SFDR 2.0: What alternative asset managers need to consider before January 2025

The EU Commission has recently closed its consultation period on the current Sustainable Finance Disclosure Regulation (SFDR) directive and is expected to announce its amendments later this year. 

In this article, Hatim Baheranwala, Cofounder & CEO of Treety, Ocorian’s ESG reporting partner discusses what these might be and how alternative asset managers can start preparations for more stringent ESG reporting ahead.

Why is the European Commission considering updating its SFDR in 2025?

The Sustainable Finance Disclosure Regulation (SFDR), implemented by the European Commission in 2021, was originally designed as a ‘disclosure’ regulation. Its aim was to provide investors with the details they need to assess the sustainability of their investments themselves.

However, the initial approach of avoiding definitions for terms like "sustainable investments" and "environmental & social characteristics" backfired during implementation. In practice, Articles 6, 8, and 9 of the SFDR started functioning as de facto labels. This, along with the regulation's complexity, caused confusion among many market participants, especially retail customers.

Recognising these issues, the EU Commission launched a formal review of the SFDR in the second half of 2023. This review aimed to assess the effectiveness and compatibility of the current rules. It involved gathering feedback from market participants and extensive consultations with national regulators from EU member states. The consultation period closed on December 15, 2023.

Based on this feedback, we expect amendments to the structure of the SFDR and its related technical standards.

While these changes likely won't take effect before 2025, asset managers should consider the following questions to stay prepared:

What are the key expected changes in the next SFDR update?

While the final details of the SFDR update haven't been released, the consultation process offered some clues about what to expect. Here are some of the key anticipated changes:

• Stronger disclosure requirements: The update is expected to require more granular information on sustainability factors considered in investment decisions, portfolio characteristics related to sustainability objectives, and the impact of investments.
• Taxonomy alignment: The EU Taxonomy for sustainable activities is expected to play a more prominent role in SFDR classification. Products labelled "Article 8" (promoting environmental or social characteristics) or "Article 9" (sustainable investment objective) will likely need to demonstrate a stronger alignment with the taxonomy.
• Sustainability risks: The concept of "sustainability risks" is likely to receive more focus. Disclosures might need to elaborate on how these risks are integrated into investment processes and risk management frameworks.
• Principal Adverse Sustainability Impacts (PASI): More emphasis might be placed on disclosures regarding Principal Adverse Sustainability Impacts (how investments negatively affect environmental or social goals). Reporting on engagement activities with companies on these issues could also be required.
• Product labelling: The existing SFDR labels (Articles 8 & 9) might be revised or supplemented with new categories to offer more clarity and comparability between different products.

Will the scope of who SFDR applies to be broadened?

SFDR is here to stay for all EU financial investors. There's no indication of any significant change in scope on who the regulation applies to. Currently, it covers all financial market participants and advisors operating in the EU.

The EU has not signalled any intention to roll back the regulation, and on the contrary, the wider expectation is that many of the reporting requirements will be made broader. This means they might even apply to financial market participants who don't promote themselves as "sustainable."

The goal of updating SFDR is to create a level playing field. Sustainable asset managers shouldn't be penalised with additional disclosure and that most disclosure requirements will apply to everyone equally.

How will reporting standards change?

The upcoming Corporate Sustainability Reporting Directive (CSRD) is prompting the European Union (EU) to consider aligning reporting requirements between CSRD and SFDR, particularly at the entity level.

The French financial regulator (AMF) even proposes dropping entity-level disclosures under SFDR entirely, allowing them to be covered by CSRD. If this position is adopted by the European Commission, SFDR reporting would focus solely on financial products.

Another potential change involves standardising sustainability reporting across all financial products. This would mean some level of ESG reporting would be mandatory for all asset managers, regardless of whether their products fall under Article 6, 8, or 9. The minimum disclosures for all products would likely cover:

• Sustainable risks: These would be considered applicable by default and must be reported.
• Justification for sustainability claims: Any sustainability claims made during marketing would require clear justification.

Are there plans to introduce new labels for financial products under SFDR?

Yes, this is a possibility. During consultations on SFDR, regulators in France (AMF) and the Netherlands (AFM) called for a formal labelling system for funds. This would help address the challenges retail investors face when trying to understand a financial product's focus on sustainability.

Their proposal involves replacing the current system of classifying disclosures under Articles 6, 8, and 9 of SFDR. There are similarities to the labelling systems being proposed in the UK's Sustainable Disclosure Requirements (SDR). Since EU and UK regulators are consulting with each other, it's likely they will try to harmonise an approach to labelling across both regions.

Will the PAI (Principal Adverse Impact) statements change after the SFDR consultations?

Yes, changes to PAI Statements are likely following the SFDR consultations. The European Supervisory Authorities (ESAs) have proposed amendments to the SFDR's technical standards. These amendments include:

• Expanding the list of social impact indicators considered in PAI assessments.
• Refining the way PAI disclosures are presented.
• Introducing requirements to disclose greenhouse gas (GHG) emission reduction targets.
• Strengthening disclosures on compliance with the "Do No Significant Harm" (DNSH) principle.
• Revising the rules for reporting on Multi-Option Products (MOPs).
• Various technical adjustments.

If these changes are adopted, we can expect new reporting templates for entities required to report under SFDR. This means entities choosing to report PAIs would need to consider and report on a wider range of potential impacts.

When can we expect the final SFDR amendments?

The European Commission is currently reviewing the proposed amendments from the European Supervisory Authorities (ESAs) and national regulators. They have a set timeframe to make any changes, then send the updated regulation to the European Parliament and Council for a further review period (expected 2-4 months). Once approved, the final regulation will be published and come into effect 20 days later.

Market expectations are that the final amendments will be adopted and implemented sometime after January 1st, 2025. However, an earlier implementation date is also possible.

The full extent of the changes is yet to be determined, but based on the recommendations, it's highly likely that additional reporting requirements will be added to the existing disclosures.

How can you get ahead of upcoming changes to SFDR regulation?

It's important to note that the potential changes discussed in this article are based on the consultation process and the final update from the European Commission might differ.

We recommend staying up to date with official channels from the European Commission.

As there is a strong possibility of additional reporting requirements being added to the existing disclosures, we recommend that all alternative asset managers review their ESG & sustainability reporting processes.

At Ocorian, alongside our fund administration services, we provide ESG reporting through our partnership with Treety, ESG reporting specialists in the alternative investment space.

We also have a team of ESG experts in our regulatory and compliance division to help you assess the impact SFDR on your business and ensure you are well placed to implement each of the amendments when they come into force.

Please contact us for a free demonstration of our ESG reporting or a consultation with one of our ESG specialists, including to discuss any additional ESG requirements, such as investor level or board reporting requirements.