EU: ESA’s recommendations on SFDR – calling for greater coherence in the framework, catering for green transition and enhanced consumer protection

When the European Supervisory Authorities (EBA, ESMA and EIOPA – together, the ESAs) published their Final Reports to the European Commission on greenwashing in the financial sector (see our blog post and webinar), they noted that a joint opinion setting out recommendations to the Commission on SFDR was also in production – that opinion has now been published.  This opinion comes at the ESAs own initiative (as opposed to at the request of the Commission) and is to be read in the context of the Commission’s own comprehensive review of the SFDR framework (see here).

The Highlights

The ESAs recommendations include proposals for the introduction of “simple and clear categories” and/or sustainability indicators for financial products, clarity to the key definition of “sustainable investment” and the disclosure of further information around key adverse impact indicators. A key focus for the ESAs is clarity for investors, particularly retail investors – particularly given recent consumer testing which shows that SFDR disclosures to investors may be complex by nature and difficult to understand. Their recommendations on the SFDR framework itself are therefore also accompanied by recommendations for rigorous consumer testing and consultation.

No doubt the recommendations will provide plenty of food for thought for the Commission as it considers next steps in its review of SFDR.  Timing on this however remains unclear – it will be for the next Commission to comment on whether it will take the SFDR review forwards, and if so the content or timescale of such review. 

What are the ESAs key recommendations?

A system of product classification

Given the market practice of using Article 8 and 9 of SFDR as de facto product labels (and the resultant greenwashing risks), in its 2023 consultation on the SFDR framework, the Commission explored the development of an EU-level product categorisation system based on precise criteria, and two broad strategies for how this might be achieved.  The ESAs build on this, suggesting as a starting point two new product categories consisting of minimum criteria (and not labels of excellence of “best in class” products):

1. Sustainable product category: for products that invest in economic activities / assets that are already environmentally and/or socially sustainable. Given the absence of a social taxonomy, thought would need to be given to whether “sustainable products” should be (1) merged in a single category or (2) split in two distinct categories (environmental or social).  The ESAs suggest a minimum “sustainability threshold” - for environmentally sustainable products based on investments in taxonomy-aligned economic activities (evolving over time as taxonomy-aligned activities grow in the coming years). The part of the investment that is not taxonomy-aligned should at least respect the DNSH principle for environmental and social objectives and good governance requirements (provided those concepts are more precisely defined than as currently in the SFDR).
2. Transition product category: for products that invest in economic activities / assets that are not yet sustainable, but which improve their sustainability over time to become environmentally or socially sustainable. The investment strategies of these products could build on a mix of EU taxonomy KPIs to reflect the progressive improvement of environmental performance, transition plans disclosed by underlying assets and their analysis, product decarbonisation trajectories, and mitigation of PAIs at product level (provided that specific and relevant indicators are designed and that a minimum level of mitigation is set out in the Regulation). Additionally, this product category could consider certain appropriate exclusions and criteria for a credible transition plan

Disclosures and marketing for products inside and outside the product categories 

The ESAs propose specific disclosure and naming and marketing requirements based on whether a financial product qualifies to fall within a product category or not, and for those that do not so qualify, whether the financial product has sustainability features or not, as follows:

Sustainability Indicators

Another proposal is for all financial products to display a sustainability indicator (in a scale – e.g. letters such as the nutri-score for food products or the energy certificate performance, EPC, for buildings, or colours) covering environmental sustainability, social sustainability, or both. Again, this seems to build on the Commission’s questions around the potential usefulness of sustainability scales in product level disclosures in its 2023 consultation. The focus here is on clarity - consumer testing and feedback from consumer associations indicates that consumers struggle to understand the different sustainability objectives of financial products and distinction between different objectives, when reading SFDR disclosures - consumers found it difficult to grasp how sustainable products are. To ensure it is a trustworthy indicator for end investors, this system would need to rely on clear and objective criteria, so the scope of each category of this indicator is clearly defined – no mean feat! - and the ESAs acknowledge that development of a sustainability indicator is not without risks and technical challenges. 

Sustainability Indications could in the ESAs view take the place of product categorisation in the SFDR Framework, or the framework could be designed to incorporate both product categories and a sustainability indicator (with the sustainability indicator either working separately within each category or working outside the product categories) – Annex II of the Opinion sets out a helpful summary of how these scenarios could work in practice for different types of hypothetical financial product. 

“Sustainable Investment” definition

The ESAs recommend the Commission revisit the coexistence of the two parallel concepts of “sustainable investment” as defined in the SFDR and Taxonomy-aligned investment as defined in the EU Taxonomy. The ESAs suggest that the Commission make the key parameters of “sustainable investment” under Article 2(17) SFDR prescriptive (given the differences of application the current principles-based parameters have fostered). At a minimum, such prescriptive criteria could, in the ESAs view, clarify the relationship between sustainable investments and investments in taxonomy aligned activities – for non-taxonomy eligible economic activity and social sustainability, the Commission could use other appropriate sustainability metrics. 

Product disclosures – relevant documentation

The ESAs strongly recommend that the Commission ensures that sustainability disclosures cater to different investor needs, and improvements in sustainability disclosures should take into account different distribution channels, including digital ones, and ensure consistency of information provided. The Commission should prioritise only essential information for retail investors while professional investors may benefit from more detailed information.

Disclosures for products currently outside the scope of SFDR

The ESAs recommend the Commission reflect on whether to include other products in the SFDR scope to ensure harmonised disclosures – this could include structured products issued under a Euro Medium-Term Note (EMTN) programme, which the ESAs say could benefit from standardised sustainability disclosure requirements comparable to SFDR disclosures. 

Transparency of adverse sustainability impacts

The ESAs see merit in expanding the current requirements around PAIs. Whilst under the existing framework “consideration” of PAIs under Article 4 and 7 of SFDR is intended to capture disclosure and mitigation of the PAIs of investment decisions on sustainability factors, the ESAs see merit in also introducing requirements for disclosure of “information” about PAIs (albeit in the case of “information” there should be no requirement to mitigate).  The ESA’s suggestion is for the Commission to:

• make “consideration” of PAIs of investment decisions on sustainability factors, mandatory for products qualifying for the new “sustainability product” category;
• make “information” on all PAIs mandatory for the “transition” category; and
• make some minimal disclosures such as “information” about select key PAIs, selecting a list of priority indicators, mandatory for all financial products that should always be disclosed. 

The ESAs also propose a few other amends to clarify the drafting of the existing Article 7 SFDR, and to clarify the sustainable finance framework where there is overlap with other disclosure requirements.

The ESA’s Joint opinion can be found here and a press release can be found here.