Three years in, the European Union's most ambitious effort to help investors gain more clarity about environmental, social and sustainability characteristics of their investments continues to sow division and confusion.
Investors say they're inundated with details. Investment managers say the legal requirements aren't clear and too many data gaps exist. And key definitions within the EU Sustainable Finance Taxonomy, which underpins understanding of what can be classified as "green," haven't been fully decided yet.
There is broad consensus that the launch of the EU's Sustainable Finance Disclosure Regulation, which aimed to create a common, transparent framework that allowed investors to more easily compare investments — and reduce greenwashing — has been less than optimal.
"SFDR still has to address several deficiencies such as unclear legal concepts (e.g. defining exactly what sustainable investment is), low quality data reported by the investable companies or the misuse of SFDR for marketing purposes," according to Joanna Frontczak, senior impact equity analyst at Swiss investment management firm Vontobel, which had AUM of 206.8 billion Swiss francs ($230 billion) as of Feb. 29.
However, recent joint recommendations by the European Supervisory Authorities have proposed a way forward.
Introduced across the European Union in March 2021, SFDR aimed to let investors know the green and ESG-related credentials of investment strategies through the introduction of a reporting framework for funds.
As it stands, the technical and detailed approach of SFDR can make it challenging for pension fund clients to understand the significance of certain data points, such as the emissions of inorganic pollutants or even a firm's anti-bribery policies. So much granular information “can lead to more confusion than clarity,” according to Elisabeth Ottawa, head of public policy for Europe at Schroders, a U.K asset management firm with £751 billion ($949 billion) in AUM as of Dec. 31.
SFDR currently categorizes funds as Article 6 — which do not integrate any kind of sustainability into the investment process; Article 8 — promoting ESG compliance; and Article 9, which are strategies with investments that specifically target sustainable outcomes.
An investor shorthand for these three classifications has been "brown" for Article 6, "light green" for Article 8, and "green" for those most ESG leaning and classified as Article 9.
Following SFDR's introduction, sustainable fund flows do appear to have reacted positively. The proportion of Article 8 and 9 funds as part of the universe of EU funds in scope for SFDR reached 60% in the first quarter of 2024, up from 33% in the second quarter of 2021, according to data from Morningstar Manager Research.
Soon after its introduction, there became a belief that SFDR, which was created as a disclosure and reporting framework, had become a “de facto labeling regime,” said Stuart Burnside, head of product governance and ESG product at M&G Investments, a U.K. firm with £343.5 billion AUM as of Dec. 31.
“I think SFDR was actually a reasonable and effective instrument, which people have then used to play the wrong tune,” Burnside said.
Perceived problems within SFDR deepened as 2022 drew to a close, when large asset managers such as BlackRock and HSBC Asset Management downgraded Article 9 funds to Article 8, and Article 8 funds to Article 6 as criteria was tightened.
The ‘Level 2’ of the regulation’s Regulatory Technical Standards, effective in January 2023, added elements such as requiring investment firms to align their ESG disclosure with the principal adverse indicators reporting framework, which identified ESG risks within an investment strategy, and share detailed information on how to avoid such adverse ESG effects of a fund.
Arthur Carabia, director of ESG policy research at Morningstar Sustainalytics, notes that "as with most EU regulation, enforcement is primarily executed by national regulators, with European Securities and Markets Authority oversight."
Recent developments
A recent feedback report, published in May and authored by the European Commission and taking views from 324 organizations and individuals with insight into the market, showed ongoing division on how to fix SFDR. For example, 56% of respondents believed that the EU should impose standardized disclosure requirements for all financial products. According to the report, a large majority of respondents also called for these disclosure requirements to be simplified and streamlined across the sustainable finance framework.
Following this report, joint recommendations by the European Supervisory Authorities to the European Commission, published in June this year, proposed a way forward.
The reported stated that SFDR categories should be simple with clear objective criteria or thresholds to identify which category the product falls into. The ESA encouraged categories of "sustainability" and "transition," replacing Articles 8 and 9.
The feedback report also showed that 72% of respondents supported the creation of a specific category for products with an ESG transition (companies with imperfect ESG credentials looking to improve) focus within SFDR.
However, Laura Kaliszewski, global head of client sustainable investing at Natixis Investment Managers, part of French banking group BPCE, with $1.32 trillion in AUM as of March 31, is in the opposite camp on this point: “We believe that ‘transition’ should not be a separate category but has its place within each different levels of ambition: it will depend on the strategy deployed by the asset manager.”
The ESA recommendations are currently being reviewed by the commission, which will then consider what amendments to propose regarding SFDR going forward. Any changes put forward will then form part of a legislative proposal to be voted on by the European Parliament.
Another ongoing issue is that the European taxonomy on sustainable activities, which act as key definitions underpinning SFDR, is yet to be completed.
The ongoing wait for the specification around areas such as pollution prevention or water protection “limits the SFDR potential and investors’ appetite as some cannot invest in parts of the value chain,” according to Vontobel's Frontczak.
SDR vs. SFDR: Culture clash?
One downside to SFDR was its position as a first mover, which meant it had no other models to learn from, sources said.
Eugenia Unanyants-Jackson, global head of ESG at PGIM, a U.S.-based asset manager with $1.29 trillion AUM as of Dec. 31, goes so far as to say regulators should've taken more time over SFDR. “Now that we know what can go not quite to plan, perhaps it would have been better to spend longer in the making of the regulations, and to test them with investors beforehand,” she said.
Following on the heels of SFDR was the Sustainability Disclosure Requirements, administered by the U.K.’s Financial Conduct Authority and with its own rules finalized in November 2023. Explicitly constructed as a labeling regime, SDR looks to regulate funds through the labels of sustainability focus, improvers, impact, and mixed goals.
In the U.S., a climate disclosure rule proposed by the Securities and Exchange Commission is also facing pushback.
The nature of SDR makes it “more principles-based and less rules-based,” said Ashley Hamilton Claxon, head of responsible investment at Royal London Asset Management, which has £170 billion AUM as of March 2024.
Christopher Fidler, head of industry codes and standards at the CFA Institute, thinks SFDR could learn a lot from SDR: “What is and isn’t sustainable is what SFDR was trying to distinguish; I think they just it just did a very poor job of it.
“They tried to make this gradation. When SFDR first came on the scene there was talk about brown, light green and dark green. That's nowhere in the legislation but that's how people talked about it,” he said.
Sources also said that something that could be hugely advantageous to international investment firms would be cooperation between regulatory bodies, so if a fund were to be labeled in a certain way by SFDR, for example, the manager could expect it to be assessed in a similar way by SDR.
“It would certainly help reduce the cost burden to asset managers and to underlying customers, if that passporting can happen. I suspect, however, that jurisdictions will be quite nationalistic in the sense that they want to have their own stamp on sustainable finance. So I'm not necessarily expecting, certainly not in year one, a straight equivalence regime,” Claxon said.
