From Disclosures to Classification Regime and Sustainability Due Diligence. Tackling the Flaws of the Sustainable Finance Disclosure Regulation

Sustainability disclosures for financial products, as prescribed under the Sustainable Finance Disclosure Regulation (SFDR), are a key aspect of the European Union (EU) Sustainable Finance Action Plan (SFAP). With the ‘level 2’ obligations having entered into force on the 1st of January 2023, the SFDR has established extensive disclosure requirements at the entity level and at the product level. At the entity level, financial market participants must explain through a Principal Adverse Impact (PAI) Statement how they consider the principal adverse impact on sustainability factors of their investment decisions in relation to a number of ESG key performance indicators (KPIs); financial market participants must additionally explain whether, and if so how, principal adverse impacts are considered in each product they manufacture.

In relation to product-level disclosures, the SFDR requires outlining how sustainability risks are managed (Art 6), and provides for specific disclosure requirements for products promoting environmental or social characteristics (so-called ‘Art 8 products’—which can include a very broad variety of ESG-related investment strategies of different stringency) and products having sustainable investment as their objective (so-called ‘Art 9 products’). A sustainable investment, as defined in Art 2(17) SFDR, is an investment in an economic activity that contributes to a social or environmental objective, does not significantly harm (DNSH) any other possible environmental, social, or governance objective, and complies with good governance practices.

As I discuss here in more detail, financial market participants have begun using the SFDR—a disclosure regime with different disclosure requirements on the basis of the ESG strategy of a product—as a classification system to try and fit their products in the Art 8 and Art 9 categories. Product ‘downgrades’ from Art 9 to 8 took place closer to the entry into force of the level 2 rules and after more restrictive Commission guidance, and possibly additional ‘upgrades’ could happen now that the Commission has confirmed through a Q&A that financial market participants hold complete freedom in determining frameworks for identifying sustainable investments, as long as they demonstrate how they meet the various open-ended limbs of the SFDR definition.

However, because the SFDR lacks unambiguous definitions and thresholds for key notions such as sustainable investment, products disclosures under Art 8 and 9 have been observed to include investments that should arguably find no place in products with an ESG strategy; for example products disclosing under Art 8, and even Art 9, have included investment in oil and coal. Obligations related to Principal Adverse Impact could also give the impression that financial market participants are mandated to reduce or eliminate adverse impacts connected to their investment decisions, whereas in fact they have wide freedom in determining how and how much to reduce their investments in harmful activities.

Supervisory action coupled with market and legal discipline from investors are expected to ‘enforce’ the appropriate manufacturers’ SFDR classifications of products. It remains to be seen whether these dynamics will be sufficient, and if more precise regulatory criteria should be introduced. While the SFDR should not over-intrude into the freedom of designing financial products and the prohibition of (investing in) unsustainable activities should be enacted through regulatory regimes others than financial regulation, there is nothing constraining a more prescriptive approach in defining characteristics of products that have sustainable investment as objective, or even the introduction of an obligation to reduce the adverse impact on sustainability factors of investment decisions.

These aspects are in fact in line with the regulatory objectives of consumer protection and combating greenwashing, and will ensure consistency with other important EU regulatory initiatives such as the Corporate Sustainability Due Diligence Directive (CSDDD). SFDR obligations require the disclosure of adverse impact through key performance indicators but focus much less on requiring financial market participants to take action to lessen their impact. With the introduction, through the CSDDD, of clear obligations for undertakings to identify and, especially, prevent, cease and remedy violations of human rights and environmental harms, sustainability due diligence would not just require disclosure of actions, but would mandate financial market participants to act to avoid association to adverse impact.
In direct relation to the SFDR obligations, additional transparency could be provided by requiring the full disclosure of the PAI connected to financial products on the basis of the same PAI indicators used for the entity-level PAI statement. This would bring more transparency, would allow investors to better understand product-related impacts, and would contribute to orienting capital away from harmful investment, in line with the SFAP objectives. Requiring all financial market participants to disclose and account for their (product-level) harm would not just embed sustainability considerations in the operation of all financial market participants, but also raise the cost of unsustainable investment.

Secondly, the EU legislators should continue in the path started by the Commission in previous Q&As, which attempted to introduce in the SFDR elements of a classification system, such as a list of excluded investments or sectors or positive substantive requirements for permissible investments in products disclosing under both Art 8 and Art 9. Recent supervisory intervention on tangent issues such as rules on the use of ESG and sustainability-related denomination in funds names or additional definitions and characteristics of greenwashing may be seen as introducing new criteria and requirements to the SFDR framework, such as a minimum share of sustainable investment for funds to use sustainability-related terminology in their names. Tackling the issues left open by the regime should, however, take place through a formal amendment to the SFDR.

The large variety in Art 8 products could be narrowed down by requiring that all investments must pursue social and environmental characteristics in order to be disclosed under Art 8. Otherwise, Art 6 should apply. In establishing substantive criteria for sustainable investments under Art 9, the SFDR regime should provide additional clarity about what investments can be included, especially in relation to their compliance with the DNSH principle. This does not mean that the SFDR should fully harmonise how financial market participants define an investment as promoting social and environmental characteristics, or having sustainable investment as objective—although more uniform methodological criteria of how these investments are selected should be provided.

Rather, as also suggested by the Platform on Sustainable Finance, a taxonomy for significantly harmful activities should be established and used in the context of the SFDR, including activity-level thresholds for harm on a variety of metrics. The list of screening criteria and excluded sectors determined in the amendments to the Benchmark Regulation and in the draft for the EU Eco-label could also be used as a basis to identify economic activities that would never comply with the DNSH principle, and thus cannot be included at least in an Art 9 product that has sustainable investment as objective. A lighter list of exclusions can also be established for Art 8 products, including for example activities from which urgent decommissioning is necessary, and harmful activities without a transition plan.

Sustainability disclosures are essential in enabling a market for sustainable financial products. Given the current legal challenges and market practices, EU regulators should not hesitate to align the SFDR with a full-fledged classification regime.

Enrico Partiti is a Senior Legal Counsel for Sustainable Finance at Triodos Bank, an Extramural fellow at the Tilburg Law and Economics Center (TILEC) and an Associate Fellow at TMC Asser Instituut.