The SFDR—Seriously Unfinished Business Meets a Host of New Developments

In less than a year, with unprecedented acceleration and accretion, the European Union’s (EU’s) ESG regulatory regime has gone from an aspiration of policy drivers to one of the fundamental pillars of EU financial regulation.

Unfortunately, in the rush to get the regime on the statute book, several practical problems have emerged. These problems have started to intersect with new developments and together they are modifying central aspects of the ESG regulatory landscape.

This article explores these developments that principally affect the EU’s ESG regulatory disclosure regime, which is comprised of:

• The Taxonomy Regulation
• The Non-Financial Reporting Directive (NFRD)
• The Sustainable Finance Disclosure Regulation (SFDR)

We’ll commence with an overview of this disclosure regime before exploring the problems and emerging developments that are affecting it.

The Disclosure Regime

Technically, there are two separate EU ESG regulatory disclosure regimes that loosely mirror each other:

• The NFRD – for corporates
• The SFDR – for "financial market participants" and "financial advisors"

The NFRD requires large EU public corporates to disclose their “non-financial” ESG performance alongside their financial performance (as required under the EU Accounting Directive). The SFDR requires similar non-financial disclosures to accompany the financial disclosures of investments. Both regimes require disclosures in relation to all three ESG factors: environmental, social, and governance.

In between the two regimes sits the Taxonomy Regulation, which establishes a classification system for the E of ESG that must be used in environmental disclosures under both regimes.

The Taxonomy Regulation links the two regimes in a limited way by requiring corporates to disclose environmental data under the NFRD that investment firms must use for their environmental disclosures under the SFDR. There is no equivalent social or governance taxonomy but these have been proposed.

While the Taxonomy Regulation is a large, complex “regime” in its own right (see our recent article for an overview), for practical purposes, its interface with the outside world arguably starts and ends with these twin sets of disclosures.

Moreover, in terms of the SFDR, the Taxonomy Regulation only applies to one of its three disclosure types, and only then, to environmental disclosures within this set of disclosures. Specifically, the SFDR is comprised of the following three separate types of disclosures, and it is the last disclosure type (3) with which the Taxonomy Regulation interfaces:

Data Problems

As noted above, in contrast to environmental disclosures under the Taxonomy Regulation, there is no specific regulatory mechanism designed to classify or facilitate the disclosure of data required to satisfy the S and G disclosure requirements under the SFDR.

In principle, investment firms should be able to rely on the NFRD for the data. However, as the European Supervisory Authorities (ESAs) have acknowledged in their response to the European Commission’s consultation on the NFRD, and again in their consultation paper (CP) on Technical Standards under the SFDR, the NFRD falls short in terms of mandating disclosure of the data necessary to meet the requirements of the SFDR, or the Taxonomy Regulation for that matter.

The problem is not just that the NFRD is inadequately calibrated to deliver the specific data investment firms need to meet their SFDR disclosure requirements; it is also a problem of coverage. The SFDR applies to all underlying investments of financial products—it does not circumscribe applicability by jurisdiction. The NFRD by contrast, only applies on a mandatory basis to approximately 6000 “public interest” EU corporates, representing a mere fraction of many investment firms’ investment universes.

Moreover, there is limited uniformity or specificity to the NFRD disclosures. To achieve compliance, the NFRD simply informs corporates that they may “rely on” national, EU, or international frameworks such as the Global Reporting Initiative, the United Nations Global Compact, the OECD Guidelines for Multinational Enterprises or ISO 26000, “or other recognized international frameworks.”

This matter has been brought up again more recently by the EU Securities and Markets Stakeholder Group (SMSG), in advice to the ESAs on their SFDR CP, in which it is further noted that “neither the timings nor the concepts of these different pieces of legislation are fully synchronized or aligned with one another.” We turn to these timing and conceptual problems next.

Conceptual Problems

In terms of conceptual problems, the SMSG point to several definitional issues around products, and inconsistencies between concepts such as “do no significant harm” (DNSH) in the SFDR and the concept of “significant harm to environmental objectives” in the Taxonomy Regulation.

These concerns build on an already shaky conceptual framework within the regulations, which do not define “ESG” and provide multiple variants of the term “sustainability” that differ subtly depending on the prefix or suffix by which they are accompanied (such as “environmental sustainability”, “sustainability risk”, and “sustainability factors”).

Equally tricky from a conceptual perspective is the fact the Taxonomy Regulation is supposed to establish an “environmental sustainability” framework yet inserts a monolithic set of minimum social and governance “safeguards” by the backdoor as preconditions for meeting the “environmental sustainability” definitional criteria.

Ultimately, the concern here is that these definitional inconsistencies and the attendant lack of conceptual clarity may have consequences in practice that could undermine the efficacy of, and perhaps even confidence in, the broader regime.

Timing Problems

In terms of timing, the SMSG makes a broad argument for a grand synchronization between the upcoming suite of ESG delegated regulatory texts and several other texts currently under review for ESG (and other) purposes including MiFID II, AIFMD, UCITS, and PRIIPS.

While persuasive, this idealism is probably unlikely to cohere with the resource and time constraints on the institutions charged with developing these detailed regulations. These institutions are already under tremendous pressure to deliver an enormous body of delegated legislation under the Taxonomy Regulation and the SFDR, among many other initiatives.

This is further borne out by the recently published letter from the Commission to the ESAs, dated October 20, 2020, which announces that the implementation of delegated legislation under the SFDR has been postponed to an unspecified future date.

Critically, the letter maintains that despite the delay, the SFDR compliance dates will remain the same, since firms can fall back on the general principles in the level 1 text in the absence of any technical requirements having been published. This may come as a relief in some quarters, since the first tract of rules under the SFDR go live on March 10, 2021. However, for others, it just pushes the burden further down the road to a time when several other regulatory obligations fall due.

Nevertheless, notwithstanding these delays, there does appear to be some level of progress on the horizon in relation to the backlog of ESG delegated legislation. This follows the recent publication by the ESAs of a survey on SFDR disclosure templates, the publication of a consultation paper on the NFRD disclosure supplements specified in the Taxonomy Regulation, and the publication of a 529-page draft of the first tranche of delegated legislation under the taxonomy (the latter of which is due for adoption by December 31, 2020).

New Proposals

Against this broader backdrop, with a regime dogged by conceptual and practical problems and with a backlog of work and delays, one might have expected the relevant institutions to have shown a degree of reticence before suggesting further development of the ESG regulatory regime.

However, this appears not to be the case, as the ESA’s letter in support of the Commission’s Consultation on a renewed sustainable finance strategy shows. This letter contains a litany of proposals for more ESG regulation, such as requirements for new social and governance benchmarks, new regulatory regimes for green bond verifiers, and ESG “rating agencies” analogous to the regulatory regime currently applicable to credit rating agencies.

The ESAs also once again re-emphasize the need to expand the NFRD to address the missing data required by the Taxonomy and the SFDR.

In addition to these proposals, there are several other “in-flight” developments intersecting with the ESG financial regulatory landscape that also need to be monitored. These include proposals for supply chain due diligence measures (see also the Commission’s study on this topic) the adoption of a new Commission climate adaption strategy (see also the EU Climate Adapt Platform), proposals for a new EU climate law, a consultation on improving the EU corporate governance framework, and another consultation on proposed measures that would require corporates to substantiate claims made about the environmental footprint of their products and services using standardized metrics.

In short, there is a prodigious pipeline of “phase II” ESG developments and the delayed publication of delegated legislation under the SFDR could cause implementation gridlock for investment firms over the next few years.

Upcoming Compliance Deadlines

Notwithstanding the various problems outlined above, on March 10, 2021, the first set of SFDR rules will go live. Measures include requirements to publish details of policies on the integration of sustainability risks in the investment decision‐making process and on the adverse impacts of investment decisions on sustainability (ESG) factors.

From the same date, for products promoted as sustainable or based on their ESG characteristics, investment firms will also have to publish on their website and in specified pre-contractual documents details of how a product meets the ESG claims attributed to it.

These product disclosures must include details of any methodologies, screening criteria, reference benchmarks, and sustainability indicators used as well as the source of relevant data. Where applicable, firms will also need to disclose product-level details of how sustainability risks are integrated into investment decisions and “the results of an assessment of the likely impacts of sustainability risks” on returns.

From January 1, 2022, for products marketed on environmental grounds, the product disclosures above must be supplemented with details of the product’s alignment with the EU Taxonomy Regulation’s first two environmental objectives (on climate change and climate adaption). The counterpart disclosures for an additional four environmental objectives in the Taxonomy Regulation apply a year later.

In addition, from January 1, 2022, firms will have to commence disclosing information in periodic reports on the performance of products in relation to ESG claims made about them. These disclosures must be taxonomy aligned for any environmental claims (again, starting with the first two Taxonomy Regulation objectives, with the counterpart rules relating to the remaining four objectives applying a year later).

Conclusion

The ambitious and yeomanlike enterprise shown by the EU in developing this formidable body of rules is already yielding normative effects globally, including the consolidation of various ESG voluntary regimes and the catalysis of other jurisdictions, such as China, the UK, and the U.S., in seeking to adopt similar measures.

Nevertheless, the regime is not without its problems. These are starting to present practical challenges for investment firms as they seek to acquire the various disparate sources of data, and the analytic and reporting capabilities they need to meet the first tranche of requirements under the SFDR.

Even though investment firms can take comfort in the fact that in the short-term they will be operating under a principles-based regime, they should be under no illusions: there are a lot of detailed rules on data, methodologies, and reporting on the horizon, forming just a small part of a much broader suite of ESG regulatory measures that will be released over the next decade. The first tranche of SFDR rules are just the tip of the iceberg.

Nels Ylitalo contributed to this article.