The EU’s Sustainable Finance Disclosure Regulation (SFDR) is unquestionably one of the most complex implementation projects asset managers operating in Europe have ever been tasked with. That’s saying something, especially for those who were involved with planning for AIFMD, MIFID 2, or Brexit.

We have previously flagged the reasons for the complexity of SFDR. But for the uninitiated, SFDR includes aggressive and mismatched implementation deadlines, data scarcity, and rigorous and complex rules that many will find difficult to adhere to. And the fact that the SFDR interacts with other EU ESG rulesets, such as the EU Taxonomy Regulation and Corporate Sustainability Reporting Directive (CSRD), only adds to the complexity. The ill-fitting timeline for these regulations also presents implementation challenges. There are several parts of the EU ESG puzzle which are interrelated and interdependent so not having them conducted in proper sequence makes the challenge all the more demanding.

Hindsight is a great thing, however, knowing what we now know, the staging of the EU ESG rollout would have been easier if the ordering had been conducted like so: 

1. CSRD.  CSRD would compel issuers to first disclose ESG and other material non-financial data to the market thereby creating a standardized base of ESG data.
2. EU Taxonomy. A standardized terminology, weighing, and measurement formulae fund managers could then universally use d for disclosures.
3. SFDR. Would create standardized disclosures based on best available ESG data as prescribed by regulations.

Life is, of course, imperfect.  The EU has framed a comprehensive multi-layer regulatory package. The societal and political will mean that things needed to move fast on a very challenging and ambitious policy agenda as the climate emergency globally continues to become more urgent.

The ill fitted staging of the EU ESG rollout has led to much confusion on the different area of the EU’s ESG regulations. The Level 1 disclosure requirements of SFDR were possibly the easiest part of the journey and while the oft used expression “a good start is half the battle” remains true in the case of SFDR, most asset managers remain far from at the half way point.

The recent July 8 announcement of a six-month delay from January 2022 to July 2022 to the detailed Level 2 disclosure provisions for pre-contractual and annual reporting disclosures was pragmatic realization by the EU policymakers that moving too fast will result in additional problems. This is a small but welcome relief as asset managers continue to grapple with the vastness and complexity of the overall SFDR project.

It is not just asset managers and banks struggling with the nuances of the rules. The policymakers themselves have been engaged in some to and fro as questions and uncertainties remain. The ESG rules are so complex that even the regulators have questions on various elements of the proposals. The entire industry waited with bated breath for responses from the European Commission (EC) to several key questions posed to them by ESMA after a period of interactions with industry.

Then last Monday, the European Commission replied by releasing a questions and answers document which aimed to address a few identified SFDR issues and uncertainties flagged by ESMA in a letter earlier this year. Initial industry reaction to the European Commission’s responses are that they are helpful in some regards but remain uncertain and confusing on several important issues.

Regarding the classification of funds as Article 8 funds, one major area of bemusement has been the definition of what it means to “promote” ESG characteristics.  The commission responses suggests that a fund can be classified as an article eight product if it “complies with certain environmental, social or sustainability requirements or restrictions laid down by law” and makes sure these factors are “‘promoted’ in the fund’s prospectus investment policy. It’s fair to say that the   definition of ESG remains a little vague. It also shows that despite the extremely high degree of prescription in SFDR, there are still crucial areas which remain highly subjective and open to a wide spectrum of interpretation.  This has led some to speculate that the rules might need to be tightened even further in the near future.

The Q&A also attempts to address the industry reservations around the applicability of the rules to non-EU alternative investment fund managers. The response suggests that information on the sustainability of a non-EU alternative investment fund (AIF) should be “included in pre-contractual and periodic documentation made available to end investors under national law.”  However, the method by which EU member state regulators extend AIFMD provisions to third country asset managers remains slightly inconsistent.  Without consistency, it is possible that non-EU AIFs have less onerous SFDR obligations than funds domiciled within the EU.  This is the classic unlevel playing field and an area which will likely be revisited.

In summary, the devil is in the details when it comes to SFDR and it seems like the assessment and iterative change to this significant regulation will continue for the foreseeable future. Should you wish to discuss SFDR, EU Taxonomy, CSRD, or any of the global ESG policy changes that are in flight please feel free to get in touch to discuss.