European policymakers finally unveiled their vision for a revised Sustainable Finance Disclosure Regulation (SFDR) today.
The European Commission has published its official proposal to reimagine the troubled law, which was created to bring more transparency to the sustainability claims being made by fund managers and pension providers.
In response to widespread market demand, SFDR will move from a disclosure regime to a categorisation or labelling framework.
In order to adopt one of the labels, a product must have at least 70% of its assets aligned with its criteria.
Funds claiming to integrate sustainability factors can continue to identify as ‘Article 8’, and those pursuing sustainability objectives can continue to use ‘Article 9’.
A new category for transition strategies
But a new ‘transition’ category will also be introduced, under Article 7 of the proposed new rules.
“You can qualify for the transition category either by investing in assets that are themselves transitioning, or by transitioning at the fund level,” explains Heike Schmitz, co-head of ESG at law firm Herbert Smith Freehills Kramer.
This can take a variety of forms, including requiring portfolio companies to have science-based targets, investing in firms with growing levels of green capital expenditure, tracking a Climate Transition Benchmark, or focusing on stewardship.
PAIs and Taxonomy loosened
According to the leaked version of today’s SFDR report, circulated earlier this month, the Commission wanted to axe a requirement to disclose the sustainability harms generated by a financial product and the entity selling it.
Under the final proposal, this Principle Adverse Impacts (PAI) reporting will still apply to some extent to Article 7 and 9 funds, but the indicators – which will be developed at Level 2 – will be selected at the discretion of the fund manager.
“The decision to remove the formal PAI reporting and disclosures, based on pre-defined indicators, chimes with the EU’s broader commitment to reduce the reporting burden for the private sector, because it was the element of SFDR that created the most pain for investors,” notes Schmitz.
Under the plans, it seems that Article 7 and 9 funds will be able to bypass the need for 70% of assets to fall under a category’s rules if more than 15% of assets are invested in taxonomy-aligned activities.
Minimum exclusions and impact strategies in
Instead of trying to capture all harms through PAI disclosures, the revised regime will introduce minimum exclusions for Article 7 and Article 9 funds.
That means that, in order to qualify for either category, a product cannot invest in companies that generate revenues from controversial weapons or tobacco, or have exposure to human rights violations.
An exception is made for use-of-proceeds bonds, which don’t have to adhere to company-level screens as long as they don’t directly finance the banned activities.
“It seems inevitable that there will be powerful lobbying to reintroduce the professional investor carve-out”
Phil Bartram, partner, Travers Smith
For the first time, impact investing has been formally acknowledged under SFDR.
The current regime has frustrated some impact investors, because none of the categories explicitly allow for their funds. Now, however, there are impact subcategories under both Article 7 and Article 9.
To be eligible, products must have a predefined, positive, measurable impact on people or planet, underpinned by a credible theory of change.
“It’s brave of the Commission to try to include [impact subcategories], because no regulator has managed it properly so far,” says Phil Bartram, a partner in the financial services and markets department of law firm Travers Smith.
Opt-outs
Under the proposals, financial market participants won’t be able to brand their products as sustainable without opting into one of the three categories. If they don’t want to do so, they can instead register as an Article 6a fund.
“Under 6a, you can’t talk about sustainability at all in your marketing,” says Bartram. “Not in the name, not in any PowerPoint presentations about the product, not at all.
“But at the back of the formal offering document for the fund, you must explain any sustainability risk management factors – as long as they don’t constitute more than 10% of the overall description of your risk management approach.”
In the leaked draft, the Commission had proposed another opt-out, specifically for alternative investment funds. It would have allowed such funds to market themselves as sustainable as long as they didn’t sell to retail investors, and didn’t mislead their institutional clients.
But that provision didn’t make it into the final text.
Bartram says the decision to backtrack “has pulled the rug from under the feet of the institutional market”.
“Given that the leaked text advocated a fundamentally different approach for the institutional market, it seems inevitable that there will be powerful lobbying to reintroduce the professional investor carve-out, with the leaked draft being held up as a reference point for industry demands,” he tells IPE.
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