The Sustainable Finance Disclosure Regulation (SFDR) has emerged as a transformative force in the financial industry, driving transparency and sustainability. The recent SFDR consultation paper published by the EU Commission on the 14th of September 2023 looks for feedback and insights across four key pillars.

We have summarised the ask of each pillar in the consultation and provided some insights and suggestions as to the challenges presented.

1. Current requirements of the SFDR

The SFDR currently imposes rigorous demands on financial market participants, necessitating the provision of comprehensive and transparent information on environmental, social, and governance (ESG) factors.

Challenges:

• Within the realm of EU distributors and sales teams, the SFDR regime has often been employed as a labelling system, with the ESG-related attributes of investment funds tagged as either “Article 6”, “Article 8”, or “Article 9” funds. As a result, investors frequently express their preferences for investment products by referencing the product categorisation outlined in the SFDR.
• Increased focus on ESG claims and reputational risks concerns has seen many Article 9 funds re-categorised to Article 8.

How to manage these challenges:

• Clear definition of ‘sustainable investment’ in line with the future European Securities and Markets Authority (ESMA ) ‘Guidelines on funds’ names using ESG or sustainability-related terms’ (currently still in the form of ‘Consultation Paper’).
• Consider abandoning the requirement for Principle Adverse Impacts (PAI) disclosures at the Entity level.
• The need for enhanced distinction between Article 8 and Article 9 SFDR financial products with targeted outcomes to improve disclosures.
• Improved guidelines on how transition assets can be adequately captured under the SFDR framework.

2. Interaction with other Sustainable Finance legislation

SFDR interacts with other sustainable finance legislation which is essential for creating a coherent and effective regulatory framework.

Challenges:

• Need to navigate and comply with multiple overlapping regulations, including the EU Taxonomy Regulation, Benchmark Regulations, and the Corporate Sustainability Reporting Directive (CSRD). This creates complexity, potential duplication of efforts, and increased compliance costs.

How this can be managed effectively:

• Harmonisation of requirements and definitions across different regulations to streamline compliance and enhance consistency in reporting.
• Continuous education, training, and capacity building for market participants to stay informed about evolving regulations, understand their reporting obligations and develop necessary expertise.

3. Potential changes to the disclosure requirements for financial market participants

The idea of uniform disclosure under SFDR may initially imply an equal playing field between sustainable and non-sustainable products, but the reality of numerous products lacking sustainability disclosures raises doubts about the effectiveness of this approach.

Challenges:

• Market participants are grappling with the increased data collection and reporting requirements placed on fund and asset managers, as well as the costs incurred to comply with SFDR.
• Lack of clarity over how Do No Significant Harm (DNSH) assessments interact with PAI indicators for product-level disclosures and lack of available data make PAI disclosures and DNSH assessments challenging.

How to manage these challenges:

• Address technical challenges and gaps in the existing disclosure framework.
• Harmonise and simplify the disclosure requirements.
• Streamline product-level PAI indicators, providing opportunity to focus on most material and relevant PAIs including consumer testing.

4. Potential establishment of a categorisation system for financial products

The EU Consultation discusses the potential introduction of new product categories that align with sustainability objectives and criteria. It addresses the potential utility and efficacy of this approach, as well as the design considerations for any new product categories.

Challenges:

• Financial market participants are already positioned therefore marketing funds under Article 8 or Article 9 may face a competitive disadvantage if these categories are eliminated or modified.
• Requires significant effort and resources to adapt to new requirements and ensure compliance with revised regulations.

How to manage these challenges:

• Implement provisions that allow financial market participants to adjust strategies and disclosures over time without causing disruption to existing investment products.
• Strike the right balance between institutional and retail investors with regards to disclosures and labelling to make ESG characteristics clear for all.
• Product categories should be clear, have targeted outcomes and measurable criteria.

There are a number of steps which firms can take to manage and streamlines the current and future regulatory demands with regards to the advancing SFDR landscape, namely:

• Consider preparing product-specific templates for different types of EU financial products so that there are fund-specific templates for funds authorised under Undertakings for the Collective Investment in Transferable Securities (UCITS) and Alternative Investment Fund Managers Directive (AIFMD) frameworks.
• Improve data collection methods, enhance data providers’ capabilities, and adopt standardised reporting frameworks. Market participants will need to establish robust data management systems to ensure accurate and reliable disclosures.
• Ensure that financial market participants are compliant by conducting impact assessments, gap analyses, and developing implementation plans to align with the evolving SFDR provisions.
• Introduce external party assurance as an important element that can challenge the completeness and robustness of SFDR frameworks and disclosures, thus providing additional comfort and trust to investors.

As organizations navigate this evolving landscape, collaboration with experienced partners like EY becomes invaluable. EY is experienced in navigating the intricate regulatory landscape, and strategic preparation is required for a sustainability reporting framework such as this.

This article was co-authored by:

Krina Gudhka, Senior Consultant, FS CCaSS, Ireland
Anthony Kirby, Partner, Risk Consulting, EY UK
Nina Emordi, Associate Director, Risk Management, EY UK
Anna Illarionova, Senior Manager, Financial Services Advisory, EY Luxembourg