EU Sustainable Finance Disclosure Regulation overhauled in new review

New product categories including a transition category and the deletion of Principal Adverse Impacts (PAIs) mark significant changes for the SFDR, with the wider implication of Omnibus proposals still to come.

Published on 20 November, the long-awaited review of the EU Sustainable Finance Disclosure Regulation (SFDR) constitutes a major reset. First launched in 2021, the regulation has had a significant impact on the EU sustainable investment landscape, though investors have wrestled with implementation challenges.

This has included misalignment of key concepts and definitions, notably around the definition of ‘sustainable investment’, and the de facto use of the disclosure requirements as a labelling regime.

The review includes several recommendations put forward by IIGCC and the wider market, including the introduction of sustainable fund categories and a dedicated transition category. These address previous challenges that hindered appetite for investment in transitioning assets.

The benefits of deleting several entity- and product-level disclosures are likely to be more contested. Implemented in the context of a wider EU simplification agenda, the criteria underpinning funds’ does leave room for flexibility, but potentially at the expense of a consistent approach.

New sustainable product categories

The headline change is the introduction of three dedicated sustainable product categories, replacing the former Article 6, 8 and 9 structure. The first focuses on ‘ESG basics’ products (now Article 8), ‘transition’ products (Article 7) and ‘sustainable’ products (Article 9).

At least 70% of the assets in each category must be invested in line with the sustainable investment strategy and exclude the ‘most harmful’ assets and activities, in line with existing exclusions under the Low Carbon Benchmark Regulation.

Helpfully, the review also incorporates explicit exclusions of companies that are expanding fossil fuel activities, as well as companies that do not have a plan to phase these activities out, for ‘transition’ and ‘sustainable’ products.

The inclusion of a dedicated transition fund should help to legitimise and clarify approaches to transition finance in the EU. Alongside investment in Taxonomy-aligned activities, new criteria that could underpin transition-labelled funds include a credible transition plan, or a target and investments accompanied by a credible sustainability-related engagement strategy.

Additionally, we welcome the specific requirements for funds with a climate transition focus to ensure both their engagement strategy and the transition plans and targets of investees are aligned with the Paris Agreement.

These new product categories could be strengthened further

The criteria proposed across the three categories are sensible and, by operating on a voluntary basis, provide investors with a degree of flexibility around how they want to approach their sustainable investment strategies.

However, a streamlined list of mandatory criteria for assessing assets could have helped to promote greater comparability between funds and coalescence around a key set of decision-useful indicators. For example, assets with transition plans and science-based targets that align with disclosures required under the European Sustainability Reporting Standards (ESRS-E1). Given the close alignment between disclosure indicators in ESRS-E1 and the Climate Action 100+ Net Zero Company Benchmark, this would be particularly helpful in supporting investor assessments of the alignment of assets with credible net zero pathways.  

Additionally, the review sets out that the transition category should capture funds with portfolio-level targets seeking to reduce financed emissions over time. We have long called for focus on financing reduced emissions, rather than reducing financed emissions. This reframing would better support real-world decarbonisation, including by holding high-emitting assets on a credible alignment trajectory. A complementary focus on asset-level alignment is preferable in this context.

All categories would also have benefitted from explicit stewardship requirements. While references to engagement strategies under the current proposals are robust, they are limited to the transition category. This is a potential oversight given the importance of engagement to investors as a primary lever to influence sustainability performance.

The review confirms that Article 7 transition products can invest in a combination of transitioning assets and climate solutions. In this context the Net Zero Investment Framework could provide a sound, investor-backed basis for the development of these products.

Principle Adverse Impacts deleted

Another major change is the deletion of PAIs, which previously required investors to produce a statement setting out the principle adverse impacts of their investments at entity- and fund-level. While ‘transition’ and ‘sustainable’ funds will still require investors to identify and disclose adverse impacts at fund-level, and actions taken to address these impacts, there is no longer a specific list of mandatory indicators that investors can refer to. And notably, entity-level reporting has been removed altogether.

Some investors will welcome this deletion. Information at the aggregate entity-level was considered of little use, while others argued that the requirements risked duplicating entity-level disclosures required by the Corporate Sustainability Reporting Directive. That said, the complete removal of PAIs is not without risks.

Following the decision to suspend work on sector-specific ESRS, the SFDR is now the only regulatory vehicle for tailored, entity-level disclosures for investors. As it stands, only the largest financial market participants in scope of the revised CSRD will need to produce entity-level disclosures, meaning the bulk of investors captured by SFDR will be scoped out.

Preserving some entity-level disclosures (e.g. stewardship and due diligence policies), remains important for understanding what actions are being taken at the firmwide level to manage sustainability-related risks and capture opportunities.

A streamlined list of fund-level PAI disclosures, such as for greenhouse gas emissions and disclosure on investor actions to mitigate these impacts, would have provided a useful basis for assessing improvements in a fund’s sustainability over time.

Wider Omnibus cutbacks expected

While SFDR was not in the scope of the Commission’s Omnibus simplification proposals there has clearly been a ripple effect. Investors and other financial market participants will rely heavily on the data provided by investees in scope of the relevant rules to meet their SFDR obligations.

This review notes that disclosures should focus on data that is ‘broadly available, comparable and credible’. However, as a result of the Omnibus proposals, fewer companies will be disclosing transition plans in line with ESRS or reporting on the Taxonomy alignment of their activities, following significant reductions to the scope of CSRD. The full impact of wider cutbacks to the wider Sustainable Finance framework remains to be seen.

Unchanged is the vital importance of access to decision-useful data and reporting indicators for investors. This is essential for the development of sustainability-focused funds and ultimately the redirection of capital in line with the EU’s climate and competitiveness objectives.

Without access to this data on a widespread basis, investor reliance on estimates and ad-hoc requests will increase: a development at odds with EU focus on cutting costs and complexity.

Simplification should not come at the cost of ambition

In this review the Commission has responded to the market call for dedicated fund categories and explicit recognition of transition-focused investment strategies, a welcome development.

That said, we reiterate our stance that the wider focus on simplification should not come at the expense of ambition. Removing a range of important disclosures at entity- and fund-level could increase complexity rather than reduce it. Without the right data from underlying holdings, investors will continue to face challenges in developing strategies and funds that can deliver on sustainability goals.

The Commission proposal will now be submitted to Parliament and Council for review. We will continue to engage with EU policymakers on the future of SFDR, making the case for a regime that meets the needs of the market while ensuring access to vital information. These new product categories must be underpinned by credible criteria that support the delivery of real-world outcomes.

IIGCC members: contact Leo to share your perspective and contribute to advocacy and engagement on this latest development. If you’re not a member and would like to find out more, get in touch with us today.