SFDR and the Future of Sustainable Finance: Is SFDR broken, or is the system that it regulates the actual problem?

Greetings, fellow ESG enthusiasts! ??

Welcome to the 22nd entry of our ESG Hot Topics blog series.

There has been little to no recent activity regarding SFDR or the EU Taxonomy in terms of new rules, guidelines, Q&A, or clarifications. I think this is a positive development—something the market both appreciates and has longed for quite some time.

Therefore, I will take the liberty to provide my review and honest opinion on SFDR and its impact on the sustainable finance markets. In some ways, it has changed the landscape, while in other ways, perhaps not at all. I won't be able to cover everything in this post, but I will begin to digest and explain the most significant recent developments in SFDR and ESG.

The key update is the Opinion on the Functioning of the Sustainable Finance Framework, published on July 24, 2024. This is an extension but separate from the European Commission’s public consultation on the functioning and future of SFDR, which marks the first step in a regulatory review process that will eventually lead to significant amendments to the current SFDR regime (which can be viewed as SFDR 2).

I believe practitioners and ESG champions alike should read both of these documents to understand the nuances and implications of SFDR to date. As we all know, SFDR was introduced during a time of economic prosperity when business activity was booming, and financial markets, especially the fund industry, saw ESG and sustainability as potential cash cows to capitalize on.

Many viewed ESG and sustainability as a nice-to-have accessory that could be added to "business as usual." As some have pointed out—most notably Desiree Fixler —ESG and sustainability have been, to a certain extent, marketing gimmicks, even labeled as a "Ponzi scheme" or a big bluff. There’s much to debate on whether this holds true, but that's not the purpose of this post.

Instead, this ESG Hot Topic aims to reexamine and provide a health check on SFDR and its accompanying regulations. By "health check," I mean reviewing the latest developments as well as longstanding positions within SFDR. These should not be taken lightly, especially since they come from the?CSSF—Luxembourg's financial supervisory authority—which has strong connections to Brussels and the lawmakers.

Before I continue, it's worth acknowledging that when SFDR first came into force in March 2021, its shortcomings were clear to many market participants. Nonetheless, the industry understood the intent behind the regulatory framework and adapted to implement new rules and procedures despite their imperfections. The implementation period was complicated by frequent shifts in regulatory interpretation, leading to moving goalposts.

ESMA’s Views Summarised

Please see the table below for a bullet-point summary of all?the proposals.

Consumer Testing

ESMA underlines the importance of consumer testing when considering how the framework should address retail investor needs to ensure the feasibility and workability of any proposals. While consumer considerations were present in the development of SFDR, such as through the testing of the pre-contractual and periodic reporting templates, ESMA:

• Distinguishes between retail and institutional investors more than under the current regime.
• Possibly views the UK Financial Conduct Authority’s (FCA’s) sustainability disclosure requirements (SDR) favorably, which focuses on retail investors.

Indeed, throughout its opinion, ESMA seems to have drawn inspiration from SDR, which is promising for international interoperability—a goal ESMA has explicitly referenced.

EU Taxonomy

ESMA is doubling down on the EU taxonomy as the central point of the EU’s sustainable finance framework to:

• Ensure a consistent minimum sustainability ambition across financial products.
• Improve comparability.

ESMA also proposes phasing out the SFDR definition of 'sustainable investments', as it:

• Leaves too much discretion to market participants.
• Hampers comparability.
• Opens the door to greenwashing.

However, if the EU taxonomy is to function as the common reference point, it needs to be completed, which would require:

• Standards, definitions, and technical screening criteria for all activities that can be environmentally sustainable.
• Standards for transition activities, including those with the potential to improve environmental sustainability and activities that should be decommissioned.
• The development of a social taxonomy.

Effectively Support the Transition

One of the major weaknesses of the current framework is its focus on sustainable finance, without properly catering to transition finance—a concept that has gained significant traction since SFDR was first developed. Therefore, ESMA proposes:

• Adopting a legal definition of 'transition investments'.
• Requiring firms to disclose similar metrics on transition activities, such as relevant shares of revenue and capital expenditure.
• Developing additional financial tools to support the transition, including:Transition benchmarks.Standards for EU-labelled transition bonds and sustainability-linked bonds.

Adapted Transparency Requirements

As signposted by the European Commission’s December 2022 consultation on SFDR, ESMA proposes that:

• All financial products within SFDR's scope must disclose specific sustainability information, regardless of the product’s stated sustainability ambition.
• Such minimum sustainability information could consist of a few key sustainability metrics, leveraging disclosures under the European Sustainability Reporting Standards (ESRS), covering both environmental and social characteristics.
• An assessment is needed to determine which financial instruments, currently not in scope of the SFDR rules, should be brought into scope and subject to standardised disclosures.

Additionally, ESMA suggests that:

• Market participants should provide a sub-set of ‘vital’ information for less sophisticated investors.
• Ensure that all investors can still access the full set of disclosures.

Implementation of a Product Categorisation System

Recognising that SFDR has been used by market participants as a de-facto labelling regime, ESMA is advocating for an explicit product categorisation system—one of the two options proposed by the Commission in its 2022 consultation. Drawing inspiration from the UK SDR regime, ESMA aims to focus the design of this system on the needs of retail investors.

The system would consist of two essential parts:

• A set of clear eligibility criteria to define the products.
• Product disclosure obligations to ensure transparency for investors.

ESMA would also explore a grading system to aggregate sustainability information and present a simple measure of the sustainability profile of a financial product, though it acknowledges the methodological challenges.

The product categorization system should, at a minimum, include:

• Distinct categories for both sustainable and transition investments.

Additionally, the system would require:

• Alignment between a product’s name, marketing materials, and sustainability profile?to reduce?greenwashing, similar to the naming and marketing restrictions under SDR and the FCA’s anti-greenwashing rule.
• An update to ESMA’s guidelines on fund names.
• The possibility of a voluntary regime, though the Commission could test a mandatory regime.

This system could lead to the phasing out of national sustainability labels. Regarding investment advice, ESMA believes this categorization system would help integrate sustainability preferences into the advisory process.

ESG Data Quality

ESMA notes that the EU Corporate Sustainability Reporting Directive (CSRD) and reporting under the ESRS will improve ESG data quality and reliability, which has previously hampered SFDR. However, not all investee companies will be in the scope of CSRD, so ESG data providers will continue to play a crucial role in market participants' regulatory disclosures.

While the Council of Ministers and the European Parliament have reached a political agreement on a proposal for an ESG Ratings Regulation, ESMA observes that its regulatory perimeter currently only covers ESG ratings. ESMA suggests expanding this perimeter to include all ESG data products to ensure data reliability across the board.

Conduct of Sustainable Investment Value Chain (SIVC) Actors

Building on its recent progress report on greenwashing, ESMA stresses that the conduct of market actors is critical for properly functioning the EU’s sustainable finance regulatory framework and for addressing greenwashing risks. Due diligence obligations for SIVC actors should align with the upcoming EU Corporate Sustainability Due Diligence Directive (CSDDD).

ESMA also advocates for further development in active engagement with investee companies, considering it a crucial lever to support the transition to a sustainable economy. To this end, ESMA proposes going beyond the existing requirements under the EU Shareholder Rights Directive and SFDR by suggesting introducing an EU-wide stewardship code, potentially leveraging the UK Stewardship Code.

Taken together, ESMA's vision would impact a wide range of regulatory initiatives, leading to significant changes for the financial industry both in the EU and internationally, including the UK.

Key Recommendations Summary

• Consumer Testing
• EU Taxonomy
• Effectively Support the Transition
• Adapted Transparency Requirements
• Implementation of a Product Categorisation System
• ESG Data Quality

Key Recommendations:

• Monitor the practical application of the ESRS.
• Continue improving the consistency of ESG metrics across the sustainable finance regulatory framework.
• Ensure reliability of estimates.
• Continue enhancing standardization and machine-readability of sustainability disclosures.
• Bring ESG data products within the regulatory perimeter.

Conduct of SIVC Actors:

• All market actors should be responsible for conducting their own due diligence, with materiality assessments commensurate with their role and responsibilities in the SIVC.
• Define due diligence obligations clearly for both the financial and non-financial sectors.
• Deeper integration of active engagement with investee companies.
• Consider introducing an EU-wide stewardship code for market actors.

EU Taxonomy:

The reaction to ESMA’s decision to double down on the EU taxonomy will depend on whether this is:

• An aspirational statement or a firm policy decision.

Regardless, it may be met by market participants with the discomfort of nails on a blackboard. The low uptake of the EU taxonomy definition of "sustainable investment" is due to:

• Data issues (which ESMA expects the CSRD will fix).
• General unworkability.

ESMA seems aware of this and supports a transition period, but the question is how long:

• If it's long enough to be workable, the EU taxonomy won’t become the sole reference point for many years.
• If it's too short, market participants may be forced out of sustainable investment objectives due to the lack of taxonomy-eligible investments.

There is a trade-off between reducing greenwashing and orienting capital flows to support the transition to a low-carbon economy, but ESMA has not explicitly addressed this.

Developing a social taxonomy alongside the EU taxonomy may not enhance its workability. ESMA might look to the UK green taxonomy for inspiration, which is shaping up to be more risk-based and less prescriptive.

Transition Investments:

Unsurprisingly, further work on transition investments is signposted, given:

• Changing investor attitudes.
• The uncomfortable position of transition finance under the current SFDR regime.

Expanding the framework to include transition-labeled financial products is positive but challenging. If regulators struggle to define?sustainable investments,?transition investments?could be even more troublesome. However, many initiatives aim to establish generally accepted principles for transition finance.

It makes sense to broaden the European Green Bond Standard Regulation to include additional instrument types. This would align with industry initiatives like the ICMA principles on sustainable debt instruments. However, the regulation's success is tied to policy decisions regarding the EU taxonomy. To ensure European sustainable bond labels aren’t dead on arrival, regulators must ensure compatibility with market practices.

New Transparency Requirements:

ESMA’s ambition to require sustainability disclosures for all financial products within and even outside the SFDR’s scope is bold. However, the industry has little appetite for additional compliance expenses, especially when not serving customers' interests. Exploring lighter-touch disclosures for institutional businesses may reduce costs and focus transparency requirements on retail investors, who benefit most from simple disclosures.

The ongoing rollout of SDR in the UK, which makes this distinction, will provide valuable lessons for ESMA.

Product Categories:

Similarly, ESMA should carefully observe UK managers' challenges with the labeling requirements under SDR. While there are lessons to be learned regarding product criteria design, the?SDR experience?reveals that the?regulatory implementation?of the labeling system?determines its success.

Workability issues will likely be aggravated by SFDR being implemented by multiple national regulators. Therefore, ESMA must provide very clear guidance to avoid inconsistent treatment of similar products across different authorities.

Final Thoughts and Conclusions:

The CSSF in Luxembourg Shaneera Rasqué-Boolell,Ph.D., FRM holds the following position and conclusion regarding SFDR:

Key takeaways:

1. The sustainable finance framework continues to position the EU as a pioneer in this field.
2. However, SFDR has significant weaknesses that must be urgently addressed for the regime to be effective.
3. Clarity, simplicity, prioritizing investor needs, and finding the right balance between qualitative and quantitative disclosures should guide the SFDR review.
4. Avoiding market fragmentation and continuing to enhance the functionality of the EU sustainable finance rulebook, particularly with the upcoming ESMA Guidelines on funds using ESG or sustainability-related terms, is crucial.
5. Iterations that fail to provide necessary clarifications create legal uncertainty and undue complexity—SFDR should be reviewed with the goal of fixing existing issues once and for all and looking ahead.

My thoughts are based on the above, though I may not address all the points in detail. I'll provide my honest opinion based on the trajectory and the statements provided by CSSF and ESMA’s Opinion on the functioning of the Sustainable Finance Framework.

It’s true that the EU Green Deal, in general, and SFDR, in particular, have played increasingly important roles in creating a level playing field for sustainable finance worldwide. This reflects the so-called "Brussels effect," where the EU, as a first mover, uses its soft power to set global expectations and regulatory standards. This is both helpful and positive in many ways, as it creates a coherent and well-thought-out approach to the most pressing topics of our time—like global warming (climate crisis) and AI. These are among the most pertinent and urgent challenges we face.

Moreover, the legislative process behind these frameworks stems from a relatively democratic system in which many institutions and stakeholders can provide their input and opinions, thereby improving the final product. That said, while it's beneficial that the EU creates frameworks, it’s important to remember that these are Western products. This means it's easier for Western companies to comply with them and, more importantly, produce the metrics and targets that these frameworks favor to be viewed as "frontier" or "best in class." We should also remember that transition finance, for example, costs much money, and emerging markets often lack the resources to comply with these regulations. This is a massive topic and something we’ll need to dedicate an ESG Hot Topics post to in the future.

Now, is SFDR really broken? Or does it operate within a system that is already broken? Why does everyone criticize SFDR and not the broader system and environment it tries to regulate? This might be an unpopular opinion, but SFDR is a disclosure regime—it’s a mirror reflecting the real economy. Its primary demand is that financial market participants disclose the data points they are financing or investing in. Simply put, it requires transparency around the companies or projects they are affiliated with.

Let’s be direct: it's not SFDR that’s broken. The?financial system?and the inbuilt greed and lobbying mechanisms within the political and financial sectors?create dissatisfaction with SFDR. The complaints—"it’s too complex," "it’s too fragmented," "it’s not saving the world fast enough"—often reflect frustrations with the system itself. But has anyone stopped to ask why we aren’t taking steps to comply with it fully? Why aren’t private markets providing clear data points on asset-level holdings? Why aren’t AFIMs disclosing their ongoing SFDR compliance on their websites? Why don’t board directors address these issues in AGM meetings, where they are legally responsible for governance and SFDR compliance and thus potentially at risk for greenwashing accusations?

It’s never really been just about disclosure. If it were, we’d probably still be using GRI and continuing business as usual, right? SFDR and the EU Taxonomy are compliance tools—they target financial market participants and their products for a reason. We need a second layer of governance and accountability around SFDR and the EU Taxonomy to protect investors from greenwashing and enable them to channel their money into genuinely green companies and projects so that people, profit, and the planet can coexist.

The real problem is that investors are frustrated because the "ESG magic" they believed would automatically generate profits hasn’t materialized. However, ESG was never meant to be a magic formula for profit; it’s an analytical tool for understanding non-financial information. If investors want profits, they should invest in green transition projects, such as green infrastructure, cleantech, and decarbonization strategies.

SFDR is far from perfect, but it’s probably the best regulation the EU has developed in a long time. Yes, it’s complex and fragmented, but we need to start engaging with it—not from a marketing perspective, but from a regulatory adherence and transparency standpoint. This is the only way to enforce its purpose, maintain favorable ecosystems in sustainable finance, and provide the right kind of data and comparability for investors. Ultimately, we must bring the general public and retail investors on board, helping them understand the nuances and differences.

We all have brains; historically, underestimating people's capacity to use them has never been a good way forward.

Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting, we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??

Best regards,

Albin Axelsson

Founder & CEO of A Triple C Consulting

[email protected]

www.atriplecconsulting.com

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