SFDR and SDR: The key sustainable regulation updates for 2024

The review of the Sustainable Finance Disclosure Regulation (SFDR) launched by the European Commission in September 2023 is about understanding how the regulation works in practice and to collect ideas on any future amendments. Some new proposals touch on the effectiveness of SFDR, its interaction with other sustainability legislation, and potential changes to product disclosures. The consultation also focuses on establishing a proper categorisation system for financial products, including a potential Article 8 and 9 category overhaul. 

The consultation deadline was on the 5 December 2023 and here below we highlight some of our key responses to the consultation, some differences between the SFDR and the UK’s Sustainability Disclosure Requirements (SDR) and further developments in sustainability regulations across Europe. 

Q. What’s been Schroders’ overall response to the consultation on the SFDR review? 

Elisabeth Ottawa, Schroders’ Head of Public Policy, Europe said: "We have a positive view of SFDR three years after its implementation. The regulation helps prevent further fragmentation in the EU regarding sustainable investment requirements and labels. However, we need to simplify the information for investors, especially retail investors who currently find it difficult to understand. When considering any future SFDR, we must balance avoiding frequent changes, which can be burdensome and confusing for investors, with making necessary adaptations based on our experience with SFDR. SFDR's wide scope covers many products and services, but it also means a one-size-fits-all approach is applied, without considering the specificities of certain products". 

Q: What is the current assessment of SFDR? 

Elisabeth Ottawa said: "Some definitions and concepts in SFDR remain vague and undefined. However, adding more detail may limit flexibility and innovation in this new space. There is also an information overload, with asset managers having to add extensive content to prospectuses. This does not help investors make informed decisions". 

Q: How do we envision SFDR in the future? 

Elisabeth Ottawa said: "We believe in moving away from the Article 8 and 9 differentiation and adopting a system that includes product categories based on investment strategies, similar to the UK’s SDR. We also emphasise the need for any SFDR changes to go hand in hand with amending MiFID sustainability preferences. Basic disclosures for all products, including non-ESG products, could enhance comparability. However, it is important to ensure that disclosed data points have sufficient coverage for meaningful comparability. 

We need to consider the specificities of certain services and products, such as unregulated AIFs. SFDR sets challenging requirements for AIFs due to the confidentiality of certain information. We must ensure that the different regulatory requirements, including confidentiality of information, are respected". 

Q: How does the UK SDR compare to SFDR? 

Richard Fox, Head of Public Policy UK, said: "The SDR and SFDR have some similarities and differences. SDR has a categorisation approach, with product labels based on the strategy of the product. The labels are ‘sustainability focus’, ‘sustainability improvers’, ‘sustainability impact’, and ‘sustainability mixed goals’. The FCA (Financial Conduct Authority) has set a threshold that 70% of the gross value of the fund must be in line with the sustainability objective of the fund, across all labels. The UK regime is principles-based, allowing managers to define their own standard within a robust, evidence-based framework". 

"SFDR has a different approach. The European Commission proposed options in the SFDR consultation, which do not align perfectly with the SDR labels. However, there are some areas of alignment. For example, category “A” in the SFDR review consultation could map neatly to sustainability impact in SDR (see table below), and category “B” in the consultation would align with the sustainability focus label in SDR. The transition category in SFDR appears to map well to the sustainability improvers label. The exclusions category in SFDR does not have a direct read across to SDR, this would be an un-labelled fund in the UK". 

"SDR also includes additional requirements such as anti-greenwashing rules and various disclosures. The timeline for SDR implementation allows firms to label their products from July 2024".  

Q. ESMA has recently released an update on the guidelines on funds’ names using ESG or sustainability-related terms. What did that entail? 

 Nathaële Rebondy, Head of Sustainability, Europe said: "The ESMA guidelines aim to prevent greenwashing and ensure that fund names accurately reflect the investment strategy.  

They cover four main areas. The first area is for products that will have ESG or sustainability-related terms in the name. The initial proposal, which has not changed, is to ensure that 80% of the portfolio is in assets that are used to meet the sustainability characteristics of the fund or its objective. This is particularly relevant for Article 8 funds, because Article 9 funds already have to invest 100% in sustainable investments (SI), except neutral assets. 

"A key change from the initial proposal is having at least a minimum of 50% of the portfolio invested in SIs, which has now been abandoned. It is replaced by a requirement to invest ‘meaningfully’ in sustainable investments, leaving that decision to asset managers, depending on the strategy and the type of investment universe".  

"The third component will be the implementation of exclusions that are related to the Paris-aligned benchmarks, and it includes companies that are violating global norms, controversial weapons, tobacco, but also fossil fuels with some different thresholds for coal, oil and gas, and a combination of revenue exposure to high intensity power production. 

It is important to note that these guidelines may differ from existing country labels, which does not help reduce market fragmentation. However, these additional guidelines can work for both options in the SFDR review consultation (whether the commission decides to stick with Article 8 and 9 with additional requirements or move towards product categories based on investment strategies)". 

"While there are no detailed guidelines yet, clarity and precision in reporting impact are important. We are advocating for a category in SFDR in the future that would be solely focused on impact because we believe that it does deserve a treatment on its own. ‘Impact’ is different to being ‘sustainable’." 

Q. What does this all mean for investors? 

Nathaële Rebondy said: "The requirement of having a minimum of 80% investments aligned with the sustainability characteristics is relatively high, and may pose challenges for certain asset classes, such as multi-assets or less traditional portfolios, but will work well for equity and fixed income portfolios. Asset managers will need to analyse their products to ensure they meet this threshold.  

"Another important aspect is the concept of meaningful investments in SIs. It would have to be defined according to the expectations that an investor might have based on the fund name. This introduces some uncertainty, especially with the abandonment of the 50% threshold, allowing for meaningful investments below that level. Asset managers will need to carefully consider client expectations and ensure robustness in defining meaningful investments and to make sure that can be demonstrated properly.  

"We think that a threshold that is below 50% is going to be acceptable. But it must be based on the investor's expectation in the investment product and the investment strategy expressed in the fund name. From the investment strategy perspective, some funds already have 50% SIs or even higher, notably Article 9s.  

"Meanwhile, the ESMA's focus on transition seems to only consider the margin of progress and not investments in enablers of the global economy's transition. This poses a challenge for asset managers like us with funds investing in transition solutions beyond the requirements imposed by the guidelines. These funds, which may currently be Article 9 funds with 100% SIs, will require further guidance on how to be considered. Additionally, the required exclusions for sustainable funds aligned with the Paris-aligned benchmark differ from existing country labels, creating complexity for products with multiple labels and necessitating compliance with multiple sets of requirements." 

Q. What’s next? 

Nathaële Rebondy said: "ESMA's final guidelines are expected to be published at the end of the current quarter or the beginning of the second quarter of this year. It should then apply to new funds in late Q3 2024. Existing funds will have a transition period of approximately six months. By the beginning of Q2 2025, all products should fully comply with the guidelines. This expected timeline presents a very brief period for meaningful changes, requiring significant effort from the industry".