds at the pre-contractual (prospectus) stage, followed up by periodic disclosures to keep them updated. SFDR also specifies the way in which these disclosures must appear on the firm or product’s website, including the specific details required in the disclosure.
‘Do no significant harm’ (DNSH) and EU taxonomy
A further issue that raises confusion and controversy relates to the alignment of disclosures with the EU taxonomy and the “do no significant harm” principle (DNSH). For sustainable investments (Article 9 funds), financial services firms are required to provide statements in accordance with DNSH.
The taxonomy sets performance thresholds for economic activities, which are required to make a substantive contribution to one of six environmental objectives, while DNSH to the other five, where relevant.
The six environmental objectives are climate mitigation, climate change adaptation, the sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and the protection and restoration of biodiversity and ecosystems.
Inclusion of nuclear and gas in taxonomy amendments creates controversy
Amendments to the EU taxonomy to include nuclear and gas as sustainable fuel investments will come into force in 2023. While many industrial groups welcomed the measure, climate activists have called it an official validation of greenwash.
The amendment calls into question the definition of sustainable investment, which only serves to further muddy the waters when it comes to SFDR.
Additional SFDR requirements that might be causing compliance concerns
The new SFDR rules allow firms to use estimated data to calculate Principal Adverse Impact Statements (PAIs) when reported data is not available. This could be confusing, especially when it comes to Scope 3 emissions. A further requirement is to align with the EU taxonomy for sustainable activities, which is also creating confusion due to its overall complexity and inclusion of gas and nuclear as sustainable fuels.
Accounting for about 75% of a company’s total emissions, Scope 3 emissions also provide important information on the impact of a company’s operations on the environment and society. Allowing the use of estimates could raise concerns over the integrity of sustainable claims, the very thing that the SFDR is designed to protect.
Guidance provided by the ESAs adds to sustainability standards and disclosure confusion
Guidance on the new requirements provided by the joint committee of European Supervisory Authorities (ESAs) may serve to add to the confusion over disclosures. Specifically, this confusion could come from distinguishing between the guidance relating to the PAIS and the DNSH requirement.
In providing clarifications on the level 2 changes in June 2022, the ESAs acknowledged that both PAI considerations and DNSH disclosures use the same adverse impact indicators. It goes on to say, however, that there is no direct link between the two as they apply independently.
The ESAs consist of three members: the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority.
Concerns over complying with SFDR level 2 requirements lead to fund downgrades
Ahead of changes in the SFDR level 2 disclosure requirements, French asset manager Amundi (PAR:AMUN) changed the classification of most of its Article 9 funds to Article 8, impacting €45 billion worth of fund assets.
A spokesperson for the company said: “While Amundi is pleased to see that regulations have come into force regarding the responsible investment market, with a view to improving transparency and protecting end investors, the current regulatory framework does not yet allow the financial industry to respond in a uniform manner as to what should be considered ‘sustainable’ or not.”
Amundi’s move comes after AXA Investment Management downgraded 21 funds from Article 9 to Article 8, a decision driven by apprehension over compliance with SFDR, according to Morningstar. They are not the only ones: at least $85 billion in industry-wide Article 9 funds are expected to be downgraded in the near future, including those held by Germany’s DWS (GER:DWS).
SFDR complexities causing review delays
Level 1 of requirements under SFDR went into effect in March 2021, while SFDR level 2 was delayed by six months and is going into effect on 1 January 2023.
In a letter to EU regulators dated November 2021, President of the European Commission John Berrigan said this was due to “the length and technical detail of those 13 regulatory technical standards, the time of the submissions to the Commission, and to facilitate the smooth implementation of the delegated act by product manufacturers, financial advisers and supervisors”.
The ESAs announced a further delay in October 2022, extending the review of key indicators in the PAIs past the original deadline of 28 April 2023. The ESAs said the 1 January 2023 deadline for level 2 rules remains intact, although industry preparedness remains a question.
Additional pushback from the industry could introduce more delays, and reduce the effectiveness of the SFDR being a tool for the EU to achieve its sustainable finance agenda.