Be careful what you wish for.
Since the European Union’s Sustainable Finance Disclosure Regulation (SFDR) took effect in March 2021, the continent’s asset managers, investors, fund service providers and even national regulators have raised objections to various aspects of the legislation and the burden of following its requirements – especially since the detailed SFDR regulatory technical standards came into force at the start of this year.
So the announcement by the European Commission on September 14 that it was launching a consultation – two, actually – on the future of the SFDR, and that the possibilities on the table included the abolition of the current categorisation of funds according to the legislation’s articles 6, 8 and 9, may have seemed at first sight vindication for the critics.
Is the EU ready to drop its definition of the sustainability qualities of funds based on whether they have sustainability characteristics (article 8) or a sustainable purpose (article 9), or make no claim to sustainability at all (article 6), in favour of a new categorisation system, perhaps modelled on the one envisaged for the UK, that would better describe the funds’ strategies or investment approaches?
That concession would tackle one of the key criticisms of the SFDR – that it was been de facto adopted by the industry and investors as a labelling system, even though legislators insist it was intended as nothing of the kind. It might also address a more fundamental issue: the lack of a single, universal, coherent and easily-understood definition of what exactly is meant by “sustainable”.
Risk of greenwashing
In its consultation, the Commission says it is looking at a categorisation system due to concern that the use of articles 8 and 9 as labels is increasing the risk of greenwashing. One option would convert articles 8 and 9 into formal product categories and develop existing principles and concepts that they embody, such as sustainable investment or doing no significant harm.
The alternative approach put forward in the consultation would focus on the type of investment strategy followed by a fund, using criteria that are not necessarily part of the current SFDR concepts, such as impact investing, while elements such as environmental and social impact characteristics or sustainable investment and the distinction between articles 8 and 9 could be dropped.
The consultation is still at an early stage, and it’s not yet clear how industry members and broader stakeholders may respond. But some have already expressed fear that the cure might turn out to be worse than the disease.
Aleksandra Palinska, executive director of the European Sustainable Investment Forum, which brings together asset managers, institutional investors, index providers and ESG research and analytics providers, says that while the SFDR framework is in need of amendment, she is wary about a ground-up reworking of the legislation, noting that the investment industry has dedicated substantial effort and expense in complying with the rules as they currently stand.
Addressing impact investing
“Let’s fix what needs fixing, but let’s not throw the baby out with the bathwater,” she pleads, “and, rather, build on what has been already achieved. One aspect that needs addressing is impact investments/transition finance, the specifics of which are neither addressed by the article 9 nor article 8 categories”.
Other industry members are similarly anxious that a total revamp of the SFDR might become a “nightmare”. At a workshop session on 10 October as part of the review process, Dennis Haensel, head of ESG advisory with Deutsche Bank subsidiary DWS in Frankfurt, said there could well be considerable frustration on the part of fund managers after their efforts to comply with rules that the Commission now suggests may not be achieving their purpose.
He was echoed by another workshop participant, BNP Paribas Asset Management head of public affairs Laurence Caron Habib, who says the current framework contains positive elements and it would be a bad idea to rewrite the legislation from scratch.
Barclays analysts Scott Gordon and Maggie O’Neal argue that the Commission’s reopening of the way sustainable investment transparency should work could disrupt inflows meaningfully, noting that a system of official fund labels could be accompanied by minimum standards and stricter rules on portfolio holdings and exclusions.
“The consultation acknowledges that the SFDR is not being used as a disclosure regime alone,” they say. “Rather, its articles 8 and 9 are being (mis)used as sustainable fund labels. These classifications are becoming badges of sustainability, rather than driving more disclosure and enabling end-investors to be more discerning in their asset allocation.”
Mass downgrading of article 9 funds
There is little dispute in the industry that the SFDR in its current form is unsatisfactory. Aside from its failures to define concepts such as sustainability and doing no significant harm, there was uncertainty about what proportion of article 9 funds, those with a primary sustainability-focused purpose, needed to consist of sustainable investments.
When last year it became clear that most regulators would interpret the rules to mean all assets, bar those held for liquidity purposes or for hedging, should be sustainable, the result was a mass downgrading of article 9 funds to the less demanding article 8 designation – affecting a total of more more 350 funds and $270 billion in assets, according to Morningstar.
This situation was itself the product of the disjointed way in which the legislation was implemented. The formal text of the regulation came into force on 10 March, 2021, but disputes over the content of the detailed RTS elaboration of the rules meant they were not agreed and implemented until the beginning of this year.
Waiting for the CSRD
Then there is the fact that the SFDR requires asset managers to report data on their investments that does not exist, or at least can only be estimated or extrapolated. The EU’s Corporate Sustainability Reporting Directive will eventually require at least 50,000 EU companies to publish data on their sustainability performance, but not any time soon – the first reports must be issued in 2025 for financial years starting from next January, but for large non-listed companies not until 2026, listed SMEs in 2027, and foreign companies operating in the EU in 2029.
To a certain extent this simply reflects that fact that the EU is the first major jurisdiction to launch such an ambitious sustainability transparency regime. Others such as the United States and United Kingdom have been able to learn from its successes and mishaps.
And opponents of a radical reshaping of the SFDR believe that while limited revisions and adjustments would be welcome, the functioning of the regime is only set to improve as implementation beds in and the availability and accuracy of data gradually improves. Better that, they say, than all but starting again from scratch, a prospect that fills many compliance departments with horror. But it will take another seven weeks, until the Commission’s consultation closes on 15 December, to find out how widely that view is shared.