A regular briefing for the alternative asset management industry.
It has been clear for some time, including to regulators, that the SFDR – the EU's Sustainable Finance Disclosure Regulation – is not working as intended. Last week, one prominent member of the ESG community described it as a "train wreck", while the European Commissioner for Financial Services confirmed in October that the EU is " learning by doing". The Commissioner's remark was made at a webinar on a recently-launched and wide-ranging consultation – which indicated that the Commission is potentially open to dramatic changes to the underlying framework. (Our detailed note on the consultations is available here.)
Early market engagement with that consultation is vital, of course – the comment period closes on 15 December 2023. But legislative changes are not imminent. Parliamentary elections next year, and the end of the current Commission's term of office, will interrupt the process. No firm proposals will emerge until 2025 at the earliest, and it is hard to predict when they might be finalised and effective. Some estimates suggest that 2028 or 2029 is most likely but, if the new Commission and Parliament prioritise reform, it could be a little sooner.
It is also not clear whether the changes will be dramatic. While purists will argue that the existing framework is fundamentally flawed – and a separate (and new) disclosure and labelling regime would be preferable – others will argue that, for better or worse, evolving the existing rules will create less disruption, confusion and cost than starting again. Like the motorist who stops to ask a passer-by for directions and is given the unhelpful advice: "If I were you, I wouldn't start from here", the Commission may be stuck with SFDR 1.0 as its point of departure.
The French regulator seems to think so. Earlier in the year, the AMF published a position paper advocating that the current Article 8 and Article 9 classifications be retained. The regulator argued for additional minimum standards to bolster those classifications, and wants more clarity around some of the fundamental concepts embedded in the SFDR – most notably, the definition of "sustainable investment". Perhaps that suggests evolution rather than revolution.
The market also seems opposed to radical reform. During the Commission webinar on 10 October, a poll of 697 participants indicated a preference for building on the current SFDR Article 8 and Article 9 classifications, rather than for developing a separate, stand-alone labelling regime. Many private markets fund managers have expressed similar sentiments: they are conscious of the investment made in designing and promoting products using the current framework and are reluctant to tear it up.
... labels are tough to define and carry with them significant downsides: for example, the necessity to draw hard lines around portfolio composition may restrict investor choice and inhibit innovation.
There are other voices, though. Some argue that the UK proposals – finalisation of which is imminent – offer a good model. The European Commission seems open to that: one of the options put forward in the consultation document resembles the UK's suggested approach, including in the descriptions of the labels that could adopted. Elsewhere in the EU, the Dutch regulator has recently published a position paper that advocates a parallel disclosure and labelling regime, with basic disclosures being applicable to all products, and labels (and certain terms used in fund names) reserved for those with higher sustainability ambition.
However, as the UK regulator is finding, labels are tough to define and carry with them significant downsides: for example, the necessity to draw hard lines around portfolio composition may restrict investor choice and inhibit innovation. In a rapidly developing and relatively nascent market, that is a real downside.
On the other hand, labels do offer value to retail investors and could be helpful in addressing greenwashing concerns. For that reason, some argue that labels should be specifically designed with retail investors in mind. Although professional investors might take comfort from them, regulators should seek to educate the sophisticated investor market that labels should not be regarded as minimum requirements for a product with sustainability aims. After all, those investors have the resources and expertise to properly interrogate a manager's specific sustainability strategy and investment policy.
Although new rules are some years away, now is a good time to influence the Commission's thinking. And it will be important to remember that the voice of the private markets will just be one of many: it will be critical that – whichever path is ultimately chosen – the issues that are specific to alternative asset managers are heard loudly and clearly by the policymakers. For example, private funds tend to invest in unlisted assets during an investment period that lasts for years, they can't predict exactly what assets they will acquire during that period, and they cannot quickly sell assets to re-balance portfolios. Private funds also tend to have a limited range of products, raised globally from a broad professional investor base, and therefore need to balance conflicting ESG expectations – and inconsistent regulations – in different jurisdictions. These features may distinguish private funds from public funds, but should not disqualify them from using labels.
There are reasons to be hopeful that the SFDR will improve. When and how it will change remains very unclear – and whether the process will herald SFDR 2.0 or something less radical is very much up for grabs.
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