A look back on the implementation of Level 2 of the EU Sustainable Finance Disclosure Regulation

On January 1, 2023, the European Commission's Delegated Regulation (EU) 2022/1288 of April 6, 2022 ("Delegated Regulation"), which introduces "Level 2" of the Sustainable Finance Disclosure Regulation ("SFDR"), entered into force. Level 2 of the SFDR complements and clarifies Regulation (EU) 2019/2088 of the European Parliament and of the Council of November 27, 2019 on sustainability disclosure in the financial services sector ("SFD Regulation"), which introduced "Level 1" of the SFDR.

Summary of the SFDR

The SFDR, applicable since March 10, 2021, is part of the follow-up to the European Commission's March 2018 Action Plan on Financing Sustainable Growth. It aims to encourage financial market participants ("FMPs") and financial advisors to make their financial products and investment decisions "greener" by publishing more transparent information for investors on the level of integration of extra-financial criteria, and more specifically environmental, social or governance ("ESG") criteria.

The SFDR applies to all financial products listed in Article 2(12) of the SFD Regulation. These include portfolio management products, alternative investment funds, insurance-based investment products, Undertakings for Collective Investment in Transferable Securities ("UCITS") and a range of pension products. Three main categories of financial products can be distinguished as follows:

1. "Article 6" products are those that may or may not incorporate ESG characteristics, but do not promote them and do not pursue a sustainable investment objective;
2. "Article 8" products are those that aim to promote, among other things, social or environmental characteristics or a combination of both, provided that the companies in which the investments are made apply good governance practices; and
3. "Article 9" products are those that (i) pursue a sustainable investment objective, i.e. an investment in an economic activity that aims to have a positive impact on the environment or society, (ii) without significantly undermining any of these objectives (the "do no significant harm" principle) and (iii) target companies that apply good governance practices.

The scope of the SFDR is broad, as it concerns all FMPs and financial advisors, as defined in Articles 2(1) and 2(11) of the SFD Regulation. The SFDR, therefore, applies to UCITS management companies, credit institutions, investment firms that provide portfolio management services and insurance companies that offer investment products.

Furthermore, with regard to the information on investment decisions and financial products that must be disclosed, the so-called "double materiality" rule applies. This means that the actors must provide the following in their pre-contractual documentation and on their website:

• information on sustainability risks: information on ESG events or situations which, if they occurred, could negatively affect the value of the investment (see Article 2(22) of the SFD Regulation). For example, the need to comply with an environmental standard or adapt a business model to account for climate risk may constitute financial risks and so need to be disclosed; and
• information on negative sustainability impacts: information on the negative consequences of investments on "sustainability factors", i.e. risks of harm to "environmental, social and labour issues, respect for human rights and the fight against corruption and bribery" (see Article 2(26) of the SFD Regulation). For example, financial products that do not account for emissions reductions or human rights risks in their supply chain may have a negative ESG sustainability impact and so need to be disclosed.

Uncertainties related to the classification introduced by Level 1 of the SFDR

The classification provided by the SFDR is discretionary and so is left to the financial actors themselves to comply with. Thus far, investment funds classified under Articles 8 and 9 have accounted for up to half of the funds present on the European market (approximately 49% of assets are classified under Article 8 and 5% under Article 9).

In this regard, a consortium of European media revealed a misuse of SFDR classifications, raising concerns of greenwashing by fund managers. In particular, there are concerns that the sustainable dimension of financial products have been exaggerated and that some funds classified under Article 9 have assets that are linked to polluting activities. In addition, in the United States, the Securities and Exchange Commission has taken legal action against funds that have presented their products as "sustainable", two of whom have since been convicted of overstating the 'green nature' of their assets under management.

It is, therefore, arguable that the classification introduced by Level 1 of the SFDR was clearly too vague. The recent entry into force of Level 2 of the SFDR attempts to resolve these difficulties by clarifying the rules for classifying funds within the EU, which will cause several fund managers to reconsider the classification of their products.

The future of the SFDR

Level 2 of the SDFR has introduced Regulatory Technical Standards for the content, methods and presentation of disclosures for financial products classified under Articles 8 and 9. These technical standards provide more complete, understandable and comparable information on disclosures for investors. For example, Level 2 of the SFDR provides for a model statement on key adverse sustainability impacts, which contains quantitative sustainability indicators, such as greenhouse gas emissions and violations of key United Nations and Organisation for Economic Co-operation and Development principles.

Level 2 of the SFDR also specifies requirements for Article 9 products. In principle, these products should only concern "sustainable investments". However, they may include other investments where in-scope actors are required to do so under specific sectoral rules. For example, operators are required to provide information on the proportion and purpose of any other investments in order to verify that these other investments do not hinder the sustainable financial product from achieving its objective. Investors should, therefore, be in a better position to assess whether the strategy of sustainable funds and the investment of their savings correspond to the values and investment objectives set out in the SFDR.

In line with the SFDR, the European Securities and Markets Authority recently launched a public consultation on the use of ESG and/or sustainability-related terms in fund names, with the aim of mitigating the risk of the misuse of the term "sustainability" and providing clear and measurable criteria to assess fund names that include the term "ESG".

It will thus be interesting to see how operators will use these new standards and whether other measures will be considered to balance the need for greater transparency on financial products with the need to prevent greenwashing practices.