The EU’s SFDR regulation came into force in March 2021. Its aim was to bring greater transparency to investment funds' level of ambition with regard to ESG criteria, and to prevent greenwashing practices.
Now, two years on, it is time for a review. Following much criticism, a consultation was launched at the end of 2023 to gather feedback from financial players regarding the regulation's implementation.
On the one hand, the SFDR has put sustainability at the heart of financial institutions' conversations, making it possible to compare European funds and achieve greater transparency over funds' strategies than was the case before SFDR.
On the other hand, it must be noted that its implementation has proved difficult. Its vague framework, coupled with new terminology, led to panic and misinterpretation on the part of financial institutions. The implementation process required considerable time and effort from teams, who were ultimately faced with trying to meet regulatory requirements without systematically improving their sustainability practices.
Add to this a complex reporting system, made even harder to grasp by its underlying structure, and the end result is a regulation under heavy criticism for encouraging greenwashing practices within finance.
In light of these findings, a consultation was launched in September to review SFDR Level 1 requirements.
Aware of the challenges facing financial players and the need to continue the work already initiated on the transparency of funds' ESG strategies, our WeeFin teams were eager to share their suggestions for improvement in response to this public consultation.
The public consultation is structured around 4 sections. Here, we will focus on section 4, which proposes a new fund categorization system. Having reviewed the document, we found that 2 solutions could emerge from this consultation:
There would be 4 such categories: thematic, sustainability-oriented practices, exclusion and transition.
At first glance, this option would appear to give end investors a better understanding of ESG fund strategies.
In practice, however, we believe it could lead to more confusion, as a fund could fall into more than one category.
A logical proposal, since these articles have been interpreted as labels.
Creating labels or categories means setting up a framework which will be difficult to define and implement on a European level. There will be a great deal of debate between all the countries involved to reach a consensus on the rules that will need to be followed in order to obtain a label or enter one of the categories.
Generally speaking, the aim to make financial products fit into ‘boxes’ at all costs actually deters fund managers from implementing highly ambitious ESG strategies. Financial players should be given more leeway to think and create strategies according to their own identity and convictions.
What if a third solution were possible?
The current SFDR regulation has already required a considerable investment in resources, and it will require even more if everything is to be deconstructed and rebuilt.
Time which is simply not available to us anymore, as social and climate emergencies remind us of the need to act now on sustainability practices.
Our preference is to build on what already exists, and focus efforts on creating and implementing ESG strategies that truly help redirect financial flows.
To achieve greater transparency, our recommendation is to remove articles 6, 8 and 9 and introduce a reporting system based on a single questionnaire for all funds, regardless of whether or not they integrate ESG, and of their level of ambition.
This reporting system would consist of a shared framework of questions which will enable the collection of quantitative and qualitative information, using yes/no answers or checkboxes, followed by additional explanations.
These questions would cover a range of topics, including commitments, processes, resources, exclusion criteria, rating methodologies, thresholds, PAI assessment, climate transition plans and compliance with EU taxonomy.
All funds should provide additional explanations in the case of a ‘yes’ response.
In the case of a ‘no’ response, funds should also provide an explanation, together with a plan for improvement.
Find below a mock-up imagined by our teams.
To avoid any inconsistencies in ESG strategies, players claiming to be committed to ESG should ensure that a minimum number of good practices are observed. For example, a fund with an environmental theme will need to provide evidence of its coal exclusion policy.
To improve clarity, we recommend that regulators work hand-in-hand with financial institutions to clarify their expectations concerning different methodologies and definitions, and to ensure alignment with other regulations in force. (DNSH, sustainable investment, PAI, good governance...)
In short, our proposed 3rd option will help: