Some elements of the Commission's proposal are welcome. The abolition of entity-level reporting on principal adverse (sustainability) impacts (PAIs) has been positively received by the market. The proposal's recognition that blind pool funds need time to deploy capital, and do not have to hit sustainability thresholds immediately, shows the Commission has listened to the industry.
Moreover, some of the most confusing aspects of SFDR 1.0, including the highly subjective definition of "sustainable investment" and the requirement to assess investee companies' "governance", are swept away in the reform proposal.
But, on closer inspection, the Commission's vision for SFDR 2.0 remains unclear. Like its predecessor, key details are left out of the primary legislation, with no clear steer on when the crucial secondary rules will be drafted and published. The Commission might say that this is a function of the uncertainties of the legislative process, but it would be helpful to either have more detail in the Level 1 text, or a roadmap. Instead, the industry is likely to have to make important choices without full information.
A case in point is the scope of the entry-level category, "ESG Basics". This remains opaque – and potentially quite broad. Firms raising now (unless fully closed before the law takes effect) will need to make decisions without knowing what the new regime will permit – and, unless the secondary rules are finalised quickly, that uncertainty might persist even after the final text is agreed at EU level. This is precisely the uncertainty that plagued the original SFDR.
Worse still, the proposal is far from clear about what a manager can disclose about its approach to sustainability – and where those disclosures can be made (in part, a function of current uncertainties in EU fund marketing rules). Different firms will take different views. For example, could an uncategorised fund's private placement memorandum (PPM) still tell prospective investors that the fund's manager is a PRI signatory? Not (yet) clear.
Some of that lack of clarity would matter less to private market firms if they could describe more fully in their communications with (sophisticated) investors what they actually do on ESG. Their approach is usually bespoke and nuanced – in response to investor preferences and anticipated value creation opportunities – and may include a mixture of approaches.
In response to industry representations, an earlier (leaked) draft version of the Commission proposal included a provision that would have allowed professional investor-only funds significantly more freedom to truthfully disclose their approach to sustainability. In the final version, this (unfortunately named "opt-out") was deleted. That means that, unless something changes, SFDR 2.0 will inevitably lead to greenhushing.
Each category also has mandatory exclusion requirements that will compound the difficulties. Even the least restrictive category, ESG Basics, prohibits investment in companies deriving more than 1% of revenue from hard coal or lignite. For managers courting certain US investors this creates obvious problems. Given politicisation of the term, the category name itself may put off some investors – even if the fund is only using sustainability as a source of value creation. But a "boycott" of coal might make selling that fund even tougher. And the more demanding exclusions for the higher tier categories might take "Transition" and "Sustainable" funds off the table for a global alternative asset manager marketing a flagship fund.
SFDR 2.0 is also clearly still focused on funds with liquid investments that can invest from Day 1 and divest to re-balance a portfolio quickly. Private funds invest for years, not days. Blind pool funds close before they know what their investment portfolio will look like, making a firm commitment to meet rigid allocation thresholds throughout the life of the fund uncomfortable. The ramp-up provisions help, but are far from a complete answer. And monitoring and dealing with mandatory exclusions is also hard – even more so for secondary funds or funds of funds.
Depending on where the disclosure restrictions and the boundaries for the categories end up, firms may be left with an invidious choice: either say very little (which is potentially misleading) – or make pledges that don't sit well with the fund's strategy or accord with investor preferences.
SFDR 2.0 is still some way off – the rules will not take effect until late 2027 at the earliest, and in all likelihood later than that. In the meantime, a market that had just started to get used to SFDR 1.0 is thrust once again into a period of uncertainty.
Brussels does not have an easy task: effective regulation of sustainable finance is vital and genuinely difficult. The Commission is standing firm in the face of political headwinds, and balancing the legitimate concerns of various stakeholders is hard. But still, the market is entitled to expect a better proposal than the one the Commission has put on the table.
Our next issue will be in January 2026. We wish all our readers a relaxing and enjoyable break.
