Reality check: What does the SFDR consultation mean for investors?

What’s the SFDR review about?

Elisabeth Ottawa, Schroders’ Head of Public Policy, Europe said:  "In a nutshell, the consultation on reviewing the SFDR is about understanding how the regulation works in practice and to collect ideas on any future amendments. The review has been kicked off by the European Commission with a consultation in September, and there actually are two consultations within that; one targeted to financial market participants who are familiar with SFDR and need to implement and apply it on a day-to-day basis; the other aimed at the wider public, whereby anyone interested can submit their response."

What does the consultation cover?

Nathaële Rebondy, Schroders’ Head of Sustainability, Europe said: "The consultation contains four sections.

"The first section is focused on the current requirements of the SFDR. The Commission is trying to understand whether the SFDR is meeting several objectives, notably if it’s providing transparency to investors, strengthening their protection and help them choose and compare products. It is also seeking views on whether the SFDR is successfully channelling capital towards sustainable investments. Interestingly here, the Commission is considering “sustainable investments” in a broader sense, beyond the Sustainable Investment definition of the SFDR. Another important question is related to investments in transition activities, where the Commission seem to acknowledge that these have not been addressed sufficiently so far.

"Other questions in this section focus on the influence that the SFDR has had on market participants and on companies, indirectly. And then it goes into the details of the implementation and what can pose issues or challenges to the various stakeholders.

"It’s really a reality check of the regulation's effectiveness, which also recognises the challenges around the lack of good quality data for the investment industry.

"Section two of the consultation focuses on the interactions of the SFDR with other types of regulations, such as the Taxonomy Regulation, Benchmark Regulation, Corporate Sustainability Reporting Directive (CSRD), MIFID II and PRIIPs. The Commission wants to understand whether the different concepts in each regulatory component are easy to understand and navigate and if there is consistency between those different components.

"For example, the Commission is asking whether the SFDR disclosures are seen as consistent with the requirements of the CSRD or whether the disclosures on sustainable investments, principal adverse impacts and taxonomy are sufficiently useful and comparable for investors to determine the adequacy with their own preferences."

"Sections three and four are much more forward looking and trying to understand what could be done or what could be useful to enhance the overall framework.

"On section three, the Commission is releasing input on potential changes to the disclosure requirements for financial market participants. They are looking at both the entity level and the product level disclosures. The Commission introduces the idea of having baseline disclosures for all funds regardless of the sustainability claims they could make, and then introducing a second layer of disclosures for the products that do have and do make sustainability claims. The Commission is also asking whether it would make sense to restrict the baseline disclosures to some products based on different types of criteria, such as the size of the fund, or whether it is intended to be sold to end clients. That's really important because if there were to be changes in these disclosures, there would be a profound impact on the whole industry."

The future of Article 8 and 9 disclosure

Nathaële Rebondy, said: "The fourth section of the consultation, which has attracted the most attention, is focusing on the potential establishment of a proper categorization system for financial products. The Commission is recognising that Article 8 and 9 are really being used de facto as product categories or product labels, although this was not the initial intention. There is also a number of national or country labels that coexist within the European Union, and this creates some fragmentation in the European market.

"The Commission wants to understand which type of investors would benefit from product categories, if it is retail investors, professional investors, or both, how such product categories could work and should work, and what should be the role of the disclosures in a system like that. The Commission is saying that applying for such a category would be voluntary at the product level, and so only the funds that would claim to be part of one category would need to meet the requirements for this category.

"There are two key options on the table. One would be to move away from the existing framework and use new criteria that are focused on the type of investment strategy and what it is trying to achieve to create the category.

"Four categories are proposed for feedback:

• One for products focused on investments that deliver targeted and measurable solutions to sustainability issues (for example, investments in renewable energy production and distribution, or social housing);
• A category for products investing in companies that do well on sustainability standards (more focused on the company behaviour);
• A third one for products that focuse on avoiding harm on people and the planet, using exclusions;

• A fourth one for product that have a transition focus (such as targets or plans to decarbonise or improve workers’ rights);

"As a result of this option, the current concepts of sustainable investment or environmental/social characteristics and the distinction between Article 8 and 9 could potentially disappear completely from the disclosures framework.

"The second option would be to keep Article 8 and 9 and transform them into real categories by adding minimum criteria, in addition to what we have today from a disclosures perspective."

What’s your impression on the consultation?

Elisabeth Ottawa, said: “The consultation is very self critical and that's quite unusual for a Commission consultation which never puts into question its own past proposals. It has a very open approach, putting many important areas into question without leading the witness.

"We welcome the recognition of the need to look much more into the investments in transition activities as well as whether we need to communicate differently depending on whether we have a professional or retail investor in front of us."

What are the views of the industry?

Elisabeth Ottawa, said: "There's a real agreement that product level disclosures have become excessive. The level of detail is so high that you really wonder whether the information is meaningful, especially for retail investors. Investors are confronted with a lot of abbreviations and very technical words, so we need to find a better way to communicate.

"It's clear that any SFDR review needs to go hand in hand with fixing the sustainability preferences, which are currently distinct from SFDR. These two pieces of legislation need to be brought together. The point where the industry is still divided is about stability versus fixing the SFDR framework.

"Articles 8 and 9 have been an extremely difficult exercise to implement and now that we've done the job, do we want to stick with that because the work has already been done? Or do we say, okay, we've done the implementation, but it’s not working, so let's fix the framework, even if that means that we deviate quite substantially from SFDR as it currently stands."

What could be the impact on financial institutions of some of the proposed changes?

Nathaële Rebondy, said: "The Commission is also asking about the cost benefits of the regulation and trying to understand what the cost has been so far. But beyond costs, the impact on the industry will be important if new categories are proposed, as it will influence product design. Similarly, introducing a change in the disclosure regime, notably if baseline disclosures are introduced for all funds, will have a large impact. I think the type of impact differs for a smaller entity with fewer resources, as opposed to bigger firms. But for very big entities, even if you have more resources you also have more funds in scope, which creates other types of challenges. I do expect more work for everyone for longer."

Elisabeth Ottawa, said: "If they go for option two i.e. introducing minimum standards for Article 8 and 9, we could see a declassification of funds that will not meet the criteria. Whereas when you go for option 1, you need to explain what kind of strategy your fund follows and prove how you meet these objectives."

POLL RESULTS

This Q&A is an extract of a Schroders webinar held in October 2023 with an audience spanning across fund selectors, portfolio managers, and ESG specialists in Europe. The below summarises the answers to two live polls during the webinar on how sustainability regulation is affecting the audience’s work and their clients.