Are SFDR and SDR on the way to becoming as similar as their names?

We have written before about the struggles faced by fund groups in the EU to determine whether they should make sustainability disclosures in line with Article 6, 8 or 9 of the Sustainable Finance Disclosure Regulation (SFDR), given that they are not fund classifications and the criteria have been subject to multiple rounds of “clarifications” from the regulators and the European Commission.

Earlier this month, the Dutch financial regulator, the AFM, published guidance warning fund managers against using the terms Article 8 or Article 9 in their marketing to imply “a certain degree of sustainability” based on “a non-existent label”.

Meanwhile, on this side of the Channel, we are waiting for the FCA to publish its final rules on investment labels and sustainability disclosure requirements (SDR), which will explain the criteria that need to be met to qualify for one of, currently, three sustainability labels; in other words, genuine sustainability fund classifications. So far, so different from the SFDR.

But in September, the European Commission published a consultation paper on “exploring possible options to improve the [SFDR] framework”.

The potential introduction of an EU fund labelling scheme

Opening with a series of questions about the implementation of the SFDR and its interaction with other parts of the EU’s sustainable finance framework, the consultation then acknowledges that there may be “shortcomings” in the regulation, one of which is that it is being used as a de facto classification and labelling scheme, although it was never conceived as such.

Because of that – and in spite of numerous national ESG labels around Europe – the Commission is consulting on “the merits of developing a more precise EU-level product categorisation system based on precise criteria.”

Two possible fund labelling schemes are suggested in the Commission’s consultation – one based on expanding on Article 8 and 9 by turning them into actual labels, and the other based on removing the distinction between Article 8 (promoting environmental or social characteristics) and 9 (having sustainability as an objective) entirely and introducing a new set of labels that would determine what needs to be disclosed.

Perhaps it shouldn’t come as a surprise that the possible new EU labels very closely resemble those that the FCA consulted on last year in its CP22/20, which can be summarised as Impact, Sustainable and Transitioning (known to the FCA as Sustainable Impact, Focus and Improver), with a possible fourth category in the EU of funds with an exclusion policy.

The biggest departure from the current definitions in the SFDR is the introduction of “products with a transition focus”, while the consultation also asks about the value, or otherwise, of differentiating between Sustainable and Impact – which could be seen as shorthand for the difference between Article 8 and 9 – or between products with a social as opposed to an environmental focus.

Should sustainability categories be mutually exclusive?

Another sign of how the SFDR and the SDR might appear to be getting closer is that the European Commission’s consultation is asking whether the categories of sustainability should be mutually exclusive. But this term means something different in the UK and EU consultations.

The EU consultation says that a fund could only belong to one category “in cases where the product meets the criteria of several categories”, while, in the UK, “the qualifying criteria…are designed to ensure that the three categories…are mutually exclusive”, so there could be no doubt which one would apply to a fund.

When the SFDR was first published, the shorthand for Article 8 was “light green” and Article 9 was “dark green”, very clearly establishing a hierarchy, which was later reinforced by the mass “downgrading” of Article 9 funds to Article 8 last year, when an attempt by the Commission to clarify the criteria only served to create more confusion. The consultation is now asking whether there should be “some additional disclosure requirements when a product falls within a specific sustainability product category”, emphasising the hierarchy, which would also apply if the option of formalising Article 8 and 9 into fund categories is adopted.

The FCA, on the other hand, is determined to avoid any implication that one category of fund is somehow greener than another, even steering clear of using shades of green for the labels themselves. Its consultation was unequivocal: “There is no hierarchy between the proposed categories: each type of product is designed to deliver a different profile of assets, and to meet different consumer preferences.”

So, are the UK and EU regulators deliberately aligning their sustainability disclosure regimes, with differences such as whether they end up with two, three or four categories and whether the definitions of each category are really “mutually exclusive” down to linguistic differences? Much will become clearer by the end of this year, when the FCA publishes its policy statement and final rules, but we will need to wait longer for the outcome of the EU consultation, as that is open until 15 December and the Commission will take some time to digest the responses.

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