EU Proposes Root and Branch Review of its Flagship Sustainable Finance Disclosure Regulation
The European Commission, in developing policy to achieve net zero and attract private investment to support the transition to a climate-neutral economy, has certainly (even admirably) led with its chin. Not for the first time, it has produced ambitious legislation which simply runs too far ahead of prevailing market and industry norms, and lacks sufficient clarity to provide market participants with their need for certainty.
On 4 September 2023, the Commission launched a consultation on how well the Sustainable Finance Disclosure Regulation (“SFDR”) works in practice, eliciting debate and views from stakeholders about fundamental changes. In short, aspects of SFDR are not proving sustainable. Within 30 months of its flagship SFDR coming into effect, the Commission has declared a time-out to reconsider "potential shortcomings within the SFDR framework" and to acknowledge that the articles 6, 8 and 9 classifications, which were intended to govern disclosure across a wide spectrum of products ensuring substantiation of sustainability claims, have instead become de facto marketing labels, susceptible to greenwashing.
A major concern is that the article 8 label encompasses too broad a spectrum, with a remarkably low entry level (but with the same “label” as a more ambitious ESG product). In contrast, the UK FCA's proposals for a sustainability labelling regime posit product labels pitched higher than even the most robust article 8 product. The use of articles 8 and 9 as a de facto labelling regime together with a proliferation of national labels within EU suggests the market really does want labels to communicate ESG/sustainability performance of financial products. To be fair to the Commission, they share that insight.
Let's recap on SFDR before we consider the Commission's consultation. SFDR started applying on 10 March 2021, and requires financial market participants and financial advisers (“FMPs”) to disclose how they integrate sustainability risks and principal adverse impacts in their processes at both entity and product level. SFDR also introduces additional granular product level disclosures for article 8 and 9 products.
Manager level disclosures
SFDR requires FMPs to disclose their policies on the integration of sustainability risks in their investment decision-making process and remuneration policies, and whether, if so, how they consider the principal adverse impacts (“PAI”) of their investment decisions on sustainability factors.
Product level disclosures
The product level disclosure requirements are built on the principle that products making sustainability claims should substantiate them. They concern risk, adverse impact and sustainability performance information, prescribing which information should be included in pre-sales and post-sales documentation and on websites.
Article 8 mandates specific disclosures for products that promote one or more environmental or social characteristics. Article 9 does so for products that have sustainable investment or a reduction in carbon emissions as their objective. Products that are not covered by article 8 or 9 have become known or labelled as article 6 products, and in some cases regarded unfairly as ESG-neutral, with investors driving demand for article 8 and 9 products.
In something of a volte face, the Commission now consults on developing a sustainability product labelling regime, one that it concedes may not even take the article 8/9 distinction as its starting point, but start over entirely. The consultation seeks views on issues in the implementation of SFDR, for example PAI disclosures, lack of clarity about key concepts such as “sustainable investment”, existence of data gaps making it challenging for FMPs to comply, the usefulness of the entity level disclosures and even whether the SFDR should house such disclosures in the first place.
However, the most startling aspects of the consultation are those that depart radically from the general philosophy of SFDR and are, broadly, twofold:
- asking whether standardised product disclosures should apply to all products irrespective of their sustainability claims;
- exploring whether to introduce an intentional product labelling regime.
Furthermore, the proposed labelling regime draws on the UK FCA’s proposed approach to a UK product labelling regime suggesting four potential labels, three of which reflect the FCA’s sustainable impact label, sustainable focus label and sustainable improvers label and one of which in principle relies on screening alone, an area where FCA has not proposed a label. The Commission has also followed the FCA in positing that unlabelled products should be subject to naming and marketing rules to inhibit greenwashing.
There will be industry concern about the prospect of having to overhaul existing SFDR-compliant systems following the investment made over the last few years. Wry smiles within the FCA are a likely reaction to the Commission’s willingness to let go of key planks on which SFDR was built, and in doing so draw unashamedly on FCA’s own policy-making. During Brexit, the UK was strident about no longer being a rule-taker (from the EU); ironically, one unexpected outcome of Brexit, in particular during more straitened economic circumstances, may be that the UK becomes at least occasionally a rule-giver to the EU, one worthy result of which would be less fragmentation and more global consistency.
Wiliam Yonge is Partner at Morgan Lewis & Bockius LLP
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