Comment: Does SFDR encourage greenwashing?

By Mark Shaw, partner at Pinsent Masons

The European Securities and Markets Authority's (ESMA) latest Report on Trends, Risks and Vulnerabilities includes some interesting observations on the Sustainable Finance Disclosure Regulation (SFDR) and greenwashing risk.

It states: “In the absence of an EU-wide labelling regime for ESG funds, some managers have also used Articles 8 and 9 as proxy labels for communication purposes. SFDR was not intended to be a labelling regime and does not include the type of requirements usually attached to voluntary labels, prompting further concerns of potential greenwashing.”

Furthermore, there is a risk that the SFDR and wider regulatory regime is creating significant systemic, market-wide unintended consequences, which are conflicting with the EU’s strategic aims of increasing additional capital deployment and investment aligned with the global low-carbon, sustainable transition.

What do we mean by greenwashing?
According to the UK FCA’s consultation on Sustainability Disclosure Requirements: “There are growing concerns that firms may be making exaggerated, misleading or unsubstantiated sustainability-related claims about their products; claims that don’t stand up to closer scrutiny (so-called ‘greenwashing’).”

The root of this issue is that, for all its complexity, SFDR is only a disclosure regime. It was not intended as a system of labelling but has nonetheless been treated as one, because that’s what issuers, consumers and investors want.

Following the staggered implementation of SFDR, ESMA has recognised that “the misuse of SFDR as a marketing tool could create potential risks to investors as demand for sustainable products remains strong”. And recognising that the market would look upon the SFDR classifications as brands, it says: “SFDR was not intended to be a labelling regime and does not include the type of requirements usually attached to voluntary labels, prompting further concerns of potential greenwashing.”

How may SFDR be encouraging greenwashing?
It is broadly recognised that the SFDR intended to increase transparency and prevent greenwashing by requiring financial firms to disclose information about their sustainability practices, but it is becoming clear that SFDR may increase greenwashing in certain ways. Some possible reasons are as follows:

The lack of standardised definitions: SFDR does not provide workable standardised definitions of sustainable investments. This could allow firms to label investments as ‘sustainable’ even if they do not meet commonly accepted ESG criteria. This is further compounded by the prescribed RTS pre-contractual format and the wider use of overlapping terminology. For example, it is possible to offer an Article 9 fund without a taxonomy alignment or PAI reporting. Does this make it more or less green than an Article 8 fund that offers both of these? This lack of consistency in definitions also makes it difficult for investors to compare sustainability performance side by side across different funds.

Compliance burden: SFDR creates a disproportionate compliance burden for some firms, particularly smaller firms. Compliance with SFDR requires companies to gather and report a significant amount of data on their sustainability practices, which could be time consuming and expensive. This disadvantages smaller managers that cannot take advantage of third-party wholesale data sources, and could also create a temptation to simply meet the minimal disclosure requirements.

Self-assessment and self-reporting: SFDR relies on self-assessment and self-reporting by financial firms, which may not always be reliable, either because of data quality or internal resource capacity. Some firms may be inclined to exaggerate or misrepresent their sustainability practices to attract investors or comply with the regulation.

Vague requirements: SFDR’s requirements are not always clear or specific, which may allow firms to interpret the regulation in a way that suits their interests. For example, the regulation requires firms to disclose how they integrate sustainability risks into their investment decision-making process, but it doesn’t specify how to measure or assess those risks.

Limited enforcement: SFDR doesn’t include strong enforcement mechanisms to ensure compliance. Firms that do not comply with the regulation may face reputational damage but they may not face significant legal or financial penalties.

Lack of interoperability: There are other emerging sustainability disclosure regimes, such as the International Financial Reporting Standards’ forthcoming International Sustainability Standards Board (ISSB) regime, which is supported by the G20. It is not yet clear how these emerging regimes will interact with the SFDR but based on draft consultation papers issued by the ISSB, there are different and sometimes conflicting disclosure requirements.

What is the potential scale of the issue?
While we don’t have reliable data for AIFs, ESMA has stated that approximately 55% of UCITS by assets under management are now designated as either Article 8 or 9 under SFDR.

A crude assumption would be that there are now €5.5trn worth of ESG investments from UCITS funds alone. While this gross figure would seem to be in line with wider global projections on the growth of ESG investments, it could be deemed to imply that a UCITS asset is more likely to be ESG than non-ESG, but of course that is not the case, as Article 8 classification may simply be the result of meeting of minimal disclosure requirements.

What should managers do about this?
Managers should consider how sensitive their investors would be towards being required to change the name of a fund versus the manager’s ability to commit to the minimum portfolio requirements required to maintain an ‘ESG’ or ‘sustainable’ label.

Irrespective of the outcome of ESMA’s consultation on fund names, it only tackles one of the many shortcomings of SFDR. A continued concern will be around varying data availability for managers to meet disclosure requirements. This is particularly notable in private markets where managers may have a sustainable investment strategy but are unable to compel portfolio companies to provide the necessary data to allow them to report. As such, they risk being prejudiced where they are unable to meet new minimum disclosure thresholds, despite what may be an obvious sustainable investment objective.