Greenwashing risk from Sustainable Finance Disclosure Regulation

The Sustainable Finance Disclosure Regulation (SFDR), which has been in force since 2021, sets out how financial intermediaries, such as asset managers, have to communicate sustainability information to investors and, according to the European Commission, it is designed to bring more transparency to the market and enable investors to make informed choices.

However, according to Mark Shaw, partner, Pinsent Masons, there is a risk that SFDR disclosure could lead to greenwashing. Shaw explained to ESG Risk Review the aims of the SFDR and how it has been misconstrued and potentially increases the risk of greenwashing.

What is the aim of the SFDR?

Mark Shaw: SFDR is one of a wide range of measures intended to implement the EU’s [Green New Deal] wider regulatory framework, ultimately intended to reorientate capital flows towards green investments, with a particular emphasis on CO2 reduction. SFDR was intended to increase transparency by requiring financial firms to disclose information about their sustainability practices.

SFDR is a curious piece of legislation because its stated aims were completely disregarded by the market. It was intended as a piece of transparency legislation, but as we’ve seen, the market wanted a product categorisation regime, and interpreted it as such. Aside from the issues with its difficult birth, most of the problems with SFDR stem from the fact that it is not fit for the purpose of product categorisation.

The EU is aware of this, and the Commission has opened a consultation on the future of SFDR, which is likely to ultimately bring it more in line with what we are seeing in the UK with Sustainability Disclosure Requirements (SDR) and the SEC’s proposed ESG disclosure rules.

How is the SFDR potentially increasing the risk of greenwashing?

Mark Shaw: EU financial firms risk inadvertently misleading customers as to the green credentials of their products given the vague and contradictory nature of the disclosure regime under the Sustainable Finance Disclosure Regulation (SFDR). The European Securities and Markets Authority (ESMA) highlighted these risks in a recent report, explaining that: “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.”

In doing so, it echoed the view of the UK’s Financial Conduct Authority (FCA) which, in its consultation on the creation of a UK-specific sustainability disclosure regime, pointed to “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’)”.

So, the root cause of the issue could arguably derive from it not being fit for purpose.

There are a number of ways in which SFDR may increase the risk of greenwashing – in particular, of product managers overstating a product’s green credentials:

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 pre-contractual format from the SFDR Regulatory Technical Standards (RTS) and the wider use of overlapping terminology. For example, it is possible to offer an ‘Article 9’ fund – which should have specific sustainability goals as an objective – without a taxonomy alignment or PAI [Principle Adverse Impact] reporting.

Does this make it more or less ‘green’ than an Article 8 fund – which should promote environmental or social characteristics and have good governance – 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 or those that cannot take advantage of third-party data sources. Compliance with SFDR requires companies to gather and report a significant amount of data on their sustainability practices, which is time consuming and expensive. This may 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. This 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 allows 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

There are no strong enforcement mechanisms to ensure compliance included in SFDR. Firms that do not comply with the regulation may face reputational damage, but they may not face significant legal or financial penalties.

The MiFID temptation

SFDR amended the Markets in Financial Infrastructures (MiFID) regime from November 2022. Product manufacturers and distributors, such as wealth managers or asset managers, must now consider sustainability factors and sustainability-related objectives at every stage of the MiFID product governance process chain.

The new rules dictate that, where no sustainability preferences have been given by a client, on the proviso that there is no difference to acceptable risk for the client in question, an Article 8 or 9 product can be deemed to be suitable for that client. However, the converse is not the case, which inevitably steers more MiFID client capital towards sustainable investments and creates an incentive for product manufacturers to meet the minimum requirements of Article 8.

Is this an issue in other areas where EU directives and regulations call for sustainability reporting, due diligence, disclosure etc?

Mark Shaw: I would pay particular attention to the Corporate Sustainability Reporting Directive (CSRD). It ties into the regime because it provides the inputs required for reporting under SFDR, i.e. mandated companies are required to provide prescriptive information to their shareholders, which may have their own disclosure obligations under SFDR.

We also have the Taxonomy Regulation, which establishes a classification system for whether activities should be considered ‘environmentally sustainable’. It ties in to SFDR as taxonomy-alignment disclosures and reports must be made under SFDR. And it bridges the gap with the non-financial reporting directive and forthcoming corporate sustainability reporting directive because it dictates how certain companies should report environmental data.