SFDR: what’s next?

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From January, fund managers with sustainable products face stricter disclosure standards - but the data challenges remain.

The next milestone on the long road to the implementation of the EU Sustainable Finance Disclosure Regulation (SFDR) arrives in January 2023.

Specifically, from the new year, firms face more detailed sustainability disclosure obligations at the product level.

The SFDR Level 2 regulation means that a fund claiming Article 8 or Article 9 status will have to describe why it meets the relevant criteria (promotion and objectives of environmental and/or social characteristics respectively) and how that is measured. It will have to do this using SFDR Regulatory Technical Standards (RTS) templates.

Managers already concerned with SFDR compliance will also have to conduct an assessment to measure the product's alignment with the EU Taxonomy, the EU's classification system for sustainable activity for funds classified as Article 8 with sustainable investments and Article 9 if the fund considers Taxonomy eligibility.

The new measures are a step in the right direction, in that they start to put Europe's Sustainable Finance Action Plan (SFAP) into a shape that alternative funds can understand.

However, major challenges remain - and not only around understanding the blizzard of connected acronyms and how they interact.

One of the most pressing issues, as we've previously pointed out, will be collecting the right data for Article 8 and Article 9 compliance.

When does SFDR come into effect?

Regarding data collection, many fund managers worry that the timeline of measures is confusing and contradictory.

The SFDR Level 2 disclosure rules are being implemented before the Corporate Sustainability Reporting Directive (CSRD).

The CSRD introduces extra obligations on companies to measure and report ESG data. It extends the scope and reporting requirements of the Non-Financial Reporting Directive (NFRD).

CSRD eventually aims to cover around 50,000 European businesses - but not until at least January 2024. Until then, fund managers with products that claim Article 8 or Article 9 status will have to coordinate with their portfolio companies for the relevant data.

In addition, sustainability information for private companies can be challenging to source if not subject to NFDR and, now as of recently, the CSRD. The feeling among many fund managers is that CSRD obligations should have been introduced before the SFDR came into force.

Article 9: now more difficult to achieve?

On top of that, the European Securities and Markets Authority (ESMA) has written to Brussels for clarification around Article 9 classification.

ESMA stipulates that Article 9 funds must only invest in sustainable assets. Yet the authority says lawmakers need to clearly define how funds are to determine a sustainable investment.

For example, can a fund's holding in a company be considered sustainable if only a portion of the company's activities contributes positively to a social or environmental objective? What if the company is in the process of transitioning to a sustainable model?

The worry is that a lack of clarity will lead to a wave of downgrades as January's stricter reporting standards edge closer and certain SFDR definitions may be subject to change.

Article 8 funds are required to "promote" environmental and/or social characteristics. Article 9 funds make sustainable investment a "core objective". The disclosure requirements reflect those differences, but ESMA believes the rules over what constitutes a sustainable investment are currently not sufficiently defined.

It's all quite confusing for investors, as well as asset managers keen on complying with SFDR. Article 8 and Article 9 classifications are widely viewed as badges of sustainability in the industry, despite ESMA insisting they are not product labels.

Trust issues may arise when investors who deliberately chose a high-impact Article 9 fund end up in a light green Article 8 one. In defence of themselves, asset managers will point to the Regulation's ever-changing sustainability criteria.

Taxonomy alignment: a zero-sum game

To add to the burden on stretched fund managers, taxonomy alignment is far from easy.

Again, this is largely down to a lack of suitable data and complex technical criteria. At the moment, many managers running Article 8 or Article 9 funds are expected to report zero taxonomy alignment, because of data limitations.

This is likely to become less acceptable after January and it certainly isn't a good look for the new disclosure framework.

It's possible amid all this that some managers will decide to take the path of least resistance and downgrade funds with sustainable ambitions to Article 6, products with a non-sustainable strategy.

It is hoped that most will not and will at least try to meet the new SFDR stipulations when they come into force in January.

The rules may be imperfect, but the direction of travel is set. Sustainability is the future of finance.

How Intertrust Group can help

• We offer expert guidance on how to take control of ESG data in your portfolio with 24/7 access to performance data.
• We can help your fund achieve Article 8 or Article 9 classification, based on your strategic goals. We produce a gap analysis and a roadmap to success and work with you to achieve it.
• We support clients across the life cycle of the investment process, using innovative technologies combined with global knowledge and experience.
• Intertrust Group has 70 years' experience providing world-class trust and corporate services to clients around the world. Intertrust Group has been acquired by CSC, the world's leading provider of business, legal, tax and digital brand services, worldwide.

SFDR timeline

March 2021 - SFDR Level 1

December 2022 - Principle Adverse Impacts (PAI) disclosure

January 2023 - SFDR Level 2 RTS

January 2023 - Taxonomy alignment disclosure

January 2024 - CSRD disclosure