EU Commission’s proposal for revised Sustainable Finance Disclosure Regulation

SFDR has required financial advisors such as investment and insurance advisors as well as portfolio managers to comply with the SFDR rules. SFDR 2.0 would remove them from the scope, and thereby direct SFDR more clearly on the financial market participants who manufacture, manage or distribute financial products to investors. The scope reduction is justified by the fact that financial advice and portfolio management services are already covered by MiFID II that requires investment advisors and portfolio managers to consider their clients sustainability preferences. Changes in sustainability preferences are not proposed in connection to SFDR 2.0, but it should be expected that MIFID II rules would be amended to align with the SFDR 2.0 product categorization.

The current SFDR article 4 has required large financial market participants to publish a principal adverse impact (PAI) statement while smaller entities have had the chance to apply comply or explain principle. Commission proposes cutting off PAI statements on entity level entirely. The Commission has justified the deletion of PAI disclosures by the fact that entity level reporting is covered already by Corporate Sustainability Reporting Directive (CSRD) and SFDR should therefore focus more clearly on sustainability-related financial products to avoid duplication. 

The changes would also remove SFDR article 5 that requires entities in scope to disclose on their website how their sustainability risk integration is consistent with their remuneration policies. The removal of remuneration disclosures has been justified by de-prioritization. The current obligation to publish such information may have served as an incentive to consider sustainability risks more thoroughly in internal documentation, but the informational value of disclosures on remuneration itself has remained limited.

Should the proposed changes be accepted, the only entity level disclosure would be article 3 that requires companies to publish a disclosure on how sustainability risks are considered in their investment decision-making.

Arguably the new and formal categorization of financial products based on their sustainability agenda is the biggest and most awaited change proposed by the EU commission.

At the current article 8 products promoting environmental and/or social factors and applying good corporate governance practices have consisted of a myriad of different types of strategies from negative screening, best in class to impact investment with high percentage of sustainable investment. Article 9 products have consisted solely in sustainable investments either abiding SFDR art. 2(17) definition, EU taxonomy aligned investments or a combination of these. It has been particularly challenging for the market to apply SFDR’s definition of sustainable investment and do no significant harm (“DNSH”) principle without binding thresholds which has led to inconsistent practices in the market.

Proposal for SFDR 2.0 removes SFDR art 2(17) sustainable investment definition as well as the DNSH definition Art 2a. Article 8 and 9 products would be replaced by (Art 7) Transition, (Art 8) ESG Basics, and (Art 9) Sustainable objective. In addition, new definition of ‘sustainability-related financial product with impact’ with additional disclosures has been introduced.

All categorized products would have minimum percentage of investments that would have to abide by the selected sustainability criteria, mandatory exclusions, and disclosures.

• Article 7 ‘transition’ category aims to capture funds that invest in improving the environmental or social performance of investees or economic activities. Transition objective could be set on Fund level, for example reducing portfolio emissions over time aligned with the EU Paris aligned benchmark or EU Climate transition benchmark or investee level through investments in companies or activities that have a credible transition plan, science-based targets or EU taxonomy aligned Capex plans.
• Article 8 ‘ESG Basics’ category consists of products that claim to integrate sustainability considerations beyond sustainability risks in their investment strategy. The approach to integration could be so called “best-in-class” or positive screening by selecting investments that outperform of the investment universe or a reference benchmark measured by an ESG rating, other investments that have a proven positive track record on certain sustainability factors. The portfolio could also consist of a combination of investments described in Art 7 and Art 9.
• Article 9 ‘Sustainable objective’ category includes investments that have a high ambition on investing in already sustainable investees or activities as current article 9 funds. Investments in the category 9 could be done for example for investees following EU Paris aligned benchmarks, EU Taxonomy aligned activities or EU green bonds.

All of the Fund categories would have to meet a minimum threshold of at least 70% of the investments aligning with the selected sustainability objective. However, article 7 and 9 funds may meet the 70% threshold by having 15% of EU Taxonomy aligned investments. Each category of Funds has also mandatory set of exclusions aligned with the delegated regulation on EU Paris aligned benchmarks and climate benchmarks. The exclusion criteria is meant to replace the current DNSH evaluation and the criteria varies between the Fund categories. Article 9 Funds have the strictest exclusion criteria whereas ESG Basics has the smallest number of mandatory exclusions.

The exclusions for ESG Basics cover only activities related to controversial weapons, the cultivation and production of tobacco, violations of the UN Global Compact principles or OECD Guidelines for Multinational Enterprises, and companies that derive 1% or more of their revenues from hard coal and lignite. Transition and Sustainable should in addition to the exclusions in ESG Basics also exclude companies that develop new projects linked to oil or gaseous fuels, and companies that develop new projects, or do not have a plan to phase-out from, hard coal or lignite for power generation. As a third layer, the sustainable category funds should exclude activities linked to oil fuels, gaseous fuels, electricity generation with a GHG intensity of more than 100 g CO2 e/kWh if the activities reach a certain revenue threshold.  

The proposal also introduces a new definition of ‘sustainability-related financial product with impact’ to cater impact investors. The ‘impact’ products could be either article 7 or 9 products or combination of those and they would have as their additional 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.  

Fund of funds and other multi-option layered products have been separately addressed as well. Should the mixed products reach the 70% threshold for their investments and comply with the exclusions, the products should be categorized being 7,8 or 9 respectively. However, even if these products would not fill the qualifications of a category, they should nevertheless disclose information about their investments in categorized products. In their disclosures, multi-layered products would be able to rely on the information provided by pre-contractual disclosures of the underlying Article 7,8 and 9 products. The categorization is of importance as the right to use ESG related terms is naming the financial products depends on the categorization of the financial product. However, the non-categorized mixed products that invest in a proportion of categorized products should be able to reference sustainability-related claims in their marketing communications including their share of categorized products.

SFDR 2.0 puts forth clearer rules on sustainability and ESG related terms in product naming and marketing building upon ESMA guidelines on fund names. According to the SFDR 2.0, only products categorized as Art 7, 8 or 9 would be able to use the sustainability related terms in their name and present ESG related claims in their marketing materials. 

However, non-categorised financial products are not entirely prevented from referring to information on sustainability aspects in their pre-contractual and periodic disclosures provided that they meet conditions specified in the new regulation (art. 6a) including that such information should not constitute a central element of pre-contractual documentation and the information does not constitute a claim. As a clarification, ESG is not seen as central element if it is limited to less than 10% of the volume occupied by the presentation of the financial product’s investment strategy. It remains to be seen how useful the exemption is as the risk of ESG information constituting a claim in marketing material is relatively high.

As the SFDR 2.0 revamps the sustainability disclosures entirely, the EU Commission will also prepare new delegated regulations on how the sustainability information is presented in precontractual and periodic disclosures of the categorized products. Separate website disclosures would no longer be prepared but instead the website should have links to precontractual and periodic documents. 

Proposal includes changes to PRIIPS regulation. Key information document (KID) of a packaged retail and insurance-based investment product (PRIIP) that is a sustainability-related financial product should provide information on its SFDR category.  

As a next step, the Commission’s proposal will be submitted to Parliament and Council for further negotiations.

According to the proposal, the SFDR 2.0, the SFDR 2.0 will become applicable 18 months after it has entered into force.

Proposal also allows closed-ended funds created and distributed before SFDR 2.0 to opt out from the new regulation with certain conditions.