The European Commission’s (“Commission”) has published a proposal to amend the Sustainable Finance Disclosure Regulation (“SFDR”) including the introduction of new product categorisation regime to replace the disclosures-based framework introduced under the SFDR in March 2021. The review has been shaped by the EU’s overarching simplification agenda and the underlying intention is to simplify the requirements while ensuring the investors can access comprehensible information on the sustainability of their investments.
Background to the Review
The Commission initiated a review of the SFDR in late 2022, with a consultation running from September to December 2023. The Commission has found that, while the objectives of the SFDR remain broadly supported, several aspects of the rules are considered complex and difficult to implement. There have been issues related to the misalignment between the concepts and definitions in the SFDR and other EU sustainable finance legislation, such as the Taxonomy Regulation, while financial market participants (“FMPs”) have faced challenges accessing reliable and comprehensive ESG data. The objective of investor protection has not been sufficiently met, compounded by the misuse of Articles 8 and 9 SFDR as quasi-labels, which was not the original intention. The Commission’s overarching simplification agenda also calls for simpler rules, lower administrative burden and better enforcement while continuing to pursue the goals set out in the European Green Deal.
The Proposals
There are two key elements to the Commission’s proposals: (1) simplify and reduce the sustainability-related administrative and disclosure requirements of the framework for FMPs and to enhance the coherence of the framework; and (2) improve investors’ ability to understand and compare sustainability-linked financial products. The Commission’s amendments therefore aim to considerably simplify reporting requirements and to introduce a three-way categorisation of financial products with ESG features.
The amendments include:
- the deletion of disclosures regarding principal adverse impacts (“PAIs”) at entity level to avoid a duplication of requirements imposed under the Corporate Sustainability Reporting Directive (“CSRD”);
- significant reduction in product-level disclosures; and
- setting up three categories for “sustainable”, “transition” and “other ESG” products.
The Definition of “Sustainable Investment”
The definition of “sustainable investment” set out in Article 2(17) has caused significant implementation challenges. The Commission notes that this has led to wide divergence in practical application. The Commission has proposed the deletion of this definition from the SFDR, with the underlying concepts instead being set out in a simplified form in specific investment requirements for the three product categories. The concepts of “contribution to an environmental or social objective”, of “do no significant harm” (“DNSH”) and of “good governance practices” should therefore continue to be reflected in the requirements under each category. The current requirement to consider PAI indicators on sustainability factors when assessing DNSH will be replaced by a requirement for FMPs to apply a common set of clear exclusions covering practices and sectors that are commonly agreed to be most harmful.
New Product Categories
Article
Article 9
Category Title
Sustainable
Sustainability objective
Investments
- 70% of investments meet clear and measurable objective related to sustainability factors, including environmental and social objectives, in accordance with the binding elements of the investment strategy of the financial product, measured using appropriate sustainability-related indicators
- Permitted investments are detailed in Article 9(2)
- Funds replicated or managed in reference to a Paris-aligned Benchmark (“PAB”) or Climate Transition Benchmark (“CTB”) will be considered to comply with the requirements for Article 9 funds.
- Funds that have ≥ 15% investments in Taxonomy-aligned economic activities will be considered to comply with the Article 9 requirements.
Exclusions
PAB Exclusions:
a. controversial weapons
b. cultivation and production of tobacco
c. violation of UNGC principles or OECD guidelines
d. ≥ 1% revenue from hard coal / lignite
e. ≥ 10% revenue from oil fuels
f. ≥ 50% revenue from gaseous fuels
g. ≥ 50% revenue from electricity generation with a GHG intensity > 100g CO2e/kWh
Additional Exclusions:
h. investments in companies that develop new projects for the exploration, extraction, distribution or refining of hard coal and lignite, oil fuels or gaseous fuels; or
i. investments in companies that develop new projects for, or do not have a plan to phase-out from, the exploration, mining extraction, distribution, refining or exploitation of hard coal or lignite for power generation.
(Certain investments in use of proceeds instruments issued by companies under the EU Green Bonds Regulation are carved out of these exclusions.)
Article 7
Transition
- 70% of investments must meet a clear and measurable transition objective relating to sustainability factors, including environmental or social transition objectives in accordance with the binding elements of the investment strategy of the financial product, measured using appropriate sustainability-related indicator(s)
- Permitted investments are detailed in Article 7(2)
- Funds replicating or managed in reference to a PAB or CTB will be considered to comply with the requirements for Article 7 Transition funds.
- Funds with over 15% of investments in Taxonomy-aligned economic activities will be considered to comply with the requirements for Article 7 Transition funds.
Limited PAB Exclusions ie, (a) to (d) above, plus the Additional Exclusions at (h) to (i) above
(Certain investments in use of proceeds instruments issued by companies under the EU Green Bonds Regulation are carved out of these exclusions.)
Article 8
ESG Basics
Sustainability factors integration
- 70% of investments integrate the sustainability factors in accordance with the binding elements of the investment strategy of the financial product, measured using appropriate sustainability-related indicator(s)
- Permitted investments are detailed in Article 8(2)
Limited PAB Exclusions ie, (a) to (d) above
(Certain investments in use of proceeds instruments issued by companies under the EU Green Bonds Regulation are carved out of these exclusions.)
Impact Funds
Specific disclosures should apply to financial products engaged in impact investing and the use of the term “impact” in the names of financial products should be restricted accordingly. A “sustainability-related financial product with impact” will be defined as an Article 7 or 9 product that has as its objective the generation of a pre-defined, positive and measurable social or environmental impact and with investments directed towards undertakings, economic activities or other assets which provide solutions to address specific social or environmental challenges.
Uncategorised Products
Uncategorised products are addressed in Article 6a of the proposed regulation. Such products cannot be marketed as ESG products.
Disclosure of Taxonomy Alignment
Where an Article 7 or Article 9 fund pursues an environmental objective, it must state whether and to what extent it invests in Taxonomy-aligned economic activities.
PAI Disclosures
Article 7 and Article 9 products must identify and disclose PAIs of their investments on sustainability factors, and explain any action taken to address those impacts. FMPs may choose to comply in full or in part with this disclosure requirement by using appropriate sustainability-related indicators.
Use of Data and Estimates
Proportionate steps should be introduced requiring FMPs to document their use of data sources and their use of external and in-house estimates. FMPs will also be required to provide their clients with information on such use upon request.
Naming Rules and Marketing Communications
The Commission notes that FMPs may refer to information on sustainability aspects of an ancillary nature in the regulatory disclosures related to financial products other than those categorised as sustainability-related financial products. However, to ensure investor protection and to clearly distinguish between categorised and non-categorised products, such information should not constitute a prominent element in disclosures and should not feature in the name or marketing communications of such financial products. Where products are categorised as sustainability-related, FMPs must ensure that claims in regulatory and marketing documentation and the names of products are consistent with the category under which they fall and with their strategies.
Sovereign Issuances
The Commission has concluded that investments in sovereign, sub-sovereign or supranational debt issuances should generally be excluded from counting towards contribution to sustainability or transition-related objectives, as there are currently no comprehensive metrics for gauging the sustainability of such debt issuances.
This will not prevent FMPs from including such debt issuances in the numerator of the proportion of investments that needs to be reached by products that come within the three categories, where the products integrate one or more way of considering sustainability factors as part of the strategy and design of the financial product, using available methodologies that are appropriate to assess the sustainability of those public investments for that purpose.
Where the use of proceeds is known, where the instruments support specific sustainability aims and provided the instruments do not directly or indirectly fund activities that are excluded from investment by sustainability-related financial products, the public instruments should be included in the numerator of all categorised financial products.
Goldplating
The proposed amending regulation provides that member states should not impose additional requirements as regards the criteria, procedures and disclosures concerning the categorisation of sustainability-related financial products.
Exemptions / Opt-Outs
FMPs may chose not to apply the regulation to closed-ended funds that were created and distributed before the date of application of the amended regulation.
Comment
The simplification of the SFDR framework to ensure that investors have relevant information to assist them in selecting products that meet their sustainability preferences is welcome. The true extent of the reduction in product disclosure requirements will not become apparent until Level 2 measures introducing new disclosure templates are adopted under the amended regulation, but the intention to reduce the sustainability indicators to facilitate comparability and the removal of Taxonomy-alignment disclosure requirements and disclosures of PAIs are positive developments. The Commission’s proposal will now have to go through the EU legislative process, where the Council of the EU and the European Parliament will have the opportunity to propose and negotiate amendments. The legislative process is likely to take 18 to 24 months, and the draft regulation is stated to apply 18 months after is entry into force. Based on that timeline, any agreed changes could come into effect between November 2028 and May 2029.
Please get in touch with your usual Asset Management and Investment Funds Department contact or any of the contacts listed in this publication should you require further information in relation to the material referred to in this update here.