SFDR 2.0: European Commission sets out proposal to revamp sustainable fund labels

The European Commission this morning published proposed amendments to the Sustainable Finance Disclosure Regulation (SFDR). The proposal, which was nearly two years in the making, envisages a revamp of fund labels, building on the earlier Article 8-9 regime.

The Commission initiated a review of the SFDR in December 2022, citing concerns over its use as a de-facto labelling regime. Asset managers using Article 8 or 9 of the erstwhile SFDR as labels, regulators noted, ran the risk of potential greenwashing. There were also concerns around the complexity and time intensity of disclosures.

The proposed SFDR 2.0, which embraces the Omnibus theme of regulatory simplification, creates a three-tier financial product classification system. It also reforms the Principal Adverse Impact (PAI) disclosure regime under the previous version.

Fund labels

Under the new proposal, funds would be categorised into one of three buckets. Funds invested in companies that are ‘contributing to sustainability goals’ (including climate goals) would fall under a ‘sustainable’ category. A stand-alone transition category has been introduced, followed by an ‘ESG basics’ category – aimed at funds that do not meet the criteria of the first two categories but integrate ESG investment approaches.

Speaking to Net Zero Investor about the new proposal, Hortense Bioy, head of sustainable investing research at Morningstar noted, “there will be a hierarchy of categories”.  Bioy says the ‘sustainable’ category is likely to see significant interest, given its alignment with Article 8 of the SFDR and the popularity of the Article 8 tag among fund managers.

“Our research shows that two-thirds of funds with the word ‘sustainable’ in their name, fall under Article 8, these will now want to be labelled as ‘sustainable’. So, I expect this category to grow”, she said.

“The draft SFDR proposal published today contains a number of significant improvements from the current SFDR, notably the introduction of clear product categories", says Anisha Galli, an investment funds lawyer at Linklaters. The draft, Galli reckons, reflects the Commission taking on feedback from industry consultations. 

"The Commission has clearly taken into account industry feedback. Significantly, a previously debated exemption for products only marketed to professional investors has been removed", she adds. 

Transition funds

The decision to introduce a separate category for transition funds, which Galli notes was anctitipated and awaited, is also likely to have wide ranging investment implications. Leading into the reform, questions remained over how transition funds - which are now increasingly popular - would be steered towards companies with genuine, credible transition plans.

The proposal includes an exclusion criterion for transition funds wherein this category will exclude investments in companies engaged in fossil fuel expansion, as well as companies which do not have a plan to phase out their fossil fuel exposure.

The European Sustainable Investment Forum (Eurosif) has welcomed the proposed categories and their exclusion criteria. “Minimum exclusions across categories also help establish greater consistency and reliability. Excluding companies expanding their fossil fuel activities from the “sustainable” and “transition” categories is particularly welcome”, Eurosif said in a statement.

Bar too low?

Simultaneously, Eurosif has warned that the criteria underlying the categories need to be strengthened and greenwashing risks remain. For instance, in the transition category, Eurosif’s statement warns that the bar might be set too low.

“The absence of any engagement-related requirements, especially for the ‘transition’ category, fails to incentivise meaningful decarbonisation efforts among investee companies. Meanwhile, the exclusions for the ‘ESG basics’ category are so limited that products with minimal sustainability commitments could be categorised under SFDR”, Eurosif’s statement reads.

“The European Commission proposal contains some positive steps forward. However, it falls short of establishing sufficiently robust criteria and meaningful disclosures needed to meet end investors’ expectations and support the EU’s sustainable growth objectives”, said Eurosif executive director Aleksandra Palinska.

Morningstar’s Bioy holds a similar view. “If the criteria are limited to exclusions, then even passive funds would meet the criteria”, she warns.

Michelle Ko, investment Funds Lawyer at Linklaters highlights another side of the qualifying criteria story - their effect on uncategorised products. 

"The specific qualifying criteria also means that the new 'ESG basics' category is an uplift compared to today’s 'Article 8' and certain products which are 'Article 8' today would have to be uncategorised under the new regime", Ko explains. "This is a significant development, given uncategorised products will be very limited in what they can say about ESG", she adds. 

The proposal also sets out to change the scope of SFDR – financial advisers no longer fall under the SFDR. Other key changes include the PAI disclosures, which are now limited to the product level for ‘sustainable’ and ‘transition’ categories. Entity-level disclosures have been removed.

Looking ahead

Viewed in conjunction with the Omnibus reforms, the SFDR 2.0 proposal mirrors Europe’s push for regulatory simplification. Eurosif’s statement, which praises the review for ‘moving in the right direction’, also warns of room for greenwashing. The proposal will now make its way to the European Parliament and Council.

The vast majority of the SFDR proposal’s investment implications will come down to interpretation and implementation. While much remains to be seen, Morningstar’s Bioy concludes, “the ball is now in the asset manager’s court”.