What’s next for SFDR 2.0?

*This is an audio transcript of the Responsible Investor Podcast. This transcript is generated by AI and may contain errors.

Dominic Webb: Good morning, good afternoon, and good evening wherever you are. My name is Dominic Webb.

Khalid Azizuddin: And I’m Khalid Azizuddin.

Dominic Webb: And you’re listening to the Responsible Investor podcast. On today’s episode, we will be discussing the state of play with the EU Sustainable Finance Disclosure Regulation. Khalid will be giving us a quick state of play before we discuss current proposals for reform and some of the more contentious areas.

Before we start, a quick reminder for our listeners. To find out more about the topics covered in this podcast and much more, visit our website responsible-investor.com, where we produce award-winning news and analysis on all aspects of sustainable investment, from regulation and standards to stewardship, data and disclosure, as well as covering key themes including climate mitigation and adaptation, transition finance, nature and human and labour rights.

You can also find details of our global events as well as webinars and roundtables. Now, on with the show. Khalid, where are we with SFDR at the moment? Can you walk us through some of the highlights of the past few months?

Khalid Azizuddin: Well, I can certainly try and Dom, extricate me if I get bogged down in the weeds on this.

Right, so the SFDR was introduced in 2021. The idea that the EU had in mind, or the issue they were addressing, is information for retail investors, essentially. They wanted to make sure that retail investors, if they so choose to invest in sustainability-focused activities, that they had the information that they needed to make informed decisions.

So SFDR introduced two tiers of fund disclosures, Article 8 and Article 9, and the Commission assigned these two tiers some broad characteristics, but they didn’t specify quantitative requirements. And so it was up to asset managers to decide which tiers their fund sort of fell into. And of course, in the end, investors started using these tiers as de facto labels, and that was not what it was set up to be.

Although some people say, perhaps with the benefit of hindsight, that this was always going to happen. Inevitably, the Commission decided that it needed to become more of a labelling scheme, and this is being sort of framed and being positioned as part of the EU’s overarching competitiveness and simplification efforts.

And so that’s some of the background. The way it will be done is, according to the EU’s sort of regular legislative process, which goes a little something like this, and apologies to any policy experts listening. So the Commission will come up with a proposal, with a legislative proposal, and that will be taken up by their two sort of co-legislators, and that’s the Parliament and member states which make up the Council of the European Union.

Both will spend some time with their respective colleagues sort of figuring out where they align on the Commission’s proposals. Once the legislative positions have been decided independently, they’ll then come into legislative negotiations to figure out what the final law will look like.

And those discussions are informally called the trilogue, and it’s mediated by the Commission. And so coming back to the SFDR, the Council is now in the final stretch of meetings to figure out and hammer out the finer points of their position on the file, and this will be finalised by the end of June.

On the Parliament side, talks on the SFDR will start at committee level, and that’s the ECON committee and will be led by the Renew MEP Gerben-Jan Gerbrandy. And so they’ll discuss that at the committee level. There’ll be a vote at committee level, and then that will then go to the Parliament floor where they’ll discuss and vote on it at plenary level.

And the final vote is only expected to happen in sort of September at the earliest, which means that trilogue or the negotiations between Council and Parliament will only commence after that date. So sometime in Q4. And so that’s the sort of legislative context. Dom, why don’t you get us started on the actual content of the file?

Dominic Webb: Thanks, Khalid. So, as you mentioned, fundamentally the biggest change with SFDR 2.0 is the transformation of the old Articles 8 and 9 into three explicit categories: Sustainable, Transition, and ESG Basics. Funds which do not have any sustainability objectives will be considered non-categorised, the old Article 6, and they will face limitations in the sustainability-related content that they’re allowed to use in their marketing.

Now, the labels pretty much do what they say. ESG Basics funds can follow a range of ESG integration strategies, while Sustainable funds must hold sustainable assets and Transition funds look to invest in assets which are, well, transitioning. There’s no dedicated impact label, unlike the UK regime, but funds making impact claims will be able to make additional disclosures on this, which I think has been particularly welcomed by the impact investing community.

In order to qualify for one of these categories, a fund will have to invest at least 70% of its assets in alignment with category criteria, and also align with preset exclusions criteria.

Now, the good news is that the Council and Parliament are so far aligned on the very basic structure of the reforms, these three categories.

However, there is likely to be a lot of discussion and debate over certain technical aspects of the new regime. Perhaps the biggest sticking point has been the treatment of general-purpose sovereign bonds, as well as bonds issued by other public sector bodies.

Under the original European Commission proposals, investors would not be able to use these bonds to count towards the 70 percent threshold for either the Sustainable or Transition categories.

The Commission said this was to avoid greenwashing and because there are no comprehensive metrics for assessing the sustainability of these sovereign bonds. However, there’s been quite a significant pushback from market participants on this front. Sovereign bonds are important to insurers for risk and solvency purposes, and there’s been a concerted pushback from insurers who say they might not actually be able to use the labels if the current proposals go ahead.

There’s also some market participants who say, actually, there are good standards for assessing sovereign sustainability, such as ASCOR, and that actually the Paris Agreement is originally designed for sovereign issuers itself.

On the Parliament side, Gerbrandy actually proposed an even stricter approach, which would require the sovereign bond investments that a fund makes to be aligned with the product sustainability approach, as well as not allowing them to count towards the threshold.

However, there is a glimmer of hope that the Council may be riding to insurers’ rescue. Member states, it’s a bit controversial between certain member states, but they seem to be aligning around allowing sovereigns to enter funds as part of this 70 percent, according to the most up-to-date proposals we’ve seen from the negotiations.

There is a proposal which would allow Transition funds managed by insurers or pension funds to invest up to 60 percent of their assets in general purpose bonds from EU public sector issuers, provided they can demonstrate these are aligned with the fund’s transition objective.

Now, this is quite a niche and restrictive set of criteria, but I think it does address the very key usability concern that’s been put forward by insurers and pension funds here.

Now, these proposals are not final. In fact, as we are recording this episode, they are due to be debated by the Council’s Financial Services Working Party, but they do provide a hope of progress to market participants and an indication that the various negotiating parties are actually listening to market concerns.

Khalid Azizuddin: So another area which is a bit contentious, or maybe I think this might vie with the sovereign question for being one of the more strongly discussed or negotiated areas, which is the case for climate Transition funds to invest in oil and gas stocks or carbon-intensive sectors maybe is probably a better way of putting it.

And we see this both in the public comments that the commission has received, as well from our contacts in the market.

So just walking back a step. At the moment, Transition funds have a complete ban on fossil fuel expansion activities and producers without a coal phase out plan. And so the question of safeguards for Transition investing is not a new one.

You know, on one hand, carbon-intensive sectors need the most capital to transition, but at the same time, you know, there’s an understandable reluctance, reticence for ESG investors to allocate capital to these sectors without requisite safeguards.

And considering the criteria put forward by the Commission is that fuel expansion activities are blacklisted and nearly all oil and gas producers are expanding production, you know, this really limits transition investing into these sectors.

It’s also worth keeping in mind that SFDR is primarily a transparency mechanism. It’s primarily a disclosure regime for retail investors. So the question that needs to be asked is, you know, would retail investors be surprised if they find that their climate fund is investing in fossil fuels?

Some people say they would be surprised and that this would not be a good policy to have.

On the other side, on the industry side, oil and gas companies are saying that these exclusions are way too blunt and they’re not fit for purpose because they don’t differentiate between companies that have adopted different climate plans. They don’t account for sort of legacy revenues from previous activities, from previous management that these firms are obliged to carry out contractually.

And so there are all these sort of nuances that producers are saying the SFDR should be accounting for. And conversations with our contacts suggest that this is a topic that industry lobbyists and advocacy groups are bringing up with EU policymakers. So it’s certainly getting a lot of attention.

In what might be good news for these sectors, for oil and gas producers particularly, this criteria is also facing opposition in the EU Council and what they’re proposing, and this is based on meeting notes that we’ve recently seen, they’re proposing that this criteria is amended to allow fossil fuel companies into Transition funds, so long as they allocate at least 20 percent of their capex to taxonomy aligned activities and also have a strategy to reduce Scope 1 and 2 emissions.

And this is a proposal put forward by the French delegation.

Moving on to Parliament, I think it’s been quite a surprise for a lot of onlookers to see that the rapporteur, Gerbrandy, he’s not made any changes to the Commission’s proposal, so he’s stuck with the prohibition on fossil fuel expansion.

He’s just kept that as it is, and he’s not provided any commentary on that. But, you know, I feel that this will be unlikely to remain the case for very long. This is an area that will be pretty strenuously litigated, I feel. And so this is definitely one to monitor.

And perhaps of interest to listeners, I heard from a contact recently that one oil and gas company had sent four representatives to a lunch organised by one of the major parliamentary parties specifically to talk about this topic, to talk about SFDR and the eligibility sort of criteria for Transition funds.

So yes, one area we’ll certainly keep monitoring.

Dominic Webb: Absolutely. And I think if you look at the transparency register for some of these companies, there’s quite a long list of meetings on SFDR with various parties. And the fossil fuel exclusion criteria is also, the Commission made a slight blunder in its drafting of these criteria based on some of the Council documents that we’ve seen, where apparently they forgot to put in or maybe neglected to put in the fact that you should be able to invest in use-of-proceeds bonds issued by these companies.

But the Council is going to have to propose that in its own negotiating position because it was inadvertently left out by the European Commission in its original proposals, which just goes to show attention to detail is very key when you’re drafting this kind of thing.

Now, it’s not all bad news and controversy.

There are several areas where there is somewhat more consensus between the various legislating bodies. The first of these is the Principal Adverse Impact indicators, which is a list of mandatory and voluntary metrics which are intended to measure the negative impact of fund investments and which asset managers are required to disclose on both a product and an entity level.

The entity-level disclosures, I think, are pretty widely despised by asset managers. They were one of the least popular aspects of the old SFDR. So the fact that they are being deleted completely in SFDR 2.0 is a very welcome change.

Both Gerbrandy and the Council are proposing that asset managers should be able to drop these as soon as the revised SFDR enters into force instead of having to wait until the rest of the regulation applies, which I think will be a welcome development for many in the market who spend quite a lot of time and quite a lot of money putting these disclosures together.

However, the S&D grouping in Parliament may throw a spanner in the works here. Lara Wolters, who is the so-called shadow rapporteur for the centre-left grouping, has warned that changes to the European Sustainability Reporting Standards, which would result in reporting requirements for asset managers’ investment activities being dropped, might weaken the case for ditching the entity-level reporting under SFDR.

However, more to be seen on this as we enter parliamentary negotiations.

Both the Council and Gerbrandy are also in favour of introducing some kind of disclaimer for funds which are not using any of the three categories, which would require them to basically say they do not qualify for a category under the rules.

Gerbrandy wants this to be for all funds, whereas the current Council consensus seems to be that this should only be for funds who are disclosing some information about their consideration of sustainability factors using a carve-out under Article 6A of the revised rules.

Khalid Azizuddin: So let’s go through some of the other proposals which are a bit less contentious, but where there still lies differences of opinion.

Let’s start with the so-called taxonomy safe harbour. Now this is a way of linking the SFDR with other sustainable finance files, in this case, the taxonomy.

So the Commission has proposed that funds with a minimum threshold of taxonomy-aligned investments should be considered automatically eligible for the SFDR categories, and so they don’t have to prove that they have 70 percent minimum exposure in line with their sustainability objectives.

What this means in practice is that funds with 15 percent taxonomy-aligned investments would comply automatically with the criteria for Sustainable and the Transition fund tiers, so long as they implement the mandatory exclusions which apply to these types of funds.

Whether this will be a route that many fund managers will take is uncertain because the taxonomy criteria is considered fairly stringent and could limit the pool of available investments. At least that’s the argument that’s been used by investors. And also, a lot of data is really required to prove that activities are taxonomy-aligned.

I think it’s interesting to note that, so the Commission held a consultation on the, when they first announced that the SFDR was due to be revised, and quite a few submissions from the industry called on the Commission not to implement sort of strict taxonomy criteria in the SFDR for these reasons I mentioned earlier.

Based on the documentation we have, member states do not seem particularly keen to modify the taxonomy safe harbour threshold. And some even say that even at 15 percent, the threshold would be too challenging to achieve, and I’m quoting here, “given current data availability and the overarching simplification objectives”.

Here, there is some disagreement with Parliament. Gerbrandy has proposed raising that 15 percent threshold to 20 percent, and he cites statistics which show that 44.1 percent of Article 9 funds, which is the most ambitious tier of sustainable funds under the current SFDR regime, already meet this requirement.

And so he’s saying you need to preserve the status quo but also raise the ambition whenever possible.

And finally, let’s talk about ESG Basics, which, you know, I think discussions on this is worth paying attention to.

Under the Commission’s proposals, ESG Basics funds can only invest in assets which outperform the average ESG rating of the investment universe or the reference benchmark.

I think it’s an interesting proposal. It’s the only bit of the SFDR that’s underpinned by commercial ESG ratings or third-party sort of data products, and so it really sort of sticks out.

We don’t really have complete visibility into what the Council is proposing on this, but Gerbrandy has proposed adding a new prohibition for ESG Basics funds which will prevent them from investing in securities with ESG ratings in the bottom 20 percent of their universe, in addition to not being able to invest in securities with below average ratings.

These proposals might become an area of concern for investors, particularly because, you know, ESG Basics is supposedly the lowest tier of sustainability ambition and supposedly the easiest for fund managers to categorise their funds under.

A note by Morgan Stanley Research noted that it could potentially force fund managers to reclassify many of their former Article 8 funds, similar to what is now known as the Great Reclassification, where fund managers over the past five years had to downgrade around 350 sustainable funds in the most ambitious SFDR tier due to regulatory changes, particularly in relation to the definition of sustainable investment.

Dominic Webb: And while we’re on the topic of ESG Basics, the actual naming of the category is pretty unpopular. We’ve heard from market participants and member states alike that the name is not a great descriptor and that it may be difficult to translate into other EU languages. In fact, Jenn-Hui Tan, who is chief sustainability officer at Fidelity International, described it as a, and I quote, “terrible marketing name,” at a conference a few months back.

As such, the Council is debating a proposal by Denmark whether to rename the categories to Sustainable Basics, Transition, and Sustainable Advanced instead.

So Khalid, we’ve talked a lot about the various positions and points and stances that are coming out. How do we think these legislative negotiations are going to pan out in the end?

Khalid Azizuddin: Well, that really is the big question. At this stage, I think there’s quite a lot of optimism that it will be a relatively drama-free process, at least in comparison with the Sustainability Omnibus, which I appreciate might not be particularly useful a comparison given how much of a blockbuster that was.

But there are hopes that there won’t be any “fireworks in this file”, as a contact of mine at the Council of the EU puts it.

However, there are big things at stake here, and there are differences of opinion on how to address them, and the corporate lobbying that we have seen so far attest to the fact that this is a file that will still be quite widely followed.

Dominic Webb: Absolutely, and I think finding consensus among member states has maybe been a little harder. In the most recent set of meeting notes that we’ve seen, the Cyprus presidency of the Council of the EU said that, and I quote again: “Negotiations have been and continue to be challenging, and finding common ground requires further and mutual concessions.”

I think we shouldn’t lose sight of the fact that Parliament and Council do agree on the very basic design of the new SFDR, but there do remain some pretty key sticking points and industry pain points and headaches that need to be resolved if SFDR is to be made a truly workable regime for the future.

Khalid Azizuddin: In terms of parliamentary negotiations, the priority for Gerbrandy’s team at the moment is to secure the support of MEPs from the European People’s Party, the EPP, which is the largest political grouping in the Parliament.

Notably, in the Sustainability Omnibus, this did not happen, which led to fractures within the dominant centrist and progressive Parliament majority and resulted in the EPP voting together with the far right, which many people consider a pretty seismic and historic development, and not a good one.

Dominic Webb: However, Gerbrandy has said that he views the file as a technical and not a political one, so it may be able to escape the more contentious debates and the ultra politicisation that we really saw with the Sustainability Omnibus.

And now unfortunately, I think that is about all we have time for, so it just remains for me to thank Khalid for joining me today.

Khalid Azizuddin: It’s my pleasure. And if you like this episode, you can listen to our whole back catalogue and keep an eye out for our upcoming episodes. Thank you for listening.