Lewis Davison, Senior Product Manager at Confluence, writes that it only feels like yesterday since the European Union’s Sustainable Finance Disclosure Regulation (SFDR) came into force, particularly the product-level disclosures applicable from January 2023. However, as we look ahead into 2025, numerous changes to the framework are already expected.
Where SFDR falls short
The formation of SFDR quickly followed the European Commission’s Action Plan on Financing Sustainable Growth. While transformative, it left room for improvement, with concerns emerging around the precision, impact and usefulness of the regulation.
One major critique has been SFDR’s lack of precise definitions, raising questions about its ability to direct capital toward sustainable investments. Its product-neutral design has led some to question whether it should include mechanisms to incentivise sustainable finance more effectively.
Moreover, SFDR’s disclosure templates are overly complex, making them difficult for end investors – particularly retail investors – to understand. Simplifying these templates should be a priority in future updates.
Another shortfall of the regulation concerns unintended consequences. Despite not being its plan, SFDR has inadvertently become a de facto product labelling regime. Additionally, lack of clear fund classification criteria has led to concerns over greenwashing, where funds exaggerate their environmental credentials, and even more concerningly, green bleaching, where funds understate their sustainable practices.
Regulatory arbitrage has also emerged, with asset managers weighing the costs and benefits of categorising funds under Article 8 or Article 9. This has led to outflows from Article 9 funds and a higher prevalence of Article 8 funds.
A final criticism of SFDR is its binary focus on whether an investment is sustainable or not, overlooking the broader transition finance needed to meet sustainability goals.
Estimates suggest that around EUR350 billion more per year is required this decade to reach the EU’s 55 per cent reduction target in GHG emissions by 2030 compared to 1990 levels. The majority of the market is not already sustainable, and more focus needs to be put toward the transition finance space to direct the needed capital.
Future proofing sustainable finance
In light of some of these challenges, the European Commission and European Supervisory Authorities (ESAs) appear receptive to feedback and we hope to see targeted changes to ensure sustainable finance receives the support required to thrive.
Improved definitions
The lack of a precise definition for ‘sustainable investment’ has been a major issue. Anticipated updates will align SFDR definitions more closely with the EU Taxonomy. However, practical application – such as the calibration of criteria and thresholds – will be critical to success.
Framework alignment
Better alignment between SFDR and the Corporate Sustainability Reporting Directive (CSRD) is expected, particularly for entity-level disclosures. While these frameworks will remain distinct, there is hope that their disclosures will complement each other more effectively, easing compliance for market participants.
Simplified disclosures
The ESAs have proposed simplifying SFDR’s pre-contractual disclosures. However, these simplifications should be consistent across periodic disclosures to maintain clarity.
Introduction of labels
One of the most noticeable changes expected is the current reliance on Article 8 and 9 classifications as informal labels. Alignment with the UK’s SDR framework introducing categories such as ‘sustainable’ and ‘transition’ would be welcomed by cross-border managers navigating both frameworks.
Overall sustainability indicator
A proposed ‘bottom-line’ sustainability indicator could enhance the clarity of disclosures. This might include metrics such as financed emissions or decarbonisation targets, presented in an intuitive format like colour coding or letter grades.
Mandatory PAIs for sustainable funds
There is potential for mandatory disclosure of Principal Adverse Impacts for funds classified as sustainable. This baseline set of metrics could standardize reporting and improve comparability.
Looking ahead
The next major milestone for SFDR will be the Level 1 review proposal, expected around mid-2025, aligning with ESMA’s sustainable finance implementation timeline.
As these changes take shape, asset managers must stay informed and adapt to evolving regulatory expectations.
