The Complications and Future Trends of the European Union’s Sustainable Finance Disclosure Regulation (SFDR)

ESG Reporting / European Union

(Source: Permian)

In 2021, the European Union introduced its ground-breaking transparency framework for sustainability information, the Sustainable Finance Disclosure Regulation (SFDR). Three years later, the regulation is a subject of significant criticism whilst being an important precedent in battling greenwashing.

Integrating the European Commission's Action Plan on Sustainable Finance [1, 2], the SFDR classifies investment funds into three categories [3, 4]. Article 9 funds, also known as dark green funds, have sustainability as a primary goal - specifically, they aim to achieve non-financial goals that bring positive societal and environmental impacts. Article 8 funds, or light green funds, do not prioritise sustainability as their core objective but still hold it as a highly considered aspect during the investment processes. Finally, Article 6 funds are less strict, and require only the disclosure of the risks associated with each investment decision [5].

So far, the policy has been credited with significant positive progress. A 2023 report done by Goldman Sachs revealed that 231 funds ascended between classifications, resulting in 60% of all funds now being classified as either Article 8 or Article 9 [6]. The European Supervisory Authorities (ESA) annual report for 2024 highlighted notable improvements in the disclosure of Principal Adverse Impacts (PAI), both in terms of their quantity and quality [7, 8, 9].

Despite the initial success of the SFDR, the policy has faced growing backlash. For example, half of Article 8 funds have increased their investments in oil and gas, and only 4% of all funds are classified as Article 9 [10]. At the end of 2023, the European Commission conducted a Targeted Consultation that revealed significant challenges of the policy [11]. According to respondents, a major problem is the uncertainty surrounding the regulation’s requirements - 82% agreed that requirements were unclear, containing concepts that are poorly defined. This uncertainty is worsened by concerns that the document is not aligned with other financial regulations, such as in terms of definition. Moreover, 88% of respondents believe that there are major data gaps that obstruct disclosure, and 98% reported difficulties in obtaining high-quality data, in particular regarding PAI indicators. As a result, the SFDR creates a gray legal area in which, according to 84% of respondents, disclosures “are not sufficiently useful to investors”. The uncertainties increase the risk of greenwashing, particularly considering that 83% of respondents indicated that the framework is used more as a marketing tool than a regulatory measure [12].

According to 58% of respondents, these concerns make the effort of conforming to the policy disproportionate to the benefits generated [12]. Moreover, the limited availability of Article 9 funds has decreased their demand. Investors are increasingly interested in the processes rather than the classification, which undermines the purpose of the SFDR in itself [13].

This widespread dissatisfaction with the current framework indicates that a reform of the SFDR may be imminent. However, there is no consensus regarding the nature of the necessary changes.

In June 2024, the ESAs issued a joint statement recommending updates to the framework, including the introduction of a simpler product classification system with clear categories. They also suggested a more nuanced measure of sustainability that would incorporate social factors alongside environmental ones. Additionally, the ESAs called for a consistent revision of ambiguous terms across all financial regulations, emphasizing the importance of presenting information in a way that is accessible to different types of investors [14, 15].

The Consultation also revealed a variety of opinions regarding potential reforms of the SFDR. A majority of respondents supported the establishment of a voluntary categorisation system for financial products [16]. However, views diverged on how to structure these categories, with opinions split between reclassifying Articles 8 and 9 or introducing entirely new categories. [12, 13, 17].

Beyond the consultation, there is a growing call for greater transparency and an updated EU Taxonomy to include new green technologies. There is also support for introducing a proportionality factor when evaluating the sustainability of underlying investments in financial products. United for Impact, an association of funds, has proposed the creation of a social sustainability component as a counterpart to the EU Taxonomy [10, 18].

In conclusion, the SFDR is likely to undergo significant changes in the coming years, despite its seemingly positive impact so far. Regardless of the specific outcomes, the actions of the European Commission will likely influence the development of similar regulations worldwide, making this issue of utmost importance to the future of sustainable finance.

Research Analyst: Cecília Zamboti Pessoa Research Editor: Zuzanna Charkowska

References:

[1] “EU taxonomy for sustainable activities”. European Commission.

[2] “Sustainable Finance: Commission's Action Plan for a greener and cleaner economy”. European Commission. March 8, 2018.

[3] “Sustainability-related disclosure in the financial services sector”. European Commission.

[4] “SFDR: Find out all about the Sustainable Finance Disclosure Regulation”. Societe Generale. November 6, 2024.

[5] “The Sustainable Finance Disclosure Regulation Explained for Investors”. Morningstar Sustainalytics. April 2024. 3 min., 42 sec.

[6] Tylenda, Evan, et al.. “SFDR, two years on - Tends and Anatomy of Article 8&9 funds in 2023.” Goldman Sachs, September 4, 2023.

[7] Joint Committee of the European Supervisory Authorities (ESAs). “Principal Adverse Impact disclosures under the Sustainable Finance Disclosure Regulation”. October 30, 2024.

[8] Clipsham, Stephen, Naeem, Raza, & Hickman, Victoria. “EU: ESAs 2024 report show significant improvements of firms’ disclosure of principal adverse impacts under SFDR”. Linklaters, November 4, 2024.

[9] Nguyen, Anh. “European Regulators Report Major Gains in ESG Reporting under SFDR”. Seneca ESG. November 7, 2024.

[10] Thiede, Lena. “SFDR: A greentech VC rollercoaster – three years in and what’s next?” Planet A Ventures Medium, August 27, 2024.

[11] “Financial Markets: Commission consults on sustainable finance disclosures”. European Commission. September 14, 2023.

[12] “Summary Report of the Open and Targeted Consultations on the SFDR assessment”. European Commission. December 22, 2023.

[13] Avery, Charles. “SFDR: A groundbreaking regulation in need of reform”. New Private Markets, September 18, 2024.

[14] Joint Committee of the European Supervisory Authorities (ESAs). “Joint ESAs Opinion on the Regulation (EU) 2019/2088 on Sustainability-related Disclosures in the Financial Services Sector.” June 18, 2024.

[15] “ESG: The ESAs publish a joint Opinion on the future shape of the SFDR”. Simons + Simons, June 19, 2024.

[16] “EU SFDR review: Summary of Industry Views”. Travers Smith, May 10, 2024.

[17] Eccles, Robert. “Where Does The Sustainable Finance Disclosure Regulation Go From Here?”. Forbes, May 15, 2024.

[18] United for Impact. “The EU needs to make impact investing a priority to achieve the fair transition”. Both, June 3, 2024.