SFDR promotes ESG integration, but its effectiveness in addressing greenwashing risks is uncertain, writes Frédéric Vonner, sustainable finance leader, PwC Luxembourg.
In the quest for a decarbonised future, government spending alone falls short of funding the urgently needed sustainable transformation of the economy, which is why the private sector and capital markets are needed to make up the difference.
However, for capital markets to actively engage in sustainable investing, it is crucial that investments’ ESG characteristics be clearly defined, transparent and reliable. Unveiled in December 2019 by the European Commission, the Sustainable Finance Disclosure Regulation (SFDR) seeks to ensure accurate disclosure of ESG information, safeguard investors from misleading claims and minimise greenwashing risks.
In essence, the SFDR was designed to ensure capital market participation in the green transition is transparent and thus effective. But a cycle of ambiguity and abrupt regulatory changes have limited its impact on catalysing ESG integration.
SFDR: Insufficient to address greenwashing risks?
European regulators are placing greater emphasis on protecting investors from asset managers’ potentially misleading ESG claims. However, the SFDR fails to provide a clear definition of what constitutes such claims and lacks prescriptive guidelines for accurately and precisely characterising sustainable investments.
With serious consequences and risks associated with greenwashing on one hand and the absence of a foolproof way to avoid it on the other, investment fund managers (IFMs) have become more cautious. When ESMA clarified that all Article 9 funds should only invest in assets meeting the definition of sustainable investment, many of such funds were ‘downgraded’ to Article 8 status at the end of last year.
‘SFDR Level II’ – a step in the right direction
In April 2022, the European Commission published the SFDR’s Regulatory Technical Standards (RTS) – colloquially known as ‘SFDR Level II’ – which came into force in January 2023. SFDR Level II brought much-needed clarification to previously ambiguous regulatory requirements as it introduces the RTS and principal adverse indicators (PAI) that asset managers might need to report on, along with formulas for estimating the PAIs.
The ESAs have sought to alleviate the industry stakeholders’ apprehensions about evaluating the sustainability of their investments and have actively engaged in joint consultations to bridge the gap between SFDR II and its practical applications.
Although the RTS are expected to continue to change throughout the year, some industry participants are optimistic, even foreseeing the reversal of some of the cautious downgrades of late 2022. PwC’s SFDR barometer for Management Companies, administered in end-2022, shows that a substantial portion of Luxembourg respondents plan to upgrade funds to a stricter SFDR classification. As a matter of fact, 75% of UCITS IFMs, 57% of AIFMs and 66% of IFMs managing both UCITS and AIFs surveyed are planning to upgrade at least one of their Article 6 funds to Article 8 status.
Regulation continues to evolve
SFDR Level II may have answered some of the industry’s burning practical questions, yet it has decisively dodged the responsibility of systematically characterising sustainable investments.
In February, France’s financial regulatory agency, the Autorité des Marchés Financiers (AMF), echoed this persistent concern in a position paper, stating that “the vague definition of sustainable investment should be clarified to become tangible.”
The modifications made to the SFDR in such a short time span have posed a challenge for asset managers, and IFMs often delegate the increasingly complex task of non-financial reporting to third parties. In Luxembourg, as per the PwC barometer, one-fifth of respondents delegate their entire SFDR periodic reporting to service providers, while a third of respondents requested assurance on their SFDR periodic reporting. Service providers mostly engage in reviewing and collecting ESG data (42% of respondents), and compiling and producing the reports (42% of respondents). Ironically, only 16% of the respondents tasked service providers with the calculation of ESG indicators, which have been the subject of many clarifications by the regulator, whereas the two riskier tasks of data collection and production of reports were mostly unaddressed in recent communications by the ESAs.
Finally, IFMs’ disclosures increasingly require detailed ESG data, which is crucial to calculate sustainability indicators. As the data checklist grows lengthier, it becomes harder to complete and is more scrutinised by regulators.
While the SFDR has been in effect for more than two years, its effectiveness in mitigating greenwashing risks remains inconclusive. The clarifications provided by the ESAs have resulted in widespread fund reclassification, raising concerns about the de facto classification approach. To its credit, the SFDR Level II has addressed practical considerations related to extra-financial reporting, instilling optimism about achieving a more standardised approach to sustainable investing.
However, IFMs now face the challenge of navigating ever-changing disclosure requirements while simultaneously demonstrating their funds’ sustainability credentials. It remains to be seen whether the SFDR can effectively mitigate greenwashing in its current form or if it is only inadvertently contributing to confusion within the ESG investing landscape.
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