The European Commission announced today the release of a series of major proposed updates to its Sustainable Finance Disclosure Regulation (SFDR), aimed at helping investors to more easily identify and invest in line with their sustainability preferences, and to simplify compliance and reporting requirements for asset managers and pension funds.

Among the most significant changes to the SFDR proposed by the Commission are the introduction of new categories for funds based on their sustainability or transition characteristics, and reduced disclosure obligations for financial markets participants.

The Sustainable Finance Disclosure Regulation, in application since 2021, sets out how financial market participants, such as asset managers, have to communicate sustainability information to investors, regarding the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products. The goals underlying the introduction of the regulation included helping to attract private funding to facilitate the transition towards greater sustainability, and helping companies pursue transition-related opportunities.

The new proposals follow the launch by the Commission in 2023 of a comprehensive review of the SFDR framework, which the Commission said revealed that the current requirements of the SFDR include   disclosures that are too long and complex, making it difficult for investors to understand and compare the environmental or social characteristics of financial products.

Among the key concerns noted by the Commission was the apparent mis-use of the regulation’s Article 8 and Article 9 disclosure regime as de-facto sustainability labels, which it said may have lead investors to believe that Article 9 funds are necessarily fully sustainable and that Article 8 funds strongly integrate ESG factors, even though this is not necessarily the case, increasing the risk of greenwashing.

To address these concerns, the new SFDR proposal effectively replaces the Article 8 and Article 9 classifications with a new simplified categorization system for financial products making ESG claims, based on three recommended categories, including “Sustainable,” for products contributing to sustainability goals, such as climate, environment or social goals, that already meet high sustainability standards; “Transition,” for products investing in companies and projects that are not yet sustainable, but that are on a credible transition path, or contribute toward improvements in areas such as climate, environment or social areas,, and; “ESG Basics,” for products that do not meet the Sustainable or Transition criteria, but integrate ESG investment approaches, such as those focused on best-in-class performers on a given ESG metric, or those excluding the worst ESG performers.

The new categories would be distinguished on the basis of exclusions, or industries and activities in which the product would not be able to invest, and positive contribution, with a requirement for at least 70% of the portfolio to follow an ESG strategy that matches product’s category, according to the Commission’s proposal.

For example, while both the Sustainable and Transition categories would exclude companies expanding their fossil fuel activities, the Sustainable category would also exclude companies active in fossil fuels or high-emitting energy activities, while the Transition category would have a less restrictive exclusion of companies generating significant revenues from coal. The ESG Basics category would also exclude companies generating significant revenues from coal and each of the categories would share social exclusions, such as companies found in violation of human rights.

The Commission said:

“With the new system, the investment journey is made easier as investors are better equipped to understand financial products making ESG claims. In addition, they will have a clearer understanding of the sustainability objectives and the level of ambition of different products. This will allow better comparability amongst ESG products within the same category and across different categories, also resulting in a higher level of investor protection compared to the current situation.”

The Commission’s new SFDR proposal also includes elements aimed at reducing the compliance burden for financial markets participants (FMPs), such as asset managers and pension providers, most notably eliminating entity-level disclosures under the current SFDR for FMPs wit more than 500 employees to disclose information on their consideration of principal adverse impacts (PAIs) of investment decisions on sustainability factors. Additionally, the new proposed SFDR update would include a significant reduction in disclosures at the product level to focus on data that is available, comparable, and meaningful, and targeted key criteria underpinning the proposed product categories. The Commission added that the revised product-level disclosures would also be more retail friendly, helping investors to quickly and easily understand the sustainability features of financial products.

The Commission said:

“The amended rules proposed today will result in simpler and more usable information for investors, enabling them to make better informed choices. Providers of financial products will see a reduction in disclosure requirements, enabling them to cut costs. Together, today’s changes will bolster the EU’s leading role in sustainable finance and the competitiveness of its financial sector.”