Targeted consultation on the SFDR and its implications for real estate
The EU’s Sustainable Finance Disclosure Regulation (SFDR) is designed to attract private investment to support the transition to a sustainable, climate-neutral economy.
The SFDR was brought in on March 2021, and it requires financial market participants and financial advisers to disclose sustainability-related information about their entities and products (it applies to all entities marketing products in the EU – meaning many UK-registered investment products will still need to comply).
What SFDR is, and what it all means
The policy’s aim is to provide transparency to investors to enable informed decision-making. It uses a double materiality approach, meaning the disclosures cover both sustainability-related risks to the investment’s financial performance, and adverse sustainability-related impacts of the activities which the investment supports.
It mandates a variety of disclosures at both the entity and the product level, including:
Disclosures on the integration of sustainability risks and adverse impacts in the investment decision-making process and advice
Due diligence statements including principal adverse impacts
Information on the integration of sustainability consideration into remuneration policies.
These disclosures are to be variously included on the entity’s website and included in pre-contractual documentation and corresponding periodic documentation.
What’s been happening so far since the launch of SFDR
Since the legislation came into effect, financial market participants have invested significant amounts of time and resources into understanding the regulation, and adapting their data collection and reporting to comply with it.
Companies that target sustainability-conscious investors have experienced significant demand and pressure for the so-called Article 9 funds (funds which have a sustainability objective at their core). Meanwhile, the Article 8 designation (for funds promoting some sustainable characteristics) has been seen as a category which most products can achieve, and therefore relatively uninformative.
The struggle to appoint funds to Article 9 in real estate
A lot of sustainability-conscious companies have struggled to designate their funds as Article 9 due to the original regulation requiring “100% sustainable investments” for a product to qualify. This was widely seen as excluding transition investments – where assets are obtained specifically with the intention of turning them around in terms of sustainability performance.
This is possibly why most of the existing Article 9 funds within the real estate sector are focused on social housing – an activity which is explicitly sustainability-oriented (similar to renewable energy or health and education within the infrastructure sector). The real estate sector has, however, struggled to designate almost any funds as Article 9 on the basis of environmental characteristics, as many sustainability-oriented funds with net zero targets will still hold some inefficient assets.
Considering the importance of the existing building stock in the grand scheme of country-level and global carbon budgets, and the fact that their emissions increase significantly with age, this was an unfortunate result. We have seen real estate companies with active strategies having to expend significant time and resources explaining to investors why they are making Article 8 disclosures for their funds and not Article 9 – and possibly suffering reduced funding availability as a result.
The clarifications are allowing unsustainable investments - what's the impact?
The regulators have tried to address some of these issues with clarifications.
Notably, the April 2023 issue clarified the definition of “sustainable investment”, explaining that it accommodates not just activities that are sustainable by nature (e.g. renewable energy), but that the label can also be applied to sustainable behaviours (activities that are not sustainable in themselves but are conducted in a sustainable manner, like manufacturing a typical product in an exceptionally environmentally and socially responsible way), and transitioning activities/companies.
They also confirmed that there is no need for revenue-based attribution of activities, which has meant that an investee company can be counted as a sustainable investment even if part of its activities falls outside that definition (as long as it does no significant harm). In some views, this clarification has significantly watered down the SFDR’s potential positive impact, weakening the Article 9 designation and allowing unsustainable investments to be snuck in.
Ahead of the clarifications being published, the market was widely expecting the rules to be tightened, rather than relaxed – a significant number of Article 9 products were downgraded to Article 8 in preparation. The clarifications have, however, gone the other way, and the market is still readjusting.
Will there be an overhaul of the regulation?
The current targeted consultation, open until December 15th 2023, has been met with quite a bit of shock. The serious questions it asks hint at a possible overhaul of the regulation. Coming after several years of ESG and investment professionals grappling with the complexity of the requirements, this is viewed with quite a bit of frustration.
Section 1 - Unsuitable data could lead to risk of Greenwashing
The consultation is split into four sections. Section 1 investigates the current requirements of the SFDR, asking respondents whether they feel that the SFDR is meeting its objectives, and seeking their views on implementation issues. The questions reflect a lot of the feedback heard in the industry over the past year – that the regulation is too costly (question 1.4 asks if the benefits outweigh the significant costs of disclosure, and other questions seek to gather numerical information on the one-off and recurring compliance costs), that it lacks clarity (question 1.6), that unsuitable data and its mis-use as a labelling system create a risk of greenwashing and mis-selling (multiple questions), etc. One significant issue with the SFDR as it stands, raised by us previously in a Jan-23 article, is that the current framework does not effectively capture investments in transition assets – the consultation seeks views on this issue in question 1.7.
Section 2 - Is there consistency with regulations?
Section 2 explores the SFDR’s interaction with other parts of the EU’s sustainable finance framework, looking to understand potential misalignments or inconsistencies with regulations including the Taxonomy Regulation, the Benchmarks Regulation, the Corporate Sustainability Reporting Directive (CSRD), and a few others. The consultation looks to find out whether SFDR disclosures are consistent with the CSRD requirements, in particular with the European Sustainability Reporting Standards (ESRS), from participants who have already reported to both.
Section 3 - Should disclosure requirements be uniform for all financial products?
Section 3 discusses potential changes to the disclosure requirements, including, among privacy and machine-readability considerations, the question of whether disclosure requirements should be uniform for all financial products, regardless of their sustainability-related claims. The current increased reporting requirements imposed on sustainable products have been likened to requiring only healthy foods to contain nutritional information on their labels, and thus indirectly penalising them. While some might say that the increased reporting burden is needed to substantiate these claims, as sustainability claims can yield an investment premium, others have argued that uniform requirements would make it easier for investors to make decisions. After all, it is easier to say no to a snack showing the serious amounts of unhealthy nutrients it contains than to one that simply has no information at all, lulling us into a false sense of security.
Another interesting area explored in Section 3 considers ratings – should certain disclosure results be put on a scale and benchmarked against each other? The questions asked are broad – to the effect of, If yes, how should those scales be established and which information should be expressed this way? but the issue raised is a curious one. There is a lot to be said for comparing each investment product against an industry average benchmark as a way to achieve recognition for the more ambitious products – but of course the practical challenges around this are significant, and would require a centralised solution for storing and comparing disclosures, which is not on the roadmap at present.
Section 4 - Currently causing a stir due to the possible radical overhaul to a labelling scheme
Finally, Section 4 – the part that is causing a stir – is about the potential establishment of a categorisation system for financial products, one that would either build on the existing Article 8 and 9 requirements, or supplant them altogether.
It acknowledges that (just as I have done in this piece) the terms “Article 8” and “Article 9” have entered industry jargon and are widely used as de facto product labels. Along with a growth in the number of investment product labelling regimes, including the UK SDR, this suggests that there is a need for a standardised labelling regime.
As an example, the United Kingdom’s Sustainability Disclosure Requirements (SDR) (At the time of writing this article, the latest publication is the consultation that closed in January 2023), while aiming for a similar target of reducing greenwashing and facilitating investment flow towards sustainable solutions, has been explicitly framed as a classification and labelling regime. It targets retail consumers, and tries to facilitate differentiation between investment products on the basis of their sustainability characteristics, themes and outcomes.
An overview of the SDR
The original version of the SDR had 5 categories, starting with: Not promoted as sustainable. The categories Aligned and Impact closely mirrored SFDR’s Article 8 and Article 9. However, the latest proposal includes three categories: Sustainable Focus, for products investing mainly in assets which already have a high standard of sustainability; Sustainable Improvers, which accommodates an active investment strategy, including acquisition of transition assets which the company then improves to achieve better sustainability performance; and Sustainable Impact, which invests specifically in targeted solutions to environmental or social problems, often in underserved markets or to address observed market failures. These three labels reflect different investment strategies, rather than forming a simplistic scale of less-sustainable to more-sustainable, and accommodate different ways to achieve possible outcomes for the environment and people.
Section 4 of the SFDR consultation seeks views on the merits of developing a more precise EU-level product categorisation system. This would either be done through building on and developing the distinction between Articles 8 and 9; or by basing a categorisation system on a different approach, for instance focused on the type of investment strategy (promise of positive contribution to certain sustainability objectives, transition focus, etc), based on criteria outside of existing concepts.
You will note that this proposal appears to be converging with the approach taken by the SDR.
Final thoughts
The question is – how should the categorisation/labelling interact with the SFDR as it currently stands, and should we be cutting our losses and doing a radical overhaul now – or leaving things as they are and creating a labelling system alongside it?
We hope that the consultation responses from financial market participants will elucidate this. There is of course a need to assess the potential implications for other sustainable finance legal acts if the SFDR legal framework was changed in the future – which is why industry feedback is critical to determine the best way forward at this juncture.
From the perspective of real estate, we support any shift in the SFDR which will accommodate different investment strategies – from investing in static portfolios of BREEAM-certified sustainable office buildings, to a more Value-Add approach of identifying older assets with poor performance and refurbishing them with sustainability in mind.
The hope for transparency and clarity from the consultation changes
We hope that any changes will be implemented in such a way as to avoid destroying the momentum around building data collection systems and increasing transparency, and that the changes will boost the clarity that regulations such as the SFDR help create.
If a labelling system is the chosen way forward, transparency is key, so that the approach could be picked up by other markets and the global financial markets can start to converge to a consistent set of labels, reducing the reporting and interpretation burden on ESG teams.
We encourage you to submit a response to the consultation, which can be completed via this link.
For any further information regarding Targeted consultation on the SFDR and its implications for real estate:
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