Foundations for simple, transparent and meaningful SFDR product categories

Introduction

As the European Supervisory Authorities (ESAs) and the Platform on Sustainable Finance (PSF) provided concrete recommendations to revise the Sustainable Finance Disclosure Regulation (SFDR), legislators should now weigh their options in light of four competing objectives that the revision must achieve:

1. Simplifying the framework in a way that it is easily understood by retail investors
2. Fostering transparency to allow assessing the sustainability level of products
3. Tailoring the framework for impact-driven investments
4. Allowing investors to express and meet their sustainability preferences

While the general direction of the adaptations to the SFDR could largely contribute to all the objectives, certain considerations will inevitably lead to prioritising one objective at the expense of the others. By way of illustration, simplifying the categorisation excessively would necessarily reduce the granularity of the information and the transparency on the sustainability characteristics of the products. To make these trade-offs, the Commission will have to consider the intended direct and indirect users of the SFDR disclosures so that it meets their needs in terms of simplicity, transparency and use.

Throughout this position paper, Finance Watch endeavoured to properly balance objectives, considering the expected use of the disclosures by institutional and retail investors.

The position paper also links the SFDR discussions to the Commission’s proposed omnibus regulation amending the Corporate Sustainability Disclosure Regulation (CSRD), the Corporate Sustainability Due Diligence Directive (CSDDD) and the Taxonomy Regulation.

I. A comparative overview of the proposed categories

A consensus appears from the Commission’s consultation and the respective positions from the PSF and the ESAs: the categorisation scheme should reconcile the financing of sustainable activities with the support of businesses in their transition. In practice, investing in sustainable activities and in the transition is necessary. Sustainable investors are therefore likely to be interested in both investment strategies. Yet, the lack of distinction between the two strategies is a major criticism of the current framework.

In that context, the Commission is expected to introduce two product categories distinguishing the related investment strategies: a sustainability-focused and transition-focused category. The distinction will result in more intuitive categories, foster transparency, prevent greenhushing and reduce greenwashing accusations. However, it is still unclear whether Financial Market Participants (FMPs) will be allowed to categorise a product under both categories. Finance Watch previously underlined the risk of non-mutually exclusive categories, as it could reduce the level of minimum criteria of both categories during the legislative process and lead FMPs to mix strategies to extend their target market and focus their engagement on already-sustainable activities. 

On top of these two categories, the PSF proposed the creation of a third category named “ESG collection”. This would result in an investment strategy similar to a DNSH approach, excluding investments performing the worst on sustainability matters from the investment universe. As explained further, Finance Watch believes that the introduction of a harmful category instead of a “light green” category would better respond to retail client preferences (e.g. to only refuse investing in harmful investments).

Finally, the PSF noted the merit of recognising impact-generating products, with the intention of achieving real-world impact. Yet, the PSF recognised the associated challenges as the notion of impact generation/contribution is not defined in the current EU legislative framework. Finance Watch already underlined the interest of creating an impact-focused category to tailor the transparency framework for impact-oriented asset managers. Nonetheless, this recommendation was accompanied by the condition that it does not lead to further confusion and the assimilation of “traditional finance” to impact finance. As explained further, integrating this concept in a normalised framework brings challenges in maintaining transparency and simplicity, and meeting retail investors’ needs. 

II. Criteria for sustainable and transition-focused products

The PSF’s report provides a comprehensive overview of proposed minimum criteria per product category, including quantitative thresholds, qualitative criteria and minimum exclusions. It leverages existing criteria from the current SFDR framework, such as the Taxonomy alignment and the percentage of sustainable investment. It also incorporates other regulatory standards, such as the exclusion criteria from the climate transition benchmark (CTB) and the Paris-aligned benchmark (PAB), while proposing adjustments to the current definitions. Finance Watch welcomes the effort for consistency across the legislative framework, but highlights attention points for the commonly proposed categories (sustainability and transition-focused) to complete the PSF’s suggestions.

A. Sustainability-focused category: harmonised concepts and criteria

Building a sustainability-focused category on the notions of Taxonomy alignment and sustainable investment would allow the creation of categories that capitalise on what FMPs have already implemented. The PSF also proposed to focus the definition of sustainable investment on activities that are not covered by the Taxonomy and on socially sustainable activities, with the intention to avoid multiple definitions of whether and how an economic activity can be deemed sustainable. This approach will prevent contradicting portfolios with a high percentage of sustainable investment and low taxonomy alignment. Ultimately, it may reinforce companies’ interest in increasing their percentage of taxonomy alignment, as it would be deemed to fully replace the notion of sustainable investment. 

However, assessing the percentage of sustainable investment of a company that reports a certain percentage of Taxonomy alignment should not lead to double counting (e.g. due to taxonomy-aligned activities also considered as socially responsible, or due to a different granularity level for economic activities between the Taxonomy and the sustainable investment concept). The notion of sustainable investment should also still respect minimum safeguards to prevent abuse and ensure the credibility of FMP’s science-based targets. Such safeguards should prevent FMPs from focusing on investing in activities that are not taxonomy-eligible in order to reach a higher percentage of sustainable investment, which would be more easily accessible. This point is particularly relevant as the Taxonomy development prioritised activities that can contribute more to environmental objectives. 

Finance Watch also warns the Commission that the proposal on the EU omnibus could affect the PSF’s approach. Making largely voluntary the Taxonomy alignment disclosure (as currently proposed by the European Commission) would have multiple negative effects: 

• Raising legislative challenges to treat eligible economic activities for companies that would opt out of disclosing their Taxonomy alignment 
• Diverting investments away from economic activities that can substantially contribute to environmental objectives
• Increasing the concentration risk of portfolios due to an investment focus on opting in companies and economic activities that are not (yet) covered by the Taxonomy. 

Finally, the proposition from the PSF to leverage exclusion criteria applicable for the PAB/CTB would increase consistency across the sustainable finance framework. Finance Watch also acknowledges that the proposed adjustments, in particular the exemption of certain green bonds from the exclusion criteria, could help finance the transition of companies in particularly harmful sectors while ensuring that the proceeds are well used. However, Finance Watch notes that the adjustments must be consistent with the adjustments proposed by ESMA  in its Q&A on the fund naming guidelines. 

B. Transition-focused category: credible targets and engagement

Engagement is a fundamental tool for financial institutions to enable the transition. This lever is well recognised by the PSF, which emphasised the importance of engagement transparency. However, to ensure a credible transition strategy, engagement should be systematised so that FMPs can monitor the existence of science-based transition targets, their credibility and their achievement. Engagement with investee companies in case of deviation from credible targets and escalation policies (with divestment as a last resort) should therefore be mandatory, including for ETFs tracking a PAB or a CTB.   

III. A trade-off between identifying DNSH and harmful products

A. ESG collection products: the limits for investors to identify harmful products and only exclude them from their investment universe

While Finance Watch recognises the interest of identifying non-harming strategies to answer retail client preferences, it identifies important limits in the PSF’s approach:

1. The name of the product category proposed by the PSF is not intuitive and rarely used by investment firms, which will necessarily lead to confusion. 
2. It is likely that this category would be perceived by retail investors as greener than it actually is. This can be exacerbated by the intention of investment advisors to simplify explanations for their retail clients. 
3. The category will still not allow an exhaustive distinction between harmful products and other products. While FMPs may voluntarily categorise products under the ESG collection category, unclassified products will not necessarily be harmful. As a result, advisors could encourage retail clients to invest in unclassified products under the rationale that ESG considerations could be integrated. 

Therefore, Finance Watch supports the creation of a harmful category that would facilitate the distinction between ‘grey products’ and harmful products. Alternatively, the Commission could, at least, introduce a warning in the PRIIPs KID for harmful products. 

B. Harmful products: the challenges to respect client preferences

The creation of a harmful category would switch the perspective from the FMPs’ investment strategy to the investors’ strategy. An ESG collection category would reflect a DNSH investment strategy from the perspective of the FMP while the creation of the harmful category would enable retail investors to apply the DNSH strategy at the level of their portfolio. This would result in the possibility for the client to exclude harmful investments only, and not all unclassified products. 

Nonetheless, this approach will also come with operational challenges, in particular for investors interested in private equity funds. Identifying harmful products would indeed require assessing the actual composition of the portfolio, making this evaluation impossible before investors commit to investing in the private equity product. 

The criteria for a product to fall under the harmful category could also foster the development of a transition-focused category. By creating an overlap between the minimum criteria defined under the transition-focused category and the harmful category, the Commission could incentivise FMPs to opt for engagement to categorise their product as transition-focused. For example, the PSF proposed to apply exclusion criteria for the transition-focused category based on the CTB exclusions. Therefore, the harmful category could apply criteria based on the PAB exclusions, which are stricter. As a result, the harmful category would cover a broader range of products, with some of them being eligible for the transition-focused category. 

For example, products that invest in companies that derive 10 % or more of their revenues from the exploration of oil fuels (part of the PAB exclusions but not the CTB exclusions) would be considered as harmful, unless engagement actions (among others) are taken. In this case, the product could be categorised as transition-focused. Oppositely, a product that would invest in controversial weapons (part of the CTB and PAB exclusions) would be considered as harmful and could never fall under the transition-focused category. 

IV. The integration of impact

A. Initial considerations

The contribution to impact will largely depend on investors’ capacity to influence the behavior of their investee companies, which is triggered by the type of investments they are making. Investing in primary markets, which consists in injecting capital directly in companies to support their development, provides stronger levers for investors to effectively engage with companies. Usually, FMPs focusing on impact contribution invest in private equity, private debt or venture capital, as such investments generally involve holding a higher percentage of shares in companies. This, in turn, increases the potential to influence their strategic direction and engage with companies. Such investments are usually made through alternative investment funds (AIFs) or non-regulated funds, which are not accessible for most retail investors. The integration of impact contribution will therefore have little contribution to the objective of allowing retail investors to express their sustainability preferences and could complexify the categorisation scheme. 

Nonetheless, the recognition of real-world impact from asset managers would contribute to fostering transparency and better embarking impact finance stakeholders who warned of the misalignment between the SFDR quantitative criteria and their own investment decision-making process. Finance Watch also noted that the ESMA fund naming guidelines do not make a sufficient distinction between the use of “sustainability”/”transition” terms and the use of “impact” terms, which could lead to impact-washing practice.

B. The limits to normalising the notion of impact contribution

An important challenge will also be heterogeneity of the investment decision processes and the assessment of impact, beyond the broad recognition that impact investing should respect the principles of additionality, intentionality and measurability. Asset managers have developed tailored due diligence processes and impact assessment metrics, leading to practical challenges to define market norms that cover all the relevant approaches without allowing traditional investors to misuse a broad and flexible definition. In that context, adding a negative definition – identifying what impact contribution is not – could reduce the risk of impact-washing without generating excessive burden and jeopardising negotiations for the evolution of the broader disclosure framework.

C. The possible ways to integrate impact

Given the challenges in defining the notion of impact contribution, it is necessary to consider how impact could be integrated in the disclosure framework. This requires answering three key questions, which will guide various approaches for integrating impact. 

Q1: Should the notion of impact be integrated at the level of disclosures or the categorisation system?

The SFDR could introduce voluntary structured or unstructured disclosures at product level, and provide the opportunity for impact-generating products to disclose relevant impact information. Oppositely, the SFDR could introduce, in its new categorisation scheme, a (sub)category that would focus on impact contribution. An alignment of the notion of sustainable preferences with the categorisation scheme would give investors the opportunity to express preferences for investing specifically in impact-generating products. The creation of a specific category would also allow impact-generating asset managers to be part of the SFDR framework without monitoring compliance-driven indicators from the sustainability or transition-focused categories. Nonetheless, such a niche category would mostly cover alternative investments unavailable to retail clients, leading to product availability limitations when considering client preferences. This would also create challenges in explaining the category to retail investors while a disclosure-based integration would simplify the categorisation scheme.

Q2: In the case of the creation of an impact-focused category, should the categories be mutually exclusive?

It should be determined whether a product could fall under both the impact-focused category and another category (e.g. transition-focused). Allowing a combination of preferences would better integrate impact-generating asset managers to the framework and favor the distribution of such products. However, the expected flexibility in defining the notion of impact contribution could lead traditional products to be eligible for categorisation as both impact and sustainability-focused. 

Q3: In the case of non-mutually exclusive categories, should the impact-focused category be a sub-category?

The impact-focused category could be seen as a sub-category of the transition-focused category, in which case the transition-focused criteria should always apply for the impact-focused category. SFDR could also allow both a combination of categories and products solely categorised under the impact-focused category. The creation of a sub-category would reduce the number of overarching categories to simplify the understanding of retail investors. However, it would force impact-generating products to meet quantitative criteria designed for traditional products, which may benefit traditional investors more than impact-focused asset managers. 

While each approach has pros and cons, the challenges in reaching a normalised definition of impact lead Finance Watch to recommend prioritising providing the possibility for all products to disclose impact metrics, and reassessing the situation at a later time. 

Finance Watch also warns that creating an EPC-like metric to disclose impact contribution levels would not meet the transparency objective due to the non-linear distribution of impact contribution. The larger number of UCITS funds focusing on traditional investments, and the binary distinction of impact potential – ‘impact vs no impact’ – rather than a gradual scale of impact contribution would lead traditional products with low impact to reach a rating very close to the rating of products contributing to a much larger impact. 

Vincent Vandeloise, Senior Research & Advocacy Officer at Finance Watch

[email protected],

+32 2 880 04 37

Appendix

Chart 1: comparison between the recommendations on product categories from the PSF and the initial recommendations from Finance Watch

Chart 2: the possible ways to integrate impact contribution