SFDR revision: New thresholds for sustainable financial products

The EU Commission in November published its proposal for the revision of the Sustainable Finance Disclosure Regulation (SFDR), which regulates the transparency around sustainability in financial products. The objective is to make the rules simpler and better aligned with market realities, and support the ultimate objective of driving capital toward sustainable activities.

Three product categories

The proposal includes three product categories, and products need to have at least 70% of the assets supporting the sustainability claim, as well as exclude from all their portfolio investments in harmful industries and activities. 

The three categories are:

Transition category (Article 7)

These are products that have at least 70% invested in assets that meet a clear and measurable transition objective, measured using appropriate indicators. These products can include, for example:

• investments in portfolios replicating or managed in reference to an EU climate transition benchmark or EU Paris-aligned benchmark
• investments in Taxonomy-aligned activities either transitional or converting eligibility into alignment
• investments with credible transition plans or with credible science-based targets
• investments with an engagement strategy and defined milestones
• investments with a credible transition target set at the level of the portfolio, e.g. portfolio emissions reduction over time

The product should be compatible with the transition to a sustainable economy and in line with the Paris Agreement. This category should exclude companies developing new projects linked to oil and gas, and companies developing new projects in hard coal or lignite for power generation.

ESG basics category (Article 8)

These include products having 70% of investments integrating the sustainability factors in line with the investment strategy, measured using appropriate indicators. The product can include: 

• investments with an ESG rating that outperforms the average rating of the investment universe
• investments that outperform the average investment universe or benchmark on a specific ESG indicator
• a combination of investments in line with Article 7 and 9.

Sustainable category (Article 9)

These include products having at least 70% of investments meeting a clear and measurable objective related to sustainability factors. These products can include: 

• investments in portfolios replicating or managed in reference to an EU Paris-aligned benchmark
• investments in Taxonomy-aligned economic activities
• other investments in assets that contribute to an environmental objective or a social objective, provided that a proper justification is disclosed.

Other key elements of the SFDR revision

Other areas of interest include:

Exclusions: investments across the three categories must exclude exposure to harmful industries and activities, e.g. violation of human rights standards, tobacco, prohibited weapons. 

Taxonomy: For Article 7 and Article 9 products, products with a proportion of Taxonomy-aligned investment equal to or higher than 15% should be considered products complying with the sustainable and transition category. 

Disclosure: As expected, the Commission proposes to delete entity-level disclosure requirements for financial market participants regarding principal adverse impacts indicators. This should cut reporting requirements and costs associated with collecting data across a wide range of indicators. The Commission also proposes a reduction in product-level disclosures, focusing on data that is available. 

Measurement: Financial market participants should measure their contribution, the compliance with the strategy and the progress towards the sustainability objective, through appropriate sustainability-related indicators and disclose those indicators. A list of voluntary indicators should be developed for this purpose.

Initial reflections

The outcome is largely in line with expectations. The 70% threshold introduced to qualify for a product category is a welcome addition. This, in combination with a sharper focus on measurable indicators, should tilt the asset selection process toward companies with demonstrable track record or credible ambitions. 

The Taxonomy should also get some boost from the 15% threshold allowed for Article 7 and 9 inclusion. A transition category was something missing from SFDR 1.0, and we expect this will draw focus on climate targets and delivery against them. While the new system is no doubt likely to encounter challenges, not least about data, we view this update as a positive step and expect it to do a better job at channelling capital toward sustainable assets. The proposal will now go through the Parliament and Council before final approval.