The evolution of SFDR: one step closer to SDR, one step further from defining impact

These two regulations were conceived with similar objectives: to enhance transparency and promote sustainable investment practices. Despite similar starting points, the regulations differ significantly as they originate from different regulatory environments, are at different stages of implementation, and have varying technical requirements.

This article explores the recent Joint Opinion by the European Supervisory Authorities (“ESAs”) on the SFDR and how the proposed changes map to the obligations of the SDR. It explores not only the similarities between these two frameworks, which many investors will be relieved to see, but also highlights a glaring difference: the continued omission of impact investing as a category by the SFDR.

Point 1 - The evolution and controversy of the SFDR

Since its adoption in 2019, the SFDR has faced consistent criticism from stakeholders for providing too little context, lacking specific definitions, and creating greater confusion among investors. On June 14, the ESAs released a Joint Opinion Report on the regulation, providing recommendations to improve the framework and its applicability. Key recommendations are outlined as follows:

The ESAs propose a new product classification system, classifying financial products into two main types (outlined below) which would replace the current disclosure categories of Article 6, Article 8, and Article 9.

1. Sustainable product category:
   
   
   • Products that invest in environmentally and/or socially sustainable economic activities.
   • Investments must meet a minimum sustainability threshold aligned with the EU taxonomy.
   • Non-taxonomy-aligned investments should still adhere to environmental, social, and governance principles.
     
     
2. Transition product category:

• • Products investing in activities that aim to become sustainable over time.
  • Strategies may include Taxonomy Key Performance Indicators (“KPIs”), transition plans, product decarbonisation, and addressing principal adverse impacts (“PAIs”).
  • Criteria for credible transition plans and exclusions may apply.

According to the ESAs, these categories aim to provide greater clarity for investors, particularly retail investors as they are more easily understood than their predecessors. At this time, it is impossible to confirm whether these recommendations will be adopted by the European Commission. However, it is important to note that the ESAs possess a profound understanding of the SFDR’s applicability and success in the market; their opinions are valuable to the Commission and are therefore likely to be closely considered.

Point 2 - The overlaps between the SFDR and SDR

It can be assumed that the ESAs have drawn inspiration from the UK’s SDR framework in their recommendations, as evidenced by the inclusion of the Transition Product category, which is referred to as Sustainable Improver in the SDR. Although these categories do not directly correspond to one another and there is no proposed or existing equivalence regime, both the FCA and the ESAs have acknowledged the need for such a classification. This classification aims to drive investment into sectors that are challenging but essential for transition.

The SDR and the Joint Opinion Paper both include a category for products that demonstrate an existing level of sustainability performance. In the Opinion Paper, this is the Sustainable Product category, while in the SDR, it is the Sustainable Focus category.

Both regulations require disclosures—both pre-contractual and annual—to provide essential information regarding the sustainability credentials of products. The goal is to enhance transparency for investors and reduce greenwashing. Within these disclosures, KPIs must be used to demonstrate the sustainability characteristics of the products.

Point 3 - The missing piece... Impact

For all the newfound similarities between the proposed changes to the SFDR and the existing SDR, the key product category that the SFDR has not adopted is the impact investing category. This is in equal measure surprising and predictable. There is reason to wonder why the ESAs have drawn from so many of the other product categories of the SDR yet intentionally omitted a dedicated category for impact. At the same time, most sustainability disclosure regulations around the world that have sprung up in recent years have elected to avoid a dedicated impact category, and the SFDR is no different in this respect. From Holtara’s perspective, this is one of the things that makes the SDR so robust and future-proof. As the impact investing market continues to grow, the need for a widely accepted definition of impact and reporting framework is increasing, and its absence presents a key challenge to impact investors. Regulation is a tool with great potential to set this standard and cultivate a mainstream understanding of what counts as impact and how financial institutions should report on it. However, the exclusion of impact from the SFDR and other disclosure regimes fails to leverage the power of regulation to achieve this mainstream understanding of impact and opens up the market to greater risks of ‘impact washing’.

To conclude, the publication of the Joint Opinion by the ESAs marks an important milestone in the evolution of the SFDR, as well as in the wider regulatory landscape and the impact investing market. The ESAs' recommendations address the market’s concerns about the appropriate classification of products and the simplification of disclosures to investors, and they provide some much-needed framework convergence with the UK SDR, reducing the compliance burden for financial institutions raising capital and investing across these jurisdictions. Despite this, the recommendations miss the opportunity to contribute to an EU definition and categorization of impact, something the market will have to continue to navigate in the pursuit of true impact and to avoid impact washing. The ESAs full report is available here.