Navigating the Future of Sustainable Investing: A Look at the SDR and SFDR Regimes
By Sarah Forster and Ben Rosoman
The financial sector is undergoing a major transformation as investors, regulators, and asset managers grapple with the growing demand for sustainable investment options. At the heart of this transformation are two key regulatory regimes: the UK’s Sustainability Disclosure Requirements (SDR) and the EU’s Sustainable Finance Disclosure Regulation (SFDR). While both aim to improve the transparency of sustainable investment products and combat greenwashing, they do so in different ways. As a trusted advisor to many of the UK’s investment managers looking to contribute to positive impact creation through their investment strategies, The Good Economy has seen first-hand the challenges and opportunities faced by organisations looking to comply with these regulatory regimes. This article explores the key features of both regimes, their current state of play, lessons learned, and what the future holds for the sustainable finance landscape.
The Drivers Behind SDR and SFDR
Both the SDR and SFDR were created to address critical challenges in sustainable investing: combatting greenwashing and mis-selling, improving comparability and standardisation, and providing more consistent and transparent information in the market for sustainable investment products.
Greenwashing
Greenwashing, or the practice of misleading consumers about the environmental benefits of an investment, has become a significant concern as more financial products are marketed as “sustainable”. This has prompted regulators to step in and require fund managers to provide clear, substantiated claims about the sustainability credentials of their products.
Standardisation
The need for greater standardisation across the market is another important driver behind the move to greater regulation. Without consistent definitions, it’s difficult for investors to compare products and assess their impact. As consumer interest in sustainable investing grows, ensuring that sustainability claims are credible and backed by concrete evidence becomes crucial for fostering trust and attracting more capital into the sector.
Differences Between SDR and SFDR
While both the SDR and SFDR aim to increase transparency and standardisation in sustainable investing, they approach this goal in fundamentally different ways.
Explaining SDR (UK)
The UK’s SDR is explicitly intended as a product labelling regime, introducing four different product labels which aim to inform and protect consumers, enhance competition, and improve trust in the market for sustainable investment products. Overall, the regime aims to create a framework that enhances comparability, empowering consumers to make informed decisions based on clear, rigorous disclosures.
SDR takes a principles-based approach, rather than a prescriptive one. This means the regulations introduce a set of high-level principles, it is then up to fund managers to interpret and apply the rules in a manner which complies with the FCA’s requirements.
Explaining SFDR (EU)
The EU’s SFDR was introduced as a disclosure regime which was designed to provide transparency around how sustainability factors are incorporated into financial products. It was never intended to operate as a labelling system, but it is commonly accepted across the industry that it is being treated as one, particularly for funds marketing themselves as Article 8 or Article 9.
In contrast to SDR’s principles-based approach, SFDR is more prescriptive in nature. As a disclosure regime, this means that SFDR requires organisations to provide prescriptive and standardised disclosures on how ESG factors are integrated at product and entity level, including information on sustainability risks, principal adverse indicators, and sustainability-related information.
As George Latham, Managing Partner of WHEB Asset Management, recently stated in an article in Responsible Investor, SFDR’s more prescriptive nature has meant that fund managers have generally found the EU Regulations to be easier to apply than the UK’s SDR, though there is a risk that this means it is less flexible and adaptive in the long-term.
Current State of Play: Challenges and Convergence
A significant challenge for fund managers operating in both the UK and the EU is the cost and complexity of complying with two different regimes. Implementing the SDR and SFDR regimes requires significant time, effort, and resources, which has led to growing calls for greater convergence between the two systems. The regulatory landscape in both regions is evolving, and there is an ongoing discussion about how to harmonise these approaches to reduce the burden on fund managers.
In September 2023, the European Commission published a targeted consultation on potential changes to the SFDR. Among the proposals was the introduction of a product classification system similar to the SDR’s categorisation approach. This would provide clearer guidance to investors and consumers and help them navigate sustainable investment options more easily.
In June 2024, the European Supervisory Authorities (ESAs) issued an opinion addressed to the Commission, providing a set of recommendations based on a review of SFDR’s implementation. The ESAs’ recommendations include proposals for adapting the SFDR to introduce a product classification system, to assist consumers in navigating the sustainable investment market.
Lessons from the UK: The SDR Experience
Under SDR, the sustainable investment product labels were formally introduced in the UK on 31 July 2024. We have since worked with fund managers on their SDR applications and have seen that there are both a number of positives and challenges.
Positive Aspects of SDR
The Need for Product Labels
The experience in the EU, where SFDR has been treated as a de facto product labelling system, and where there are now calls to formally adapt the regulation to introduce product labels, shows that there is a distinct desire from the market for a consistent framework of product labels to protect consumers and guard against mis-selling. We therefore think that the FCA took the correct approach in focusing SDR on the development of a small set of product labels.
Rigour and Transparency
The requirement for funds to demonstrate the evidence behind their sustainability claims, especially regarding impact strategies, has set a high bar for transparency – a move that we welcome. This means that funds need to be clear and rigorous in articulating how their investment strategy contributes to the overall sustainability objective.
Consultative Approach
The FCA has been highly consultative and responsive in developing the SDR framework. Feedback from the industry has been incorporated into revisions, as seen between the FCA’s Consultation Paper (October 2022) and Policy Statement (November 2023).
Ownership and Accountability
SDR’s more principles-based approach places the onus on fund managers to demonstrate how and why their strategies meet sustainability requirements. This encourages funds to take ownership of their sustainability claims rather than relying on a rigid set of predefined definitions.
Challenges of SDR
Lack of Clarity
However, the UK’s SDR regime has not been without challenges. Some fund managers have experienced fatigue from frequent revisions, and there is still a lack of legal clarity regarding some key concepts, as well as issues around data availability to evidence sustainability-related claims.
Unintended Consequences
In general, there has been a slower than expected uptake of funds choosing to apply for a label, with only two funds having received approval for an impact label as of November 2024. The reality is that significantly more funds are choosing to drop sustainability-related terms from their names or disclosures, rather than choosing to apply for use of a label (Responsible Investor).
While we view it as a positive that SDR has set a relatively high bar in terms of what is required to demonstrate that a fund strategy is sustainable, this reaction from the market highlights the risk of unintended consequences when introducing regulation and the need to strike the right balance.
What Can SFDR Learn From SDR?
The experience of SDR provides useful insights for the evolution of the SFDR and potential future iterations of SDR. These include:
- Categorisation and Labelling: There is strong support for a clear product categorisation system, as seen in SDR’s approach. Industry feedback during the 2023 SFDR consultation highlighted the need for clearer, more consumer-friendly labels to help navigate the range of sustainable investment options.
- Industry Feedback and Flexibility: Listening to industry stakeholders and adapting regulations accordingly is crucial to ensure that regulations remain fit-for-purpose. SDR’s consultative process has highlighted the importance of being responsive to the needs of fund managers and investors alike. However, the challenges faced under both SDR and SFDR highlight the continuing need to be receptive to the market as the regulations evolve over time.
- ‘Principles’ vs ‘Prescriptiveness’: SDR’s principles-based nature gives firm’s greater scope to interpret the rules in a way which fits their strategy, which should help to limit a box-ticking approach to compliance. Yet with this greater flexibility, there is also the potential for a divergence of approaches, and increased confusion over what is needed to comply with the regulations. This has been a challenge faced by fund managers in the early months of SDR, and a contributing factor to the slower than expected uptake of labels.
- Balancing Rigour and Burden: It’s essential to strike the right balance between rigour and feasibility. While rigorous requirements improve credibility and protect against greenwashing, overly complex rules can place an undue burden on funds, hindering their ability to comply and ultimately slowing down the development of sustainable finance.
- Interoperability: Though the UK’s SDR rules were designed to be broadly interoperable with SFDR, the reality is that investors have found implementation of the two regimes challenging in practice. Major difficulties for fund managers have included a lack of consistency in what qualifies as a sustainable investment as well as differences in reporting requirements. As noted, the European Commission is currently considering a set of potential updates, which may include amending the regulation to further align with SDR, so this challenge may be mitigated by future updates to SFDR.
Conclusion: Striking the Right Balance
The goal of both SDR and SFDR is clear: to ensure that financial products making sustainability claims are credible and genuinely contribute to positive environmental and social outcomes. However, this goal needs to be achieved without stifling innovation or overwhelming fund managers with excessive regulatory burdens.
The ultimate challenge is to create a regulatory framework that fosters trust, improves comparability, and drives more capital towards sustainable strategies. It’s important to set a high bar for sustainability claims to combat greenwashing, but also to ensure that the regulatory landscape is navigable and doesn’t become an obstacle to real, impactful change.
As the SDR and SFDR regimes continue to evolve, regulators will need to carefully balance these competing priorities. At The Good Economy, we believe that the experience of SDR in the UK offers valuable lessons that can help refine both the UK and EU frameworks, ultimately creating a more effective and efficient sustainable finance ecosystem that benefits investors, fund managers and consumers alike.
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