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On 18 June 2024, the European Supervisory Authorities (EBA, ESMA and EIOPA) (ESAs) published a Joint Opinion on the assessment of the Sustainable Finance Disclosure Regulation (SFDR).
The ESA’s opinion includes several recommendations for the European Commission to consider in the context of its ongoing review of the SFDR framework, of which you can read more about here.
The ESAs acknowledge that the current framework could be improved, and as shown by consumer testing, SFDR investor disclosures may be complex by nature and difficult to understand, particularly for retail investors. The ESAs also acknowledge that in practice ‘Article 8’ and ‘Article 9’ products have been used since the outset in marketing materials as quality labels for sustainability, thereby creating greenwashing and mis-selling risks.
The opinion mainly focuses on the merits of the potential introduction of a categorisation system and/or indicator of sustainability for financial products. This is aimed to eliminate the risk of misuse of the SFDR, by allowing for simplified disclosures.
Other topics covered include the review of the definition of ‘sustainable investment’ and the interaction with a categorisation system, the simplification of relevant documentation and improvements to the transparency of adverse sustainability impacts at financial product level. To ensure a successful outcome, the ESAs encourage the Commission to undertake consumer testing prior to changing the regulatory framework.
Summary of the ESAs recommendations
1. Product classification
The ESAs are in favour of the introduction of regulatory product categories that would help address the greenwashing problems arising from the misuse of the disclosures under Article 8 and Article 9 of the SFDR and provide clarity for investors, in particular, retail investors.
The ESAs suggest the following new categories which would replace the current practice of categorisation in Article 8 and 9 of the SFDR i.e. products would no longer differentiate between those promoting environmental/social characteristics and those with sustainable investment as their objective.
Sustainable product category
This category would be for products that invest in economic activities/assets that are already environmentally and/or socially sustainable.
As social topics are less developed, and in the absence of a social taxonomy, the ESAs suggest that ‘sustainable products’ could be merged into a single category or split into two categories (environmental or social).
The ESAs also recommend that sustainable products should comply with a minimum “sustainability threshold”. For environmentally sustainable products, the threshold should be based on investments in taxonomy-aligned economic activities. The threshold could evolve over time as taxonomy-aligned activities grow in coming years. The part of the investment that is not taxonomy-aligned should at least respect the DNSH principle for environmental and social objectives and good governance requirements, provided these concepts are more precisely defined.
Transition product category
This category would be for products that invest in economic activities/assets that are not yet sustainable, but which improve their sustainability over time to become environmentally or socially sustainable.
The ESAs suggest that the investment strategies of these products could build on a mix of EU Taxonomy key performance indicators (KPI’s) to reflect the progressive improvement of environmental performance, transition plans disclosed by underlying assets and their analysis, product decarbonisation trajectories and mitigation of principal adverse impact indicators (PAIs) at product level. This is provided that specific and relevant indicators are designed and that a minimum level of mitigation is set out in the regulation. The ESAs further suggest that this category could consider appropriate exclusions and criteria for a credible transition plan.
The ESAs recommend that the Commission consider the potential benefits and drawbacks of requiring that a share of the product’s investment initially complies with the requirements of the transition product category, and that such share can subsequently be increased over time.
The transparency obligations should provide investors with clarity on the level of ambition and performance in the short and long term (including quantitative targets and intermediate milestones) and how the investment strategy delivers on the ambition. It would not be necessary to apply the DNSH principle to all investments to support investments to activities that are currently harmful, but which are in a transitioning trajectory, or in activities that are permanently harmful, but which are in the process of being decommissioned. The ESAs suggest that this could be demonstrated by measurable transition plans by companies engaged in such harmful activities.
Finally, the ESAs suggest a sub-category under the transition category for “investor’s impact”, designed for products that invest in economic activities/assets that aim to offer solutions to sustainability-related problems together with a financial return. Alternatively, this could be a cross-cutting indicator for all categories based on the “impact potential” scoring. The ESAs note that any “impact” sub-category would need to be sufficiently clear for retail investors to understand.
2. Disclosures and marketing for products inside and outside the categories
The ESAs propose that the sustainability disclosures for products that would fall under the new categories could be adjusted to focus on the theme of the category and have naming and marketing consistent with the category.
Financial products that would not qualify for any category could be divided into:
i). products with sustainability features - should be required to disclose their sustainability features in regulatory documentation and should be subject to restrictions on using ESG or sustainability-related terms in naming and marketing
ii). products with no sustainability features - should be required to include a disclaimer and should not be allowed to use ESG or sustainability related terms in marketing. The disclaimer could be supplemented by minimal disclosures on the product’s adverse impact on sustainability
3. Sustainability indicator
The ESAs note that consumer testing and feedback from consumer associations indicates that consumers struggle to understand the different sustainability objectives of financial products and the distinction between different objectives when reading the current SFDR disclosures.
Subject to prior consumer testing, the ESAs propose the introduction of a sustainability indicator for all financial products covering environmental sustainability, social sustainability, or both. The sustainability indicator would illustrate to investors the sustainability features of a product in a scale, thereby simplifying complex sustainable information.
The ESAs present various options for the development of a sustainability indicator and emphasise that the system should rely on clear and objective criteria, so the scope of each category of the indicator is clearly defined. These criteria could, among others, relate to the EU taxonomy, decarbonisation targets or indicators such as fossil fuel exposures or GHG intensity.
The ESAs further propose that a grading scale could refer to letters (such as the nutri-score for food products) or colours, for example, the most harmful products may be identified by a red colour.
In considering the options for a sustainability indicator, the ESAs suggest that the Commission test:
i). product categories with no additional sustainability indicators
ii). a mandatory single sustainability indicator applying to all products
iii). a combination of product categories and a sustainability indicator (either separately within each product category or outside of the product categories)
4. Sustainable investment definition
While providing flexibility to financial market participants, the principle based key parameters of the definition of ‘sustainable investment’ under Article 2(17) of the SFDR have led to differences in application. To address this, the ESAs suggest that the Commission should consider making the key parameters of ‘sustainable investment’ prescriptive. Also, depending on how criteria for a categorisation system and/or sustainability indicator(s) are developed, and/or there is a full taxonomy covering social sustainability, the ESAs note that the Commission could revisit the need for a sustainable investment definition at all.
The ESAs refer to consumer testing showing that consumers find the distinction between the concepts of ‘taxonomy-aligned’ and ‘sustainable investments’ challenging. ‘Sustainable investments’ are perceived as more sustainable than taxonomy-aligned investments.
At a minimum, the ESAs recommend that the relationship between sustainable investments and investments in taxonomy-aligned activities should be clarified in the current legal framework. In the interim, since there is currently no social taxonomy, the ESAs recommend that the current definition of ‘sustainable investments’ could be amended to rely on the EU Taxonomy for disclosures on environmental sustainability. For other economic activities (such as non-eligible economic activities and social sustainability) the Commission could use sustainability metrics (e.g. related to the current PAI indicators and requirements of DNSH and good governance).
5. Product disclosure documents
The ESAs recommend that consideration is given to the audience for pre-contractual disclosures. The Commission should distinguish between the need for very simple disclosures of information that is key to retail investors (such as the level of greenness disclosed in a simple and understandable manner in a sustainability indicator) and more comprehensive technical information for sophisticated investors.
The ESAs also recommend that the format of disclosures is adapted to the increased digital consumption of information allowing investors to read or process information electronically through layering.
6. Scope
The ESAs suggest that the Commission should reflect on introducing appropriate disclosures for products currently out of scope of the SFDR. This could include e.g. structured products issued under a Euro Medium-Term Note (EMTN) programme and certain categories of insurance-based investment options offered in multi-option products (MOPs) that are not currently addressed in SFDR disclosures.
The ESAs note that the absence of sustainability disclosures comparable to SFDR disclosures for structured products leaves room for greenwashing as the assessment of their sustainability features is currently made at the sole discretion of manufacturers.
7. Transparency of adverse sustainability indicators
The ESAs believe that while “consideration” of PAIs (Article 4 and 7 of the SFDR) is intended to capture disclosure and mitigation of the PAIs of investment decisions on sustainability factors, there is also merit in considering “information” on PAIs. They suggest that “information” on PAIs could exclude a requirement to mitigate them, but still provide useful information so that investors have a better idea about the negative consequences of potential investments.
The ESAs suggest that the Commission consider making “consideration” of PAIs on investment decisions on sustainability factors, based on the indicators in Annex I of the SFDR delegated regulation, mandatory for products qualifying for the new sustainability product category. By contrast “information” on all PAIs could be mandatory for the transition category, and some minimal disclosures such as “information” about select key PAIs, mandatory for all products.
The ESAs also call for clarifications relating to the obligations under Article 7 of the SFDR for product level disclosures. For entity-level disclosures, the ESAs consider ways to address the overlap of information disclosed under the Corporate Sustainability Reporting Directive (CSRD).
8. Other technical issues
In addition to the core elements of the Opinion, the ESAs highlight several other technical challenges that could be addressed by the Commission in the potential review. These include, among others, the role of auditors and funds’ depositories, reducing the frequency of the reporting of the annual assessment of PAI disclosures and harmonisation of website disclosures.
9. Commentary
The ESAs have issued the Opinion at their own initiative in the context of the Commission’s comprehensive review of the SFDR framework. The ESAs recommendations are therefore not binding on the Commission. The Opinion does however provide a helpful indication that the ESAs support significant change to the framework and on what they think a ‘coherent sustainable finance framework’ could look like in future.
The timing of the Commission’s regulatory proposals is uncertain, fund managers and other financial market participants should keep track of the evolving proposals, which could involve significant change to the level 1 text of the SFDR and delegated regulation.
For more information on this topic, please contact any member of A&L Goodbody’s Asset Management and Investment Funds team.
Date published: 1 July 2024
