SFDR disclosure compliance risks ‘greenwashing’ by EU financial firms

Investors, consumers, product owners and regulators are increasingly alive to the role to be played by the financial system in the green transition, with more and more purchasers of financial products seeking out more sustainable choices. SFDR was intended to increase transparency by requiring financial firms to disclose information about their sustainability practices – but vague drafting and lack of standardised definitions risk the disclosure requirements being seen as a proxy for greener products.

The European Securities and Markets Authority (ESMA) highlighted these risks in a recent report (46-page / 1.44MB PDF), explaining that, “in the absence of an EU-wide labelling regime for ESG funds, some managers have also used Articles 8 and 9 as proxy labels for communication purposes.” In doing so, it echoed the view of the UK’s Financial Conduct Authority (FCA) which, in its consultation on the creation of a UK-specific sustainability disclosure regime (SDR), pointed to “growing concerns that firms may be making exaggerated, misleading or unsubstantiated sustainability-related claims about their products; claims that don’t stand up to closer scrutiny (so-called ‘greenwashing’)”.

UK regulators, as with those in the US, have recognised the importance of labelling to help consumers and build trust. By contrast, the SFDR, for all its complexity, was never intended as a system of labelling – but has nonetheless been treated as one because that’s what issuers, consumers and investors want.

Following the SFDR’s difficult birth and delayed implementation, ESMA has now recognised that "[t]he misuse of SFDR as a marketing tool could create potential risks to investors as demand for sustainable products remains strong”. And, in recognising that the market would look upon the SFDR classifications as brands: "SFDR was not intended to be a labelling regime and does not include the type of requirements usually attached to voluntary labels, prompting further concerns of potential greenwashing."

It would be naïve to judge the high proportion of Article 8 or 9 funds as being an indicator of the success of the SFDR regime. Greenwashing is in the regulatory crosshairs, and rightly so, and there remain a huge number of issues to be resolved before the EU finally has a regulatory framework that helps consumers navigate the ESG product landscape. In the short to medium term, many managers will be at risk of being required to rename or redesignate a fund under proposals put forward by ESMA towards the end of last year.

Why might SFDR encourage greenwashing?

There are a number of ways in which SFDR may increase the risk of greenwashing – in particular, of product managers over-stating a product’s green credentials.

Lack of standardised definitions

SFDR does not provide workable standardised definitions of sustainable investments. This could allow firms to label investments as “sustainable” even if they do not meet commonly accepted environmental, social, and governance (ESG) criteria.

This is further compounded by the prescribed pre-contractual format from the SFDR Regulatory Technical Standards (RTS) and the wider use of overlapping terminology. For example, it is possible to offer an ‘Article 9’ fund – which should have specific sustainability goals as an objective – without a taxonomy alignment or PAI [Principle Adverse Impact] reporting. Does this make it more or less ‘green’ than an Article 8 fund – which should promote environmental or social characteristics and have good governance – that offers both of these?

This lack of consistency in definitions also makes it difficult for investors to compare sustainability performance side-by-side across different funds.

Compliance burden

SFDR creates a disproportionate compliance burden for some firms, particularly smaller firms or those that cannot take advantage of third-party data sources. Compliance with SFDR requires companies to gather and report a significant amount of data on their sustainability practices, which is time-consuming and expensive. This may create a temptation to simply meet the minimal disclosure requirements.

Self-assessment and self-reporting

SFDR relies on self-assessment and self-reporting by financial firms. This may not always be reliable, either because of data quality or internal resource capacity. Some firms may be inclined to exaggerate or misrepresent their sustainability practices to attract investors or comply with the regulation.

Vague requirements

SFDR’s requirements are not always clear or specific, which allows firms to interpret the regulation in a way that suits their interests. For example, the regulation requires firms to disclose how they integrate sustainability risks into their investment decision-making process – but it doesn’t specify how to measure or assess those risks.

Limited enforcement

There are no strong enforcement mechanisms to ensure compliance included in SFDR. Firms that do not comply with the regulation may face reputational damage, but they may not face significant legal or financial penalties.

The MiFID temptation

SFDR amended the Markets in Financial Infrastructures (MiFID) regime from November 2022. Product manufacturers and distributors, such as wealth managers or asset managers, must now consider sustainability factors and sustainability-related objectives at every stage of the MiFID product governance process chain.

The new rules dictate that, where no sustainability preferences have been given by a client, on the proviso that there is no difference to acceptable risk for the client in question, an Article 8 or 9 product can be deemed to be suitable for that client. However, the converse is not the case, which inevitably steers more MiFID client capital towards sustainable investments and creates an incentive for product manufacturers to meet the minimum requirements of Article 8.

A regulatory sticking plaster?

Ultimately SFDR Article 8 sets a relatively low barrier to entry in terms of consideration of basic environmental and social factors. Since greenwashing refers to exaggerated claims, as well as false ones, it is arguable that products that edge into Article 8 could be greenwashed, as they benefit from the goodwill of being an Article 8 fund while not necessarily committing to sustainable investments.

ESMA recognised this issue with its recent consultation on ESG and sustainability-related terms in fund names. We await the output from this consultation, but ESMA proposed a new quantitative threshold of 80% for the use of ESG-related words and an additional threshold of 50% for the use of “sustainable” or any sustainability-related term, although it should be noted that these thresholds remained largely undefined.

The proposal is arbitrary, and risks causing further consumer detriment by layering on a complex naming system after the event. Under the FCA’s SDR in the UK, and the SEC’s proposals in the US, a single threshold is proposed, and would be introduced in parallel to disclosure rules.

For funds and managers falling under Luxembourg’s financial regulator, the CSSF, a further safeguard has been added under its 13 March 2023 update to its FAQ on SFDR. The new guidance draws from the existing requirements of the SFDR RTS, which states that the information provided under it should be “notably easily accessible, simple, fair, clear and not misleading” – the CSSF position is that this principle also extends to fund names. As such, sustainable terms in fund names “should be used only when supported in a material way by evidence of sustainability characteristics, themes or objectives”, with a materiality test rather than a percentage threshold. Other national regulators may follow suit.

What should fund managers do now?

While there are a number of regulatory patches to fix the flaws of SFDR, there is no clear solution, and any attempt at a one-size-fits-all solution will be unworkable or simply change the nature of the greenwashing risk.

To date, we have seen managers being less committal towards portfolio disclosure requirements under SFDR despite the fact that they run sustainable investing strategies. This has been due to SFDR’s poor drafting and a disorderly implementation of the rules, rather than any ill intent of the managers in question.

Managers should consider how sensitive their investors would be towards their being required to change the name of a fund should ESMA’s proposals go through, as opposed to their own ability to commit to the minimum portfolio requirements required to maintain an “ESG” or “sustainable” label.

Irrespective of the outcome of ESMA’s consultation on fund names, it only tackles one of the many shortcomings of SFDR. A continued concern will be around varying data availability for managers to meet disclosure requirements. The specific challenges vary between asset classes and markets, but may be data availability, quality, granularity or volume, whether too high or too low.