ESMA vision for SFDR and sustainable finance in the EU set

In ESMA’s view, the framework – which includes the Sustainable Finance Disclosure Regulation (SFDR) – should serve two purposes: to facilitate the investor journey by providing investors with adequate information to make informed decisions in line with their sustainability preferences; and to support the transition to a sustainable economy.

The way in which the framework has been implemented to date, though, has not served these purposes as well as intended. ESMA’s vision for the future would, if realised, entail a major overhaul of existing rules for businesses.

ESMA’s views summarised

For a bullet-point summary of all the proposals, please see the table below.

Consumer testing

ESMA underlines the importance of consumer testing when considering how the framework should address retail investor needs to ensure the feasibility and workability of any proposals. While consumer considerations were present in the development of SFDR, such as through the testing of the pre-contractual and periodic reporting templates, in its opinion, ESMA distinguishes between retail and institutional investors to a greater degree than under the present regime. In this regard, it is possible that ESMA has viewed favourably the UK Financial Conduct Authority’s (FCA’s) sustainability disclosure requirements (SDR) regime, which puts retail investors at its core.

Indeed, throughout the opinion it appears that ESMA has drawn inspiration from SDR. This is promising for international interoperability, which is a goal ESMA has explicitly referenced in its opinion.

EU taxonomy

ESMA is doubling down on the EU taxonomy as the central point of the EU’s sustainable finance framework, to ensure a consistent minimum sustainability ambition across financial products and to improve comparability.

ESMA would like to phase out the SFDR definition of ‘sustainable investments’ as it believes it leaves too much to the discretion of market participants and, in turn, hampers comparability and opens the door to greenwashing.

However, if the EU taxonomy is to function as the common reference point, it needs to be completed. This would require: standards – definitions and technical screening criteria etc – for all activities which can be environmentally sustainable; standards for activities with the potential to improve their environmental sustainability and activities which should be decommissioned (transition activities); and the development of a social taxonomy.

Effectively support the transition

One of the major weaknesses of the current framework is that it focuses on sustainable finance and does not properly cater to transition finance – a concept that has gained significant traction since SFDR was first being developed. Accordingly, ESMA is proposing that the framework adopts a legal definition of ‘transition investments’ and in that regard it positively views the definition the European Commission set out in its recommendation on financing the transition issued last year.

ESMA would seek to require firms to disclose similar metrics on transition activities, such as the relevant share of revenue and capital expenditure.

ESMA also proposes that additional financial tools should be developed to support the transition, including new transition benchmarks and standards for EU-labelled transition bonds and sustainability-linked bonds.

Adapted transparency requirements

In a move signposted by the European Commission’s December 2022 consultation on SFDR, ESMA is proposing that all financial products currently in scope of the SFDR rules should disclose specific sustainability information regardless of the stated sustainability ambition of the product. Such minimum sustainability information could consist of a small number of key sustainability metrics leveraging disclosures under the European Sustainability Reporting Standards (ESRS), covering both environmental and social characteristics. ESMA is also calling for an assessment of which financial instruments not currently in scope of the SFDR rules should be brought into scope and subject to standardised disclosures.

In a nod to similar rules in the UK, ESMA is proposing that market participants should produce a sub-set of ‘vital’ information for less sophisticated investors while seeking to ensure that all investors can still access the full set of disclosures.

Implementation of a product categorisation system

Recognising that SFDR has been used by market participants as a de-facto labelling regime, ESMA is putting its weight behind an explicit product categorisation system – which was one of the two options put forward by the Commission in its 2022 consultation. Taking inspiration from the UK SDR regime, ESMA proposes focusing the design of the product categorisation system on the needs of retail investors.

Such a system would have two key parts. First, a set of clear eligibility criteria to define the products. Secondly, product disclosure obligations to ensure transparency for investors. As part of these disclosure obligations, ESMA would like to explore a grading system to aggregate sustainability information and present a simple measure on the sustainability profile of a financial product, although it acknowledges serious methodological obstacles.

The product categorisation system should, at a minimum, have distinct categories for both sustainable and transition investments.

The system would also require alignment of a product’s name with its marketing materials and sustainability profile to reduce greenwashing – a similar approach to the naming and marketing restrictions under SDR and the FCA’s anti-greenwashing rule. This would require an update to ESMA’s guidelines on fund names.

ESMA floats the idea of a voluntary regime, although the Commission could also test a mandatory regime. Additionally, ESMA considers that this system would lead to the phasing out of national sustainability labels.

In relation to investment advice, ESMA believes that a product categorisation system would support the integration of sustainability preferences when giving investment advice.

ESG data quality

ESMA notes that the phasing in of the EU Corporate Sustainability Reporting Directive (CSRD) and reporting under the ESRS will improve ESG data quality and reliability, which has hampered SFDR to date. However, it points out that not all investee companies will be in scope of CSRD, meaning ESG data providers will remain important for the regulatory disclosures of market participants.

Although the Council of Ministers and European Parliament have reached political agreement on a proposal for an ESG Ratings Regulation, ESMA observes that its regulatory perimeter is limited to ESG ratings and could be expanded to include all ESG data products to ensure reliability for all ESG data.

Conduct of sustainable investment value chain (SIVC) actors

On the back of its recent progress report on greenwashing, ESMA believes that the conduct of market actors is key for the proper functioning of the EU’s sustainable finance regulatory framework and addressing greenwashing risks. Due diligence obligations of SIVC actors should build on the upcoming EU Corporate Sustainability Due Diligence Directive (CSDDD).

ESMA would also like to see further development around active engagement with investee companies, which it views as an important lever for the framework’s objective to support the transition to a sustainable economy. Accordingly, ESMA would like to go beyond existing requirements under the EU Shareholder Rights Directive and SFDR by proposing an EU-wide stewardship code – potentially leveraging the UK Stewardship Code.

Taken together, the vision set out by ESMA would impact a wide array of regulatory initiatives and lead to significant change for the financial industry both in the EU and internationally, including the UK.

What this means in practice

ESMA’s proposals would represent a serious overhaul of the regulatory regime and would also extend it to businesses not currently subject to disclosure requirements. There is a lot to unpack.

EU taxonomy

The acuteness of industry reaction to ESMA’s decision to double down on the EU taxonomy will depend on whether it is an aspirational statement of intention or a firm policy decision. Either way, it will reach the ears of market participants with all the pleasure of nails on a blackboard.

There has been very low take up by market participants of the EU taxonomy definition of ‘sustainable investment’. This is as a result of data issues, which ESMA appears to believe CSRD will fix, and general unworkability. This has not gone unnoticed by ESMA, which purports to be in favour of a transition period. However, it must be questioned how long such a period would be: either long enough to be workable, in which case the EU taxonomy won’t be the sole common reference point of the framework for many years; or too short such that market participants will be forced out of sustainable investment objectives due to a lack of taxonomy-eligible investments.

There is a trade-off to be balanced between reducing greenwashing and orienting capital flows to support the transition to a low carbon economy. There is no indication in the opinion that ESMA is aware of and considering this trade-off.

Workability of the EU taxonomy is unlikely to be enhanced by developing a social taxonomy to supplement it. In this regard, ESMA may seek to take aspiration from the development of the UK green taxonomy, which is shaping up to be more risk-based and far less prescriptive.

Transition investments

It comes as no surprise that further work on transition investments is signposted given changing investor attitudes over recent years and the uncomfortable position transition finance suffers under the current SFDR regime. Expanding the toolbox to bring transition-labelled financial products within the framework will be a positive development, although not one to be underestimated: if regulators struggled with a workable definition of ‘sustainable investments’ they will find that ‘transition investments’ are more troublesome. Nonetheless, regulators will be able to draw on a significant number of initiatives currently seeking to establish generally accepted principles for transition finance and investing.

Further, it makes a lot of sense to broaden the European Green Bond Standard Regulation to include additional instrument types. This would keep up with industry-led initiatives such as the various ICMA principles on sustainable debt capital market instruments; although the success of the Regulation will be closely tied to policy decisions regarding the EU taxonomy. If regulators are keen for European sustainable bond labels to be anything other than dead on arrival, they should ensure compatibility with common market practice.

New transparency requirements

ESMA’s ambition for all financial products currently in scope of SFDR, and even some currently out of scope, to produce sustainability disclosures is bold and up against an industry which has no appetite for further compliance expenses which do little to serve the interests of their customers. Exploring lighter touch disclosure requirements for institutional business may be a viable route forward to reduce expense and keep transparency requirements focused on retail investors, who benefit from simple disclosures the most. The ongoing rollout of SDR in the UK, which involves this distinction, will be instructive for ESMA.

Product categories

In a similar manner, ESMA should be paying close attention to the difficulties that UK managers are currently encountering with the labelling requirements under SDR. There will be some lessons to be learned with respect to product criteria design, but the SDR experience in the UK reveals that it is the regulatory implementation of the labelling system that will ultimately make it work or not. Potential workability issues are only likely to be aggravated by SFDR being implemented by many different national regulators. Accordingly, ESMA will need to issue very clear guidance to avoid the different treatment of similar products by different authorities.

Final thoughts

When SFDR was first published, its shortcomings were clear to many market participants. Nonetheless, industry understood the intention of the regulatory framework and adapted to implement new rules and procedures that were far from perfect. The implementation period was undermined by frequent shifts in regulatory interpretation, leading to moving goalposts.

Upon the dust settling, we now find one of the EU’s three main financial services regulators setting out its vision for a major overhaul. While the proposals outlined include a number of positive updates, it is imperative that regulators learn from the inefficiency of their first attempt so as to minimise costly disruption to industry, particularly at a time when fund managers are under pressure to deliver value to investors.