SFDR 2.0 - The Impact for Asset Managers

The long-awaited SFDR 2.0 has finally been published by the European Commission. It proposes a significant reset of the EU’s sustainable finance disclosure framework, reshaping the current disclosure regime into a product categorisation regime. Three new product categories have been introduced along with specific criteria for aligning products to such categorisations. 

Key takeaways for asset managers

The new categories

All of the new categorisations are anchored by two key pillars:

• A 70% threshold, applied to the proportion of investments meeting the respective category’s binding elements and objectives; and
• Specific exclusions.

Helpfully, there is recognition that funds investing in private assets may find it difficult to meet the 70% threshold on day one and therefore the concept of a phase-in period has been introduced, which must be adequately disclosed. Managers must ensure that the 70% threshold is met at the end of the disclosed phase-in period. 

The three new categories are as follows: 

• Transition (Article 7) - Funds designed around a clear and measurable transition objective related to sustainability factors.
• ESG Basics (Article 8) - Funds that integrate sustainability considerations in their investment strategy (such considerations must go beyond merely considering sustainability risks as part of risk management (like the old Article 6 funds).
• Sustainability (Article 9) - funds investing in companies, assets, activities or projects that are already sustainable or that pursue a particular sustainability objective.

The regulation sets out certain types of investments and activities that would automatically fall into one of the above categories. In addition, the Commission has recognised impact investing for the first time, embedding the objectives of intentionality and targeting measurable change for both transition and sustainable products. Certain disclosures are mandated for each category as well as those pursuing an impact investing objective. Below is a table which summarises the different requirements for each category: 

Category	Criteria	Investment that qualify for the 70% criteria
Transition	70% of the portfolio to align with the strategy of the product to demonstrate positive contribution to the transition towards more sustainable practices. The assessment of performance against the objective should be monitored and disclosed and should be based on appropriate indicators chosen by the manager, and any principal adverse impacts on environmental or social factors should be identified and clearly disclosed, together with any actions taken to address them. Exclusion of companies involved in tobacco or controversial weapons or found in violation of human rights as well as those generating significant revenues from coal or expanding their fossil fuel activities.	Portfolios managed in reference to the EU climate transition benchmark and EU Paris-aligned benchmark;  Investments in certain Taxonomy-aligned economic activities;  Investments in companies with a credible transition plan relating to at least one sustainability factor at the level of the company or activity; Investments in companies with credible science-based targets; Investments accompanied with a credible sustainability-related engagement strategy, targeting specific changes with defined milestones measures with reference to those targets and milestones;  Investments with a credible transition target set at the level of the portfolio, such as reduction of carbon emissions over time; and Other investments that credibly contribute to the transition provided proper justification is included in the disclosure.
ESG basics	70% of the portfolio to align with the overall strategy for integrating ESG factors. The assessment of performance against the objective should be monitored and disclosed based on appropriate indicators chosen by the manager. The same social exclusions as for the transition category above apply, as well as an exclusion of companies generating significant revenues from coal.	Investments with an ESG rating that outperforms the average rating of the investment universe or the reference benchmark;  Investments that outperform the average investment universe or reference benchmark on a specific appropriate sustainability indicator;  Investments that favour undertakings or economic activities with a proven positive track record in terms of processes, performance or outcomes related to sustainability factors;  Other investments integrating sustainability factors beyond the consideration of sustainability risks, provided proper justification is included in the disclosures required.
Sustainability	70% of the portfolio to align with the strategy of the product for positive contribution to sustainability. The assessment of performance against the objective should be monitored and disclosed and should be based on appropriate indicators chosen by the manager, and any principal adverse impacts on environmental or social factors should be identified and clearly disclosed, together with any actions taken to address them. Exclusion of investments into companies involved in tobacco or prohibited weapons, or found in violation of human rights, or active in fossil fuels or high-emitting energy activities, or expanding their fossil fuel activities.	Investments in portfolios replicating or managed in reference to an EU Paris-aligned benchmark; Investments in taxonomy-aligned economic activities; Investments in European Green Bonds Investments, including co-investments, that finance the same undertaking, project or portfolio identified in financing and investment operations benefiting from a Union budgetary guarantee or financial instruments under Union programmes pursuing environmental or social objectives;  Investments in European social entrepreneurship funds;  Other investments in undertakings, economic activities, or assets that contribute to an environmental objective or a social objective, provided that a proper justification is included in the disclosures.

 

What do the new categories mean in practice? 

Some initial practical considerations:

• The bar has been raised and the new categories will have a greater impact on  a fund's investment universe which is a shift from SFDR 1.0. This will be a particular step up for previously lighter green Article 8 funds;
• The addition of the mandatory exclusions may prove problematic for global sponsors looking to target both European and US investors and this will need to be carefully considered at an early stage of the product design;
• The concepts of do no significant harm and good governance are no longer relevant (being replaced by the exclusion criteria);
• The regulatory technical standards will include more details on the different criteria, so how the categories will operate in practice is still somewhat to be determined.
• New pre-contractual disclosures are expected to be set out in the regulatory technical standards with a significant reduction and simplification in the information required to be disclosed to investors. Website disclosure requirements are also significantly reduced.

Products not falling within any of the categories above

Firms are not prohibited from including ancillary references to sustainability aspects in regulatory disclosures even where a product is not categorised, provided such references are clear, fair and not misleading, are not prominent within the disclosures, and do not feature in the product’s name or marketing communications. This replaces the old Article 6 and will limit the level of sustainability details which can be included in fund documents for non categorised funds.  

Manager level disclosures

Entity level principal adverse impact disclosures and remuneration policy disclosures have been deleted, but entity level sustainability risk disclosures will remain. 

Grandfathering

There is no automatic grandfathering. However, sponsors of closed products that were created and distributed before the regulation’s application date can opt out of SFDR 2.0. This will be helpful for existing closed ended funds. However, open-ended funds will need to assess how they transition to the new rules. 

Other changes 

SFDR 2.0 has also reduced the entities in scope of the regime, excluding both portfolio managers and financial advisers from the regime and it will be interesting to understand how this reduction in scope interacts with the sustainability preferences under MiFID. In addition, the PRIIPs regime has been amended to require KIIDs to set out the financial product’s categorisation, a description of its sustainability objective and relevant indicators.

Next steps

The draft regulation must now pass through the EU's legislative process, which may result in additional changes. Once agreed, it will then come into force 18 months after publication in the Official Journal so SFDR 2.0 implementation is still some way off. 

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