[Quotes have been redacted, and should be compared against the full quote, available in the book.]

The implementation of the Sustainable Finance Disclosure Regulation (SFDR) has, I’m afraid, not worked well.

SFDR is a regulation, not a directive. A “regulation” is a binding legislative act. It must be applied in its entirety across the EU. A “directive” is a legislative act that sets out a goal that all EU countries must achieve. However, it is up to the individual countries to devise their own laws on how to reach these goals.

There was great opportunity here. Not a directive, subject to the regulatory cultures of member-states, but a European-wide regulation that applies to all European investors. It was intended to re-orient capital towards sustainable growth and to help retail and institutional investors make more informed investment decisions. It was also intended to address greenwashing.

SFDR sets out disclosure requirements for three types of funds in the regulation’s articles 6, 8 and 9. Article 6 describes the default fund. The investor must integrate financially material ESG issues, but that is the extent of their approach to sustainability.

An article 8 fund promotes environmental or social characteristics, such as 50% lower greenhouse gas emissions. An Article 9 fund pursues a sustainability objective. For many market participants, the distinction between Article 8 and 9 funds was unclear, prompting the European Securities and Markets Association (ESMA) to write to the European Commission to say so. It’s implied that an Article 9 fund prioritises its sustainability objective. In short, it’s a higher bar.

For many investors, SFDR is confusing. Noting the time scales involved in European policymaking, SFDR was introduced during a period of change for responsible investment, during which investors increasingly focused on how investment can contribute to sustainability outcomes.

Most responsible investment professionals will have an opinion on how to fix SFDR.

There are positives to the regulation. It is at entity and fund level, and so there’s a degree of comprehensiveness that was previously lacking. It requires all investments to integrate financially material ESG issues or explain why not, which, while more and more accepted as a requirement for investment decision-making, was by no means universal.

It introduces principal adverse indicators (PAIs) requiring investors to disclose the extent to which their investment activity causes adverse impact (or harm).

And so, there’s much to welcome.

But, unfortunately there are also many challenges. SFDR is a disclosure regulation. It is not a label but it was inevitable that it would be interpreted as a label.

National regulators were issuing guidance through the course of 2022, while asset managers were seeking to interpret and either change their investment strategy or change the disclosure.

There’s also no definition of what constitutes “sustainable”. That’s left to the investors.

Given attention to greenwashing through 2022, investors became risk-averse, and began to “downgrade” their funds from Article 9 disclosures to Article 8. As such, Article 8 became such a broad category as to undermine the intention of the regulation.

Article 9 was mostly reserved for unlisted assets, or if listed, then active portfolios without a mainstream benchmark.

For active and passive portfolios with a mainstream benchmark, Article 8 could be a fund with strong stewardship, engaging companies with conviction to change and transition or Article 8 could be a fund that just excludes coal or tobacco.

It means that asset owners are back to reading prospectuses unable to compare like-for-like given the breadth of Article 8 funds.

Because asset managers are left to define a sustainable investment, each will have their own methodology, often based on a data provider’s methodology, which in turn, will differ (for example, say, MSCI’s SDG alignment score with, say, ISS’s SDG alignment score).

SFDR has been costly in legal fees and goodwill. Lawyers are the winners, charging a fee for updates to prospectuses to meet the new requirements.

But that said, I don’t regret SFDR. It has forced asset managers to think about their products and how they’re marketed. It has forced the industry to address its conflated and confused terminology, using terms interchangeably, with little regard for how the terms are interpreted.

In the meantime, there’s little love for SFD-Argh.

I put this to Jon Lukomnik, asking for a US perspective of the regulation.

“You can’t understand the strategy by looking at portfolio holdings. But regulation is based on holdings analysis …

“It is too easy to have holdings-based disclosure, and an asset manager buys Sustainalytics, ISS or MSCI ratings, and doesn’t think at all and gets Article 8 status.”

Philippe Zaouati said, “SFDR is a good example of demonstrating that the most important thing for a piece of regulation is the way that the market adopts it.

“Sometimes you issue regulation, and sometimes it’s useless, because the market doesn’t react.

“The purpose of SFDR is transparency and therefore to incentivise the fund manager to report. The more you commit, the more you report. So, if you don’t do anything, you don’t report, if you do ESG integration, you report a bit more, and if you do positive impact, then you report more again.

“But the fact is that these three levels have been translated by the market into a label, because we don’t have any label in the market.”

“When we were developing this piece of law”, Martin Spolc told me, “investors said, ‘don’t be too prescriptive, give us flexibility, we know how to do this’. So that’s the approach we took with our proposal. It was never meant to be a labelling regime. It was supposed to be a disclosure regime.

“I personally think that the sustainable finance framework, including the SFDR, has all the features that allows investors to invest sustainably.”