‘Declaration of regulatory bankruptcy’ – mixed opinions on EC’s SFDR review

Market participants welcome possible fixes to SFDR woes, but prospect of further compliance changes prompts increasing frustration.

Market participants have welcomed an EU consultation on the future of its flagship anti-greenwashing regulation, but the possibility of having to make yet further changes to compliance procedures and investment processes has led to increasing frustration.

Last week, the European Commission released a wide-ranging consultation on investor experiences with SFDR and potential changes. The 44-page questionnaire covers topics ranging from proposals to abolish the Article 8 and 9 system, potential changes to disclosure requirements and whether the purpose of the regulation itself is still relevant.

One of the most significant proposals was the introduction of four categories for funds under SFDR, broadly mirroring those put forward by the FCA in the UK.

While those in the market welcome the commission acknowledging that SFDR is not working as intended, frustration is beginning to show with the frequent changes, alterations and clarifications to the regulation.

One market observer who did not wish to be named described the Q&A as “pretty staggering”.

“On the one hand it’s great that they are willing to face reality,” they said. “On the other hand it’s a regulatory bankruptcy declaration. [The commission is saying] ‘listen, we know what we have built over years is completely useless and we will completely tear it down. What size wrecking ball should we use in your opinion?’”

Benjamin Maconick, managing associate at Linklaters, said it was widely recognised that the commission, along with many others in the industry, were unhappy with how SFDR turned out.

That said, firms had incurred “huge” costs implementing the regulation the first time around and constant tweaks and course corrections along the way have resulted in adjustments to compliance approaches.

“Sometimes it seems to change on a half-yearly basis and this has caused some frustration in the market,” he said.

A slightly more nuanced opinion came from Andreas Hoepner, professor of operational risk, banking and finance at University College Dublin and member of the EU Platform on Sustainable Finance.

He emphasised it could take a long time to implement any potential changes, saying the proposals are “intellectually interesting but unlikely to affect fund management work being carried out over the next five, possibly seven years”. This is based on that a new European Commission will not be in place until November next year due to oncoming EU election, then changes need to go through Parliament, member states and trilogue negotiations, he added.

A research note by Commerzbank was slightly more optimistic on the timeline. However, Stephan Kippe, its head of ESG research, said it was unlikely significant changes would come into force before 2025. The note acknowledged the consultation as a “a surprisingly frank admission by the EU Commission of fundamental problems with the existing SFDR regime,” but said this would be likely of little comfort to investors who have to deal with the overly complex existing structure in the mean time.

Responsible Investor understands that no decision has been taken within the commission on whether any action will be taken as a result of the review.

To change or not to change

While there are widespread complaints about SFDR as it currently is, the investment already made in staff, processes and compliance means that asset managers may be reluctant to move too far away from the current status quo.

A senior ESG figure at one large EU-based asset manager told RI that the most resource-intensive aspects of SFDR had been Principal Adverse Impact statements, and working out Do No Significant Harm processes and sustainable investment definitions. Major changes in these areas would result in significant frustration, they said. The commission should not start again from the ground up, they added, but should enhance and clarify aspects of SFDR, giving the market time to adapt.

While the EU manager said they found value in entity-level PAI statements, Ferdisha Snagg, counsel at Cleary Gottleib Steen and Hamilton, said that many of the law firm’s non-EU clients would welcome reduced requirements in this area. Doing so would reduce compliance risk and allow them to focus on other disclosure regimes such as CSRD, she said.

Commerzbank’s Kippe noted that the investment in people and systems at the largest managers to comply with existing regulatory structures represents a significant barrier to competition from smaller peers or new entrants, and suggested that they may resist changes that would undo much of this investment.

This was echoed by Hoepner, who said that there was likely to be resistance to fundamental changes from responsible investors who had already established their systems. Given the initial aim of SFDR, it would make sense to keep disclosures under Articles 8 and 9 as transparency categories, he said.

“The overriding ambition of SFDR is to stop greenwashing so having transparency categories is of the utmost importance,” he said, noting it could make sense to have both transparency and strategy categories in place.

Polling carried out by Morningstar at a webinar on Tuesday showed initial opinions were already split. Of the 384 votes cast in two polls, 39 percent were in favour of refining Article 8 and 9, while half were in favour of the new categories. Looking at PAI disclosures, 13 percent of respondents were in favour of abolishing the disclosures altogether, while 29 percent wanted to keep entity and product disclosures and 54 percent were in favour of ditching disclosures at the entity level.

Hortense Bioy, global director of sustainability research at Morningstar, said that while the Commission’s willingness to revamp the regime or even start from scratch “may be welcome by some market participants who see too many flaws in the current regime, others will be reluctant to think that all the time, money, and efforts that have been put into complying with the current SFDR in the past 3-4 years will go to waste”.

Another industry observer also urged caution. “I would caution against a complete overhaul of the framework given that the financial industry has made a substantial effort and spent lots of time and energy implementing the rules.

“Let’s fix what needs fixing, but let’s not throw the baby out with the bath water and rather build on what has been already achieved,” they added.

Interoperability increases

The prospect of fund categories being more closely aligned with proposals in the UK was welcomed on both sides of the English Channel. James Alexander, chief executive of UKSIF, said in a statement that it was “encouraging” to see the commission proposals closely mirror the incoming UK regime.

“We continue to see a key role for the UK in establishing a world-leading regime that builds on other jurisdictions’ frameworks, and the potential, even more now, for the UK to help positively shape other countries’ approaches and encourage international alignment of disclosures and fund labelling in the coming years,” he said.

Three of the four proposed categories put forward by the Commission broadly mirror their UK equivalents, with an additional category for funds with exclusions policies.

The link to the UK regime was also welcomed by the ESG figure at a European manager.

However, this approach is not without its pitfalls. Linklaters’ Maconick warned that unless technical standards were very closely aligned, there could still be instances where a fund which qualifies for a UK label might not meet the criteria for the EU equivalent, or vice versa.

Hoepner also noted that while the UK has widely been praised for its approach, it is yet publish technical criteria for the labels. Setting out high-level criteria for these label categories is easy, he said, but actually working them out is more difficult. The Commission will be watching closely to see the reaction to the UK criteria when they are released, and whether they will be “blown apart”, he said.

Transition focus

One welcome aspect of the consultation was an explicit reference to transition funds. While clarifications earlier this year had seemed to allow for transition investments to be classified as sustainable investments, this was not explicit. One of the categories included in the consultation is for transition funds.

A spokesperson for German fund association the BVI told RI that it was it was important to take transition approaches into account to “provide incentives for promoting sustainable transformation in the real economy”.

Similarly, the figure at an EU manager said that while the previous focus had been around impact funds and Article 9, attention in the market had shifted to transition.

Market participants had a number of other observations on questions in the consultation.

Nadia Humphreys, head of climate and regulatory sustainable finance solutions at Bloomberg, said that questions around data availability and flexibility around estimates were a welcome addition, as these would allow investors to explain current limitations in disclosures.

Meanwhile, the BVI also called for “urgent” simplification of SFDR-related information provided to retail investors.