ESG: European Parliament study recommends changes to the SFDR

On 3 July 2024, the European Parliament (EP) published a study, "The current Implementation of the Sustainability-related Financial Disclosures Regulation (SFDR)" (the Study).

The Study was commissioned by the EP's ECON committee, and looks into how well the SFDR is working, particularly for retail investors. Although it does not set out the EP's formal thinking, it is, perhaps, a useful contribution to the general debate over how (and how far) the SFDR should be amended.

What's the background to the Study?

The SFDR came into effect on 10 March 2021, complemented at Level 2 by Commission Delegated Regulation (EU) 2022/1288 (as amended) from January 2023.

The SFDR lays down harmonised transparency rules for financial market participants (FMPs) and Financial Advisors (FAs) in respect of

• integration of sustainability risks;

• consideration of adverse sustainability impacts in their investment decision making and advisory processes; and

• disclosure of sustainable investment objectives or the promotion of environmental or social characteristics with respect to their financial products.

Shortly after its introduction, the Commission (and others) noted that the SFDR was not working as intended. A comprehensive assessment of SFDR was launched and includes a public consultation and a targeted consultation, both published in September 2023.

As a result of this process, the Commission is expected to adopt a legislative proposal to amend the SFDR in H2 2024.

For our summary of the 'Top 10 Talking Points' from the Commission's September 2023 consultation see here.

For other client notes on the SFDR, see here.

What does the Study say?

The aim of the Study was to "inform the policy debate on sustainability disclosures under the SFDR and provide a legal assessment on possible changes to be brought to relevant legislation in order to improve the framework".

Among its recommendations for change are:

• more recognisable product labels or categories;

• better interaction between SFDR and other disclosure rules;

• expanding the scope of Principle Adverse Impacts (PAI); and

• more supportive information infrastructure.

The key messages the Study makes are as follows:

(a) Disclosures made under the SFDR are not hugely useful

The Study finds that, at present, investors - especially retail investors - have "little use for most of the information generated under the SFDR". Its disclosures are complex and based on concepts that are unfamiliar and unintuitive for investors, such as PAIs, sustainability risks, "taxonomy aligned", "sustainable characteristics", or "sustainable objectives".

The Study considers that investors would not be able to differentiate Article 8 funds from Article 9 funds and even, perhaps, Article 8 and Article 9 products.

The Study also regards the SFDR as being a "catering" text, which accommodates fixed investor preferences. It may, in time, evolve into a more "transformational" text, looking to nudge the market towards sustainability. Or it could try to be both, with some provisions ensuring that investors receive clear information about products and their characteristics, while others facilitating engagement by stakeholders.

In any event, the Study concludes, any reform "should prioritise clarity and usability of information by investors and other relevant actors".

(b) Proposed new product categories

The Study notes that instead of being used as a disclosure regime, as was the original aim, the SFDR is, in practice, being used instead as a labelling scheme for "dark green" and "light green" products.

The lack of a binding threshold to substantiate claims of "greenness" makes it hard for investors to assess the veracity of green claims, in turn, increasing the risk of "greenwashing" and mis-selling as well as the possibly more widespread "green bleaching" (where FMPs choose not to claim ESG features for their products to avoid extra costs and legal risks).

Although the Study accepts that product categories or "labels" are useful "light green - Article 8" and "dark green - Article 9" are too complex and unintuitive for investors for them to be used as categories.

The Study recommends that new categories should be established to include "impact" products and "transition" products. A "sustainable" category is also felt to be promising but would need to be more precise.

All categories, though, should be based on consumer testing to ensure that the categories work as intended, with more emphasis on market analysis, to ensure that the categories encompass a sufficiently large part of the market.

(c) Interaction with other sustainability regulations

The Study also notes that the SFDR has had what it terms a "fraught relationship" with other sustainability regulations, with problems with the Taxonomy Regulation (including with the very concept of a "sustainable investment"), exclusions under the Benchmarks Regulation and reporting under the Corporate Sustainability Reporting Directive.

The Study proposes that the overall framework should be streamlined so SFDR disclosures work seamlessly with other disclosure rules, while the revised SFDR should also include a mandatory disclosure regime of "adverse impact" and cover more products.

More widespread reporting of PAIs is needed, but should be calibrated between sustainable or impact products, transition products, and general products with no sustainability features.

To ensure these improvements take hold, the Study argues that an adequate information infrastructure, methodologies and technological tools need to be developed.