The ESAs urge the European Commission to consider a labelling rather than a disclosure regime to help consumers understand the sustainability goals of financial products.

By Nicola Higgs, Jaime Martin, Sara Sayma, and Charlotte Collins

On 18 June 2024, the European Supervisory Authorities — the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA), and the European Securities and Markets Authority (ESMA), collectively the ESAs — published a joint opinion on the Sustainable Finance Disclosure Regulation (SFDR).

In the opinion, the ESAs suggest that the European Commission should replace the current SFDR disclosure framework with either voluntary product categories, sustainability indicators, or a combination of both, to help consumers understand the aims of financial products such as investment funds, life insurance, and pension products. The ESAs also propose a number of other improvements to the regime.

The ESAs emphasise the issues experienced with the current SFDR disclosure regime (discussed below) and how investors find current disclosures “complicated and hard to read”. The ESAs are thus advocating an approach that focuses on clear, simple, and concise consumer-facing information that would allow investors to appreciate the sustainability goals of relevant financial products. They also urge the Commission to carry out robust consumer testing when developing any potential policy options, to try to ensure that any suggested changes would improve the regime in practice.

Product Classification

While the SFDR was designed to enhance transparency around sustainability, the ESAs note that, in practice, the disclosure regimes under Article 8 and Article 9 of the SFDR have instead been used as product labels. It is widely accepted that the use of such disclosures as a labelling regime has caused confusion and posed greenwashing and mis-selling risks.

The Commission has acknowledged these problems and suggested two options in its September 2023 consultation on the SFDR: developing the distinction between Article 8 and Article 9 products more clearly, or introducing product categories based on investment strategies (see this Latham blog post).

The ESAs firmly back the second option, suggesting that replacing the current Article 8 and Article 9 disclosure regimes with product categories would improve consumer understanding. The ESAs emphasise that the categories should be simple with clear objective criteria or thresholds, to facilitate investors’ understanding of the key characteristics and objectives of the product, uphold the integrity of the categories, and build investor trust. The ESAs suggest two categories that could be used as a starting point: “sustainability” and “transition”. These categories would be voluntary, although the ESAs propose that the Commission could test a mandatory regime. The ESAs also emphasise that the categories would be based on minimum criteria and so would not represent only “best in class” products.

Sustainable Products

The ESAs recommend that this category would be for products that invest in economic activities or assets which are already environmentally and/or socially sustainable. They suggest that, if the Commission takes this forward, the Commission considers whether to split this into separate environmental and social categories. The ESAs propose that the minimum threshold for environmentally sustainable products should be based on investments in taxonomy-aligned economic activities, but they do not indicate a potential percentage threshold in their opinion. They recommend that the portion of the investment that does not count towards the minimum threshold should at least comply with the “do no significant harm” principle and good governance requirements, provided that these concepts are more clearly defined.

Transition Products

This category would include products that invest in economic activities or assets that are not yet sustainable, but which improve their sustainability over time to become environmentally or socially sustainable. The ESAs recommend the Commission considers carefully what proportion of a product’s investments should initially comply with the requirements of this category, considering that this proportion may increase over time. The ESAs propose that there should be appropriate transparency obligations so that investors are provided with clear information on the level of ambition regarding sustainability, and how the investment strategy delivers on that ambition. The ESAs do not consider it necessary to apply the “do no significant harm” principle, acknowledging that products in this category may invest in activities that are in the process of transitioning. They also suggest the Commission considers whether it would be desirable to include an “investor’s impact” sub-category.

Interestingly, the two categories that the ESAs propose represent a more simplistic approach than the four labels the FCA is introducing under the UK Sustainability Disclosure Requirements (SDR) and investment labelling regime (see this Latham Client Alert). However, these categories are suggested as a starting point only and the Commission would of course be free to develop more granular categories if it were to take this proposal forward.

Disclosures and Marketing

The ESAs propose the following requirements, depending on whether a financial product meets the criteria for a sustainability category, or otherwise has some sustainability features:

Type of financial productDisclosure and marketing requirements
Category products– Disclosures in regulatory documentation appropriate to the category
– Naming and marketing consistent with category
Products that have some sustainability features but do not qualify for categories– Limited disclosures in regulatory documentation on sustainability features
– Restrictions on naming and marketing
Products with no sustainability features– Minimal disclosures on adverse impact on sustainability
– Disclaimer to make clear that product has no sustainability features
– Restrictions on naming and marketing

In contrast, the UK SDR only imposes disclosure requirements and naming and marketing requirements for products which either qualify for a label, or which do not qualify for a label but have sustainability characteristics. The UK regime does not impose requirements on products with no sustainability features, although all firms must comply with the FCA’s anti-greenwashing rule.

Sustainability Indicators

The ESAs also suggest the potential use of sustainability indicators, like those used for Energy Performance Certificates (illustrated in the diagram below), for financial products. They propose that these indicators could be used as an alternative to, or in combination with, product categories. These indicators could refer to environmental sustainability, social sustainability, or both, illustrating to investors the sustainability features of a product in a scale. The ESAs propose that any grading system should rely on clear and objective criteria, and should be tested by the Commission to help ensure investors can properly understand it.

The ESAs acknowledge that the use of such a system has both potential benefits and drawbacks. While its simplistic approach would be easy for retail consumers to understand, it could also risk oversimplifying what can be quite a nuanced judgement, leading to binary and misleading results. The ESAs suggest that the Commission tests three different regimes to see what works best:

  • A framework based only on product categories
  • A framework based only on a sustainability indicator
  • A combination of product categories and a sustainability indicator

Annex II to the opinion sets out the potential treatment of a number of hypothetical financial products to illustrate how the different categorisation options and indicators would operate in practice. The diagram below serves as a useful summary of the ESAs’ proposals.

Definition of “Sustainable Investment”

The ESAs recommend that, given divergent interpretations of the definition of “sustainable investment” under Article 2(17) of the SFDR, including following the Commission’s clarificatory Q&A, the Commission should consider making the key parameters of the definition prescriptive rather than principles-based. However, the ESAs highlight that, depending on the development of a categorisation system or sustainability indicators, such a definition may not be necessary in the longer term.

The ESAs also emphasise the difficulties with the coexistence of the two parallel concepts of “sustainable investment” as defined in the SFDR and “Taxonomy-aligned investment” as defined under the EU Taxonomy. They suggest that, as a minimum, the Commission should clarify the relationship between these two concepts. The ESAs also urge the Commission to prioritise completing the EU Taxonomy and extending it to social sustainability, as this would provide a key baseline against which to measure financial products. In the meantime, the ESAs propose that the Commission could amend the definition of “sustainable investment” to reference the EU Taxonomy for disclosures on environmental sustainability and to use appropriate sustainability metrics for other activities, including social sustainability.

Sustainability Disclosures

The ESAs strongly recommend that the Commission ensures that sustainability disclosures cater to different investor needs, and improvements in sustainability disclosures should take into account different distribution channels, including digital ones. The ESAs consider the Commission should focus on only very simple disclosures for retail investors, with additional detail for more sophisticated investors. The ESAs also suggest that, if product categories and/or sustainability indicators are implemented successfully, sustainability disclosures might not need to be as detailed and extensive.

The ESAs also encourage the Commission to consider consistency between SFDR disclosures and other disclosure documents, such as the PRIIPs KID, in order to aid comparability and consumer understanding.

Scope of the SFDR

The ESAs propose that the Commission could carefully reflect on whether to introduce standardised sustainability disclosure requirements for products currently outside the scope of the SFDR. By way of example, the ESAs highlight the fact that some types of structured products currently fall within scope of the SFDR, while others do not.

Adverse Sustainability Impacts

The ESAs highlight that, despite Commission Q&A on this topic, there is still much uncertainty concerning the disclosure requirements around principle adverse impacts (PAIs), particularly what “consideration” of PAIs entails. The ESAs recommend that the Commission should introduce requirements to disclose “information” on PAIs, and could then make consideration of PAIs mandatory for products in the sustainable category and information on PAIs mandatory for products in the transition category. Provision of information on PAIs would not include a requirement to mitigate those PAIs. The ESAs also propose making some minimal disclosures on PAIs mandatory for all financial products.

Other Changes

In Annex I to the opinion, the ESAs set out several other technical changes that the Commission could address as part of its review of the SFDR, based on their own observations and the feedback they have received on the SFDR. These include, for example, clarifying the interaction between reporting under Articles 3, 4, and 5 of the SFDR and CSRD reporting, and harmonising required website disclosures.

Next Steps

The opinion was delivered at the own initiative of the ESAs (meaning it was not requested by the Commission). Reviews of the SFDR and related Regulatory Technical Standards are ongoing, although their timing and status is currently uncertain and will be determined by the new European Commission.

The ESAs strongly encourage the Commission to undertake consumer testing when developing policy options, in order to have a stronger evidence basis for changing the regulatory framework and ensuring more successful outcomes. The ESAs also recommend a public consultation to gather industry feedback on any potential changes.

Market participants will no doubt hope that improving the SFDR framework and making it more practical and useable will be a priority of the new Commission.