SFDR (Sustainable Finance Disclosure Regulation): What Impact on European Markets?

Two years after its introduction in 2021 as part of the EU's Green Deal Sustainable Finance Action Plan, the European Commission launched two consultations in 2023 on the SFDR regulation to assess its effectiveness and gather opinions from stakeholders regarding a possible revision of the regulation.

As a reminder, this regulation requires financial market participants to be transparent about how the products they market take into account ESG (Environmental, Social, and Governance) issues. The regulator's aim is to redirect financial flows toward more sustainable activities while reducing sustainability risks within the financial sector. However, the regulation has been criticized for certain ambiguities that have led to mistrust and accusations of greenwashing, particularly concerning the definition of "sustainable" investments and the distinction between funds categorized under Articles 8 or 9.

In this context, the European Commission initiated two consultations:

• The first on Level 1, which defines the overall objectives and principles of the regulation;
• The second on Level 2, which details the technical standards and procedures for practical implementation of the SFDR regulation, aiming to identify the challenges faced by participants and to gather feedback on the solutions proposed by the Commission.

The results of the Level 1 consultation published in February 2024 show participation from more than 300 stakeholders, 47% of whom are directly impacted by the regulation (financial market participants and financial advisors as defined in the SFDR regulation), highlighting the engagement of key stakeholders. Additional contributions came from NGOs, regulators, data providers, and the academic world, confirming the broad interest in SFDR. These quantitative results are supplemented by "Position Papers" where respondents elaborate on their answers to the consultation in a more qualitative manner.

The consultation addressed various topics such as current disclosure requirements for sustainable finance, interactions with other regulations, potential modifications to disclosure obligations, and the introduction of a classification system for financial products.

Assessment of Three Years of SFDR Regulation: Successes and Challenges

Positive Effects on European Financial Markets...

The SFDR was introduced to strengthen transparency on the sustainability of financial products, a key pillar in the EU's transition to a sustainable economy. A large majority of respondents, over 80%, recognize the crucial importance of SFDR in clarifying sustainability information for financial market participants. This regulation effectively supports the goals of the Paris Agreement through a common European reporting tool, seen by many as a key element to combat greenwashing and avoid fragmentation of capital markets. Triodos Bank goes as far as to describe SFDR as "the cornerstone of the transition to a sustainable economy."

At the same time, the SFDR has raised investor awareness on sustainability issues beyond just mitigating climate change (notably through the "Do Not Significantly Harm" or DNSH concept) and has increased awareness of the negative impacts of investment decisions (for 65% of respondents). This awareness can also be observed at the company level, as a result of investor disclosure demands. According to the BPCE banking group, ESG issues are now a daily concern and better understood within companies.

However, despite increased awareness, the impact of the SFDR on practices has been less pronounced than expected. The consultation reveals that only 40% of respondents perceive a real evolution in investment decisions and the development of financial products (question 1.5.B). Nevertheless, regarding fundraising, Mirova notes that the financial product classification system has directed investors toward more sustainable funds, in line with the SFDR's original goals.

...Which Do Not Overlook the Challenges Faced by Participants

Despite these advances, the SFDR appears to be struggling to meet its primary objectives. A large proportion of respondents, 72% for question 1.2.C, believe that the SFDR does not effectively enhance investor protection. Furthermore, 52% of participants contest its effectiveness in steering capital toward sustainable investments. This ambivalence is reinforced by question 3.2.11, where a majority of professional investors question the improvements in the quality and transparency of sustainability information for financial products.

Moreover, the implementation of SFDR is not without costs, which are considered significant by 58% of respondents, according to question 1.4. Position papers from the European Banking Federation and the Caisse des Dépôts (CDC) highlight that the costs, both financial and human resources, for collecting the necessary data often outweigh the expected benefits.

Interpretation challenges regarding SFDR, particularly concerning sustainable investments and Principal Adverse Impacts (PAI), remain a critical point, with 82% of respondents considering the concept of sustainable investment ambiguous, and around 72% encountering methodological difficulties in using PAIs within the DNSH framework. Additionally, a significant portion of participants (47%) regrets the lack of alignment with other European regulations such as the CSRD, while 48% believe that SFDR does not facilitate the collection of sustainability preferences under MiFID II and IDD regulations. Various position papers from organizations such as the AMF, the French Banking Federation, and ADEME advocate for adopting harmonized indicators with the ESRS of the CSRD to strengthen regulatory coherence. Regarding the EU Taxonomy, opinions are divided on its effective integration with the SFDR, notably due to the complexity of its criteria.

Proposed Evolutions in Response to Identified Challenges

Towards a New Categorization of Financial Products?

Among the proposals advanced by the European Commission, two different approaches have been outlined to reform the classification of financial products within the framework of a revamped SFDR, often referred to as SFDR 2.0:

1. A first option proposes to define new product categories, distinct from the current classifications under Articles 8 and 9, focusing on the investment strategies adopted (exclusion policies, recognized sustainability standards and benchmarks, transition activities, etc.).
2. A second option considers clarifying and expanding the definitions of Articles 8 and 9 to include more detailed criteria related to environmental and social characteristics, as well as sustainable investments and the "do no significant harm" principle.

The results of the consultation show a preference for the first option, with 50% of responses favorable and 28% unfavorable, while the second option received more mixed feedback, with 31% of responses favorable and 38% unfavorable.

Some participants, such as Société Générale, Allianz, and Mirova, support option 2, emphasizing the advantage of capitalizing on the already well-established concepts of SFDR and the significant investments already made. These stakeholders advocate for improving the existing regulation rather than starting from scratch, seeking a balance between innovation and building on existing progress to avoid disorienting the market.

These proposals from the European Commission highlight a challenge faced by participants since the SFDR’s implementation. Initially designed as a transparency regime, the SFDR has often been used as a labeling system for funds and asset managers, despite clarifications provided by the European Commission, notably through the FAQ published in April 2023.

Introduction of Transition-Focused Products: Making SFDR a Central Tool for Financing the Transition of the European Economy?

For RSM, the proposal to include a new category of products focused on financing the transition is a significant development. While frameworks such as the Green Taxonomy and Paris-aligned Benchmarks help identify financial products reducing greenhouse gas emissions, there is a lack of consensus on products specifically intended for the transition. In March 2022, the Platform for Sustainable Finance proposed expanding the Green Taxonomy to cover a larger share of activities and businesses that, although not fully aligned with the Taxonomy, can implement measures to become more sustainable. However, this 2022 proposal was left unaddressed, partly due to concerns over regulatory overload. Expanding the framework could complicate an already heavy system, creating "regulatory fatigue" among economic actors.

This new proposal from the European Commission in the context of the SFDR consultation opens the door to complement the current regulatory framework with a new central piece. With clear definitions and criteria, this proposal could allow investors to direct capital toward activities supporting the ecological transition. Combined with other initiatives proposed by the Institute for Sustainable Finance (IFD), such as mobilizing savings and facilitating access to credit for businesses engaged in the transition, this approach would effectively help meet the financial needs of the ecological transition, which in France are estimated between 30 and 35 billion euros, according to the IFD report.

Seeking Synergies Between the New Categorization and Existing Labels

We emphasize that it would be inappropriate to transform the SFDR into a labeling system. The revision of SFDR should instead focus on the categorization of financial products to clarify their sustainability characteristics, enabling investors to make informed choices. Unlike labels, which attest to compliance with a specific set of requirements, the SFDR categorization should enhance the visibility of financial products' sustainability practices.

While SFDR defines transparency criteria, specialized labels impose requirements in terms of investment policies and measures to be implemented. These requirements go beyond regulatory standards, as shown by the recent revision of the ISR Label in 2023. This third update of the ISR Label specification linked compliance with SFDR but also strengthened, for example, exclusion criteria, engagement, and control mechanisms. Another point of differentiation: under SFDR, the classification of products is the responsibility of market participants, while labels require third-party certification audits.

Therefore, the Sustainable Finance Disclosure Regulation should not replace labeling systems but rather complement them, enabling market participants to adopt differentiated approaches.

In anticipation of regulatory developments, which will only occur after the formation of the new European Commission and the reshaping of the European Parliament following the June 2024 elections, it is essential for financial market participants to anticipate the medium- and short-term implications of SFDR.

Among the actions to be implemented, we recommend aligning your PAI policy based on the recommendations of the European Supervisory Authorities (ESAs), which specify that PAIs require a detailed and contextualized approach. It is crucial for entities not to rely on generic approaches but to define specific thresholds for criticality and mitigation measures tailored to their specific activities. Furthermore, the identification and integration of sustainability risks must be strengthened through robust processes that measure the financial impact of these risks, in line with initial regulator controls (Common Supervisory Action launched in 2023).

In the short term, attention should also be paid to the decision the European Commission must make regarding recent recommendations from the ESAs for Level 2. These proposals aim to simplify RTS models, complete the PAI indicators with new social indicators, and clarify the thresholds or criteria for demonstrating the "do no significant harm" (DNSH) principle. In the medium term, as the evolution timeline for Level 1 remains unclear, market participants are advised to proceed with caution in structuring their future funds.

Finally, SFDR, envisioned in this evolving context, should be seen not only as a regulatory obligation but also as a strategic lever to integrate extra-financial issues into practices aimed at achieving sustainable performance.