SFDR 2.0: The Commission’s proposal and its implications for investors

Welcome to Sustainability Bridges, a Eurasif podcast that aims to build bridges between policymakers, investors, academics and civil society around the theme of sustainable investment. Eurasif, the European Sustainable Investment Forum, is the leading Pan-European Association promoting sustainable finance and investment at the European level. In these podcasts, Eurasif's executive director invites distinguished guests for a 30-minute conversation on current events shaping the sustainable investment community. Hello, my name is Natalie Donnier and I'm the chair of Eurasif. For this episode of Sustainability Bridge, I'm happy to be joined by Ellen Bussier, head of DG Fisma Asset Management Unit at the European Commission. As our listener might already know, the European Commission published its long awaited review of the Sustainable Finance Disclosure Regulation or SFDR last month, proposing significant changes to the current framework. This is a key file for many stakeholders working on sustainable finance and we would like to take this opportunity to better understand what the European Commission proposes for the review, what it means for investor and what will happen next. Ellen, many thanks for joining us today. Thank you, Natalie. It's a pleasure to be here. I believe that many of our listeners will be familiar with the SFDR, but for those who are not, could you give us a brief introduction to this regulation and its objectives? So the SFDR was first introduced in 2021, that's when it started to apply, and it's considered a major piece of work and major piece of legislation and it's part of the many initiatives to deliver on the objective of the Green Deal. I think what is important to notice that when the SFDR was negotiated and discussed between the college stateers, it was one of the first piece of regulations requiring and organizing how financial disclosures relating to ESG matters would be organized, structured and communicated to investors. It was the first time in the world that a jurisdiction, I mean, the EU, would organize such disclosures. So it was in that sense a very, very important piece and it had huge effects on market practices and on ESG data made available to investors. It's been in application for four years, a bit more than four years now and the commission has assessed how it's been functioning as part of the review we launched a few years ago. Many thanks, Helen. On a personal note, I would say that, you know, I have been saying for the last four years that I love SFDR and this is the only piece of regulation when I issued that statement. But the European Commission published proposal to review the SFDR on November. This review follows a comprehensive assessment and aims to address a different challenge identified during the first year of implementation of SFDR. Could you give us a quick overview of the main changes the European Commission is proposing and what these amendments are aiming to achieve? So the SFDR was just referring to as had huge effects on how financial market participants, so the industry, all financial intermediaries, had to organize their ESG disclosures. At the time, it was conceived purely as a disclosure regime, meaning structuring the type of ESG information that financial market participants have to consolidate collect from underlying assets and the lying companies. And so one of the first feedback we received from the market on the SFDR is that it was relatively complex to operate. What I mean by that is that I mean the level of granularity of information, I mean having access to information, communicating that information to end investors, it was identified by many users of the SFDR as complex. Another important shortcoming of the of the current SFDR is the fact that despite being conceived as a disclosure framework, it was used as a labeling framework. So you must be familiar with the concept of article eight and article nine being the sort of article structuring disclosures. But in practice, what we've seen in the markets is that financial market participants were marketing their financial products as either article eight or article nine without the necessary conditions and requirements in the framework supporting this type of claims. Because being purely a disclosure framework, it didn't contain minimum conditions, minimum criteria, ensuring that those so-called article eight or article nine products would comply with minimum requirements. This the fact that the industry has been making certain EIC claims on the base of the SFDR was identified as a source of greenwashing risks by many investors and many actors from the industry who reported and I think that's one of the main complaint we've heard that almost two years of assessment is the fact that the SFDR despite its its good intention was creating a real risk of greenwashing and misleading claims for and investors. Final important aspect in the list of weaknesses that we've identified is the fact that the type of disclosures that were done under SFDR were either too complex for retail investors not sufficiently elaborated for professional investors who have very specific needs. So in a sense, you have this problem of misalignment between the needs of and investors, either retail investors who need relatively high level and simple communication material. So for those retail investors, SFDR is in a sense too complex and for professional investors, the type of information they would get is not entirely fit for their specific needs. So we had this issue of misalignment between what SFDR is doing and the type of information that investors need to receive. So that's a very brief outlook of the problems. And that's why the objective of the review is along three lines. So the first objective is to increase the robustness of the SFDR. Robusness meaning that we need to insert in SFDR the minimum conditions that will allow financial market participants to make certain ESG claims and to market financial products with minimum conditions allowing for the credibility and the robustness of those claims. So robustness is one. Second of all, we would like to make the SFDR more user appropriate so fit for investors needs. As I said, we need to, on the one hand, simplify the type of disclosures and the way information is communicated to retail investors. And on the other, we need to accept that for professional investors, they must have more flexibility to sort of establish their specific ESG needs, but actually with with financial market participants. And that's where the idea of product categories is so important because it will facilitate in particular the communication and the interactions with retail investors. And final objective of the of the SFDR review, it's simplicity, meaning relying on concepts that can be understood and used by both the financial industry and then investors. And this idea of more simplicity, more alignment between the SFDR and other frameworks of the symbol finance universe was particularly important. So a number of aspects of the review aim in particular to better align the SFDR with the tax on regulation, for instance, with the climate benchmarks that we have developed in the EU, to ensure also better consistency with the CSRD, which has been recently agreed and revised by the college stateers. So this idea of simplicity and alignment is the third important objective of this SFDR review. So with those objectives, what we're doing and I mean, I'm sure we're going to discuss that in more details in a minute, is that on the one hand, we will simplify and streamline these closures. And on the other, we want to, we always suggest to create robust ESG categories that will facilitate information sharing with investors. Yeah, it is a paradox, isn't it, that SFDR was loved so much by the industry that it was used beyond its initial intention. So the way to address it now is in the one of the main change proposed is introduction of categories of sustainability related product with minimum criteria. And full-fooling the criteria will allow product to be named and marketed as sustainable transition, et cetera. Can you explain the rationale between these three categories and some of the minimum criteria and also let the auditor know how these were built upon or deviate from the recent SMA guidelines on funds using ESG or sustainability related terms. So a lot of work went into the creation and the calibration of these three categories indeed. First, I would like to recall that the proposal and the way the proposal is structured is the result of a lot of consultations, a lot of engagement with stakeholders, with industry participants, with national competitive authorities, representatives of the industry. We've tested different models, we've tested the model of like two categories, the model of three categories, different type of criteria and opening those categories. So that's how we came to the result that now features in the proposal with three categories, one category which is the sustainable category, which acknowledges the fact that some products will be invested in assets or projects that are already sustainable, so already compliant with the highest standards of sustainability ambition. The second category is the transition category, here the objective is to incentivize investment into assets and projects that support the transition of in particular transition of the of the economy towards climate change. And finally, we recommend the creation of an ESG basic category that will be fit for products that do make efforts that do implement some ESG investment approaches, but with a lower ambition compared to the sustainable transition category. Those categories are built around essentially two pillars and there are differences and similarities in the in the way those pillars are constructed. So all three categories contain a positive element, so a positive pillar, which is a contribution to an investment objective, environmental objective or social objective in particular for the sustainable category, a transition objective for the transition category and more general objective for the category. Financial market participants will have to demonstrate that at least 70% of their portfolio aligned with that investment objective, the claim that are made by the financial products. So that's the positive elements and of course we do define in the proposal a list of investment approaches that are considered eligible to meet or to demonstrate the compatibility with the objective. The second pillar of the categories is the exclusions. So the fact that to comply or to be eligible for the category, financial market participants must demonstrate that they do not invest in certain type of assets or activities that are not considered compatible with the proclaimed investment objectives. So those are really the two driving elements for the categories and we have established so when it comes to the positive element of the categories, we have a list of investment approaches like if I take the sustainable category, for instance, we consider that financial products that qualify as sustainable could invest in EU green bond assets, for instance, or they could invest in taxonomy aligned assets, they could invest in assets that demonstrate a real and credible sustainability objective. And the other hand, again, if I look at the sustainable category, we have a list of exclusions and we've tried again with the subjective of entering a maximum alignment with other pieces of the sustainable finance framework. We are building on what already exists and in particular for the sustainable category, exclusions that are already in application under the Paris line benchmark, I mean for the Paris line benchmarks, those exclusions have been available for many years already. And they are proving quite efficient. It seems at least that's the feedback we have received. And therefore we build exclusions for the sustainability category on those PAB exclusions. That brings me to another aspect of your question, which is the alignment with the smag guidelines on funds names. It's absolutely true to say that those guidelines that is adopted last year have had huge impacts on market practices and on how financial market participants are making ESG claims. And so we've decided when looking at how to structure the future framework, we've decided to largely build on those smag guidelines. But we also consider that certain aspect of the guidelines had to be strengthened to make the framework even more robust than it is today. And that's why we've deviated on certain aspects of the guidelines. And I think one particularly important aspect that I would like to highlight today is the fact that we've added for the sustainable and transition categories. We've decided to add an additional exclusion in the form of not allowing investment in assets or projects that would support the expansion of fossil fuel activities. This is not currently an exclusion of the Paris line benchmarks. So this is an additional exclusion. But this was considered necessary to make sure that the two categories, the two more ambitious categories, sustainability and transition would be sufficiently robust. So as a short answer to your question, we've to the extent possible try to build those categories on existing market practices. And in particular those that the smag guidelines have generated. But to the extent necessary we've we've made some adjustments to make sure the framework would be sufficiently solid. And we'd also ensure that retail investors are not confused by the type of assets in which they invest when having a conversation with their financial advisors on the features of sustainable products. According to some of the preliminary feedback we received some investor regret the deletion of the definition of sustainable investment. Despite some of claiming that it's lack of clarity, it created an incentive for asset manager to develop their own stringent methodologies to identify positive sustainable objective and to ensure their investments are avoiding environmental or social arm while supporting companies with good governance. Would you say the criteria behind the sustainable category, leave room for such approaches and create the same level of incentives? This has been our objective all along, in fact, as you may be aware, a number of stakeholders considered that the definition of a sustainable investment as a concept was a good one. But the way it was implemented in it is implemented in the current SFDR makes it difficult to operate in practice. And that's why our recommendation for the future SFDR is to say that we would not keep the concept of a sustainable investment as it is today and the article to 17. But we would maintain the building block that supports the definition of a sustainable investment and apply it to the different categories. So again, if you look at the definition of sustainable investment today, you have a positive element, a contribution to an objective and sort of a negative leg with the do not significant harm. And that's why we've decided to convert this concept of sustainable investment with this positive leg of a contribution and negative leg of exclusions. So we keep the spirit, if you want, of the sustainable investments, but we make it more suited to a product categorization system. So I think it's not correct to say that we are lowering the ambition by removing the concept itself. It's quite the opposite. We are strengthening the ambition by making the individual component of the definition more operational under the three categories. As you know, sustainable investment for our often involved in national labeling scheme, how is the SFDR review categorization system intended to interact with national labels? There will be interactions with tested with some member state on a bilateral basis, the features of their in particular national regimes. But the at this stage, the position of the commission is that we are not regulating or we are not forcing anyone to adjust their national labels or the criteria of any ad hoc ESG label. What we expect is that over time, they will most likely be a form of convergence in the sense that national labels put either a line very clearly with one of the category, in which case financial market participants could fit in one of the SFDR category and at the same time claim the benefit of a local or national label. Or when there are discrepancies, it would be for the financial market participants to decide whether they want to meet the conditions of the label and whether they are in the capacity of using one of the SFDR category. I think the criteria of the SFDR categories will be sufficiently clear to allow financial market participants to to establish whether they meet those conditions or not. Probably over time a form of convergence, but it's going to be for members to decide how they want to implement this convergence in practice. One thing that probably I would want to highlight here because we haven't had the time yet to discuss this aspect is the fact that we are making a very clear link in the proposal between the categories and the naming and marketing rules. So we are establishing the fact that it's not possible for non-categorized products to market themselves as under one of the category if they don't meet the conditions. I think it's a very important step compared to the current SFDR, of course provided that the college's leaders agree and endorse this approach, but it's a very important step because it means that it's not going to be possible for non-categorized products to make and to market openly their product as a ESG, which is clearly one of the main weakness of the current SFDR. And so we want to establish that marketing claims have to be backed and supported by real evidence, real specifications. The review overall proposed significant changes in SFDR disclosure posed at the level of financial institution and at the level of financial product. For instance, principal adverse impact indicators have become a central element for investor decision making as many investors use them as a basis for investment and to conduct their engagement activities. The SFDR review deletes the current list of mandatory PIs, or some disclosure on adverse impact maintain and if so for which products. I would first start by saying that evidence we've collected over the years of assessment of SFDR, then to show that entity level principal adverse indicators were actually not used or at least not to a very large extent by investors. That's probably one of the main findings of our analysis is that with the exception of a few principal adverse indicators, the rest of those indicators were considered either not sufficiently robust in terms of underlying data or not sufficiently capable of measuring a real impact. So what I want to say here is that if you take the list of the 14 mandatory indicators and the current SFDR, we I mean, we came to the conclusion that only four or five of those principal adverse indicators impact indicators were really used to support investment decisions. Other indicators were used but to a much lower extent and most stakeholders tend to believe that making those indicators voluntary instead of mandatory would be a much better outcome for investors because those financial market participants who have the capacity to collect the data to consolidate the data and allow the data will continue to make use of those principal adverse impact indicators for the benefit of end investors, but for those PIAs that are not sufficiently robust and supported by concrete and relevant data, it's not justified to make them mandatory for all entities and all products. That's why in fact in the in the proposal, we are proposing to remove entity level disclosures entirely from the SFDR, so we established that the SFDR is essentially a product level regime. However, we keep the possibility for financial market participants to use principal adverse impact indicators for the sustainable and transition category. What I mean by that is the fact that if I mean for products that claim to have a sustainable transition ambition, they will have to identify and disclose the principal adverse impact of their investment strategies and they will have to choose which PIAs are most appropriate to precisely demonstrate their compliance with their objectives. In a sense, we keep the concept and we keep the notion of principal adverse impact indicators, but we make them voluntary and that's also part of the objective to simplify the framework and to make it more proportionate in terms of burden created for FMPs versus benefit for investors. Similarly, our taxonomy alignment disclosure is still required for some product. So by default, no, so for none of the categories, it's going to be mandatory to disclose the degree of taxonomy alignments. However, for products that claim to have an environmental objective, they should say whether the taxonomy is the reference framework for measuring their alignments with the environmental objective. So we expect based on our consultation that the taxonomy regulation will continue to be used as a reference point for measuring environmental objectives and especially for those products that claim to have climate transition as one of the main objective. The SFDR review does not include any dedicated disclosure for non-categorized product apart from how they consider sustainability risk. We're such an option discussed during the preparation process to have all product to make some disclosure and why is it not included in the final proposals. That's in fact a dimension of the proposal that has been extensively discussed with many stakeholders, whether we should keep a minimum set of disclosures for all products, both categorized and non-categorized. But the essential feedback we got from many stakeholders is the fact that it would be confusing for products that are not categorized to be able to make some active ESG disclosures towards end investors. And that's why we've decided that for non-categorized products, of course, there remains subject to the obligation to make disclosures on sustainability risks under Article 6. It's also possible for them to make certain ESG disclosures in their contractual documents, but it's not possible to make ESG disclosures in a proactive manner, or in a way that could send misleading messages to end investors and in particular retail investors. So we establish a very clear distinction between those products that make ESG claims that can back those ESG claims and therefore belong to one of the three categories, and those products can market towards end investors and non-categorized products for which we've decided to really limit the ability of making outward claims. So for those non-categorized products, disclosures are still possible in contractual documents, but they shouldn't be marketed to any investors. Entity-level disclosures are a controversial topic. However, many investors were still keen to maintain such disclosures as it allowed them to clearly flag their action to address the adverse impacts of their investment. Especially since the Omnibus Initiative removed the European Commission mandate to adopt sector-specific standards for financial institution. Additionally, European authorities regularly highlighted the usefulness of this disclosure for supervisory purposes. So what was the rational behind their deletion? It's true to say that Entity-level disclosures were one of the core components of the, well, initial SFDR as it is currently in application. However, the feedback received during the assessment, again, so during the consultations, the various workshops that were organized with industry participants, showed that those were not used significantly by investors. And they were not either used significantly for supervisory purposes. That's why we've decided to ensure some consistency in particular with the scope of the CSRD. Now revised CSRD as per the agreement recently reached by the ecologist leaders, and to clearly indicate that the SFDR would contain product-level disclosures, and that all Entity-level disclosures would now belong to the scope of the CSRD. Therefore establishing this very clear distinction between the purpose of the two frameworks. I think there are several justifications to that. Well, first of all, there's a question of costs. Because, of course, it's costly to establish certain type of Entity-level disclosures, to produce those disclosures, to collect the data, etc. But it's also a question of duplication, because to the extent that such disclosures are made under the CSRD, the question is legitimate to then ask whether it's justified to require those disclosures to also be done in another legal framework and another regime, even if to very large extent we've tried to align these CSRD disclosures and the SFDR disclosures as they are done today. So that was mostly the reason for deciding to scope out of the SFDR Entity-level disclosures. I would like now to focus on the scope for a moment, so to whom this regulation applies. In the proposal, the scope of SFDR is revised, so that financial advisors and portfolio management services would no longer be covered. What was the reason for this change? In the same vein, I think we now establish SFDR as a product-level regime. We create very key disclosures for product that are categorized under the various categories, and therefore we do not consider that it's appropriate in that context to require specific disclosures for as financial advisors and portfolio managers. However, those will still be captured by the framework, but not under SFDR, or at least not entirely under SFDR, and here I need to explain. Financial advisors, who are those who interact with clients, will still be captured by the MiFID and IDD-level two rules. As you know, there are certain obligations for financial advisors when recommending products to retail clients in particular. Those rules are established in the MiFID and IDD delegated acts. Those rules will remain in place, but they will evolve. In the future, we will revise those MiFID and IDD rules to align with whatever is the outcome of SFDR negotiations, meaning that financial advisors will have to adopt new behaviors to be able to sell and to recommend to their clients financial products according to the SFDR categories. They will still be captured in a certain way by the SFDR rules, but they are no longer directly under the scope of the SFDR when it comes to making certain disclosures. As regards portfolio management, here again, the main reason for scooping out portfolio management is because portfolio management is a service. It's not a product, but we still foresee the possibility for clients to ask that when they are mandating financial intermediaries to manufacture certain products for them. They can ask that those services are provided following the SFDR categories or the future SFDR categories, I should say. In that context, we make it clear in the proposal that portfolio managers should follow the preferences expressed by their clients. SFDR links with many other EU rules. For example, the MiFID IDD rules on the assessment of clients' sustainability preferences. We understand the European Commission is also planning to make targeted changes to these rules to make sure they reflect the SFDR review. Can you elaborate on this? Absolutely, that's correct. So as I said, there is a very clear and direct link between SFDR and the MiFID and IDD delegated acts. In the sense that, as I explained before, financial advisors are subject to certain obligations when it comes to recommending certain products to their clients, and in particular, they have to assess the sustainability preferences of their clients. Under the current system, they are supposed to follow like a three-step analysis and they are supposed to ask their clients whether they want to invest according to the taxonomy or in line with the SFDR disclosures or to take into consideration certain elements of the principal adverse impact indicators. It seems that this process is too complex and not particularly suited for retail investors who do not necessarily understand the specificities of the three grids, let's say. It would be much more efficient from what we've heard from financial advisors in particular to be able to follow a simple framework building on the future SFDR categories. So the three types of categories that we are proposing to establish once the revised framework is in place. And that's why if this new framework is approved by the collegiators, we will, as part of the implementation work preparing for the application of the new rules, we will also revise and amend the MiFID and IDD delegated acts to align the analysis of the client's sustainability preferences with the existence of the new categories under SFDR. The legislative proposal will now be discussed by the EU college is later on the European Parliament and the Council of the EU. What are the next steps and by when can investor expect to apply the new rules, especially with regards to the new delegated act replacing the current SFDR delegated regulation that will shape the detailed disclosure at product level? And can you provide more clarity as to the sequencing, the implementation time table in particular for existing product, but also for facing out of current requirement on the SFDR one that will no longer apply? Negotiations are a long process. It's extremely difficult to anticipate how much time it will take. So on this aspect, I really cannot predict, but we'll take the necessary time to ensure the best outcome for EU citizens. Usually takes some months or maybe up to two years to negotiate a legislative framework. Maybe in that case could be a bit quicker. Let's see. In any event, once the new I mean, the parameters of the new SFDR are agreed, there will be an implementation period of at least 18 months, this in the proposal we foresee 18 months, the college leaders may wish to extend that implementation period, I mean, to be to be discussed. And during those 18 months, the commission will work on the level two, as I said, so the level two of SFDR, which will be a priority, of course, but also the level two of me feed and IDD to ensure a perfect alignment of all implementing rules. So that on the day of application of the new upgraded SFDR framework, everything is in place, everything is clear for financial market participants and investors, so that they know exactly what to produce or what to expect from the manufacturers. We will do all possible efforts to prepare the level to in a relatively short amount of time, so that there is enough time for the industry to be able to implement and prepare for the application of these of these new rules. But again, this is going to be discussed in the context of the negotiation, so it's a bit early to predict what the likely application dates would be for the new SFDR. But taking into account the various steps I would expect probably in something like three years from now, more or less, maybe four years, depending on the, again, on the transition phase, that is agreed by the college leaders. Thank you, Elaine, for joining us today and for this insightful conversation. Many thanks. Thank you, Natalie, for the pleasure. 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