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The Sustainability Story
Simone Ruiz-Vergote: Decoding SFDR 2.0 for Asset Managers and Investors
00:35:52
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- [00:00]
A
Foreign. And welcome to the Sustainability Story Podcast. On this episode we explore critical sustainability issues and global trends shaping our industry. I'm Nicole Garrig, Director of Global Industry Standards at CFA Institute and one of three co hosts. Today's episode will zero in on the topic that's set to to impact asset managers across Europe and beyond. And that's the proposed changes to the EU's Sustainable Finance Disclosure Regulation, or SFDR. Joining me today is Simone Ruiz Vergot, Head of Sustainable Finance Policy Research at MSCI Issue Research. Simone leads research and methodology development at msci, empowering clients to navigate sustainable finance and climate related regulations. With two decades of experience in sustainable finance and climate strategy, spanning both private and public sectors, Simone brings a wealth of experience to our conversation. So, Simone, thank you so much for being here and I look forward to our discussion.
- [01:12]
B
It's a pleasure, Nicole, thanks for having me.
- [01:14]
A
Yes, thank you. To get us started, I'd love to hear more about your personal sustainability story. So can you share with our audience how you first became interested in sustainable finance and what inspired you to focus on EU policy research?
- [01:31]
B
Yes. So I was born in a small town university town in Germany, in Freiburg in the Black Forest. And the one particular feature of this town is that it has more bikes, bicycles than it has inhabitants. And it's also the cradle of the solar industry. So with that background and with two parents being both biologists, I was quite sensitive to the topic of planetary boundaries and related environmental challenges. But I also felt a need to earn a living. So I decided to become an economist. Trained as an economist and then I moved over to work in Brussels at the EU Commission for an internship and followed by some stay at the ecb, the European Central bank, before I went back in fact to Brussels to work on carbon market topics. And it just fascinated me to have this sort of public policy steering based and a market based instrument with that emissions trading and see the change this can have. And that's where it started off really with my passion for green finance sustainability. And then five years ago I joined MCI in this role.
- [02:44]
A
Great. Thank you so much for sharing your journey into sustainable finance. And it's inspiring to see how your parents really shaped your thinking in environmental challenges growing up and you were able to develop a career really marrying your economics background as well as with your environmental interests. That's very inspiring. So now let's turn to our main topic, the Sustainable Finance Disclosure Regulation, or as I mentioned, sfdr, which we will be calling it throughout this podcast. And so for our listeners that may not be familiar with SFDR. It's been in effect in the EU since 2021 and it requires investment products to communicate how sustainability risks, sustainability objectives and characteristics and adverse impacts are addressed. And the intent was really to increase transparency and allow investors to better compare products. However, even though the EU legislators did not really set out to create a formal fund classification system, the rules led to this de facto classification system where products became known as Article 8 or Article 9 labels. And so this has resulted in really some significant complexity, confusion and different interpretation issues among retail investors. And so, Simone, we have this new proposal that was introduced in November and it really aims to address some of these challenges by really clarifying product categories and minimum stages standards and drawing on your experiences within asset management and sustainability data and the engagements that you've had with EU regulators. What do you see as the core issues the Commission is trying to solve for with SFDR 2.0 and where do you think, if anywhere, do they accept any trade offs or imperfections to get there?
- [04:45]
B
Yes, thank you. I guess most of the market was waiting for this proposal since a while. It's also typical in an EU context of legislation and lawmaking that you have every few years a revision to the MOTHER legislation to keep abreast with recent developments with changes in the market. We have seen the UK come forward with labels and the EU essentially has started with a disclosure regime, which has quickly morphed into, as you described it, a labeling, quasi labeling regime. And so I think since I took over about four years ago on this topic, really on SFTR and the principal adverse impact indicators, which is data points, we offer to assess how sustainable investments fare on a range of harm indicators. That has quickly become clear that we might see some change. So the whole last year we were already engaging with the regulators, there was a consultation, and then when the proposal came out, there was even a leaked version. And then the proposal proposal came and it was quite a change to the leaked version. So there was a lot of commotion last year and I think the market has now had some time to assess the proposal. And also the responses that I've seen from our clients has been rather positive on where, you know, we might have seen some challenges in understanding what different products mean. Very broad classification between the article 8 and 9 and overall spanning over 50% of the market. So quite a success in terms of capturing a large market share for this sort of sustainable or environmentally minded products. You can think of this as a real success. It's a leading market globally for sustainability products. But then Is it so clear what a sustainable product is? And I think this is where this whole initiative is now looking at. Can we provide more clarity, more comparability across different products? And so this is the main aim, is really improving usability, comparability and then also the credibility of sustainable investments. So you could see that there is this strong market demand for more well defined categories of sustainable investment products. And this is now being served by this proposal. It's a proposal, it could still change quite dramatically. We'll have to see how it plays out in the negotiation between the different EU institutions, Council, Parliament and Commission. But I think what is now more or less the market expectation is that a formalization of these labels would help direct capital flows, increase transparency, and then also strengthen investor confidence in this market.
- [07:30]
A
Great, thank you for the clarification on that. So when we think about the shift from Article 8 and Article 9 labels toward clear product categories defined in this, can you provide what you see as the most significant implications of this move and which aspects might still need further clarification from the regulators?
- [07:55]
B
Yes. So I think an aspect that was coming on, repeatedly put forward is that there is a lot of complexity on the disclosure side. So one thing is the labels, but another thing is the disclosures and how they were implemented. We had both entity level reports. So where you had to actually report across all your assets at firm level, that was not easy to do. It was not always clear how to do it. And then there were data issues. So altogether there was a lot of emphasis from the market to revise and simplify reporting requirements. And that is something they are doing here now. So first they replaced the Article 8 and 9 categories with three new sustainability related categories. Second, they simplify reporting obligations by removing the entity level report. But also supposedly in the future with the Delegated act that is still expected next year, they would also much simplify the product level reports. And then thirdly, there's also some alignment with existing regulation, such as the Corporate Sustainability Reporting Directive and the related standards, but also the EU taxonomy and then the esma, which is a regulatory authority, Fund name guidelines, which were coming in last year and sitting on top of the SFTR requirements, requiring certain exclusions of certain activities based on the name of a fund. So these are the different elements of the proposal. But I think overall that's really an aim to simplify, clarify and then also align more closely with other regulation, which makes sense because SFTR was one of the first regulations of the entire package that was part of the EU Green Action Plan in 2018 and the other pieces came later. And so there is a need to readjust, realign with what has happened in the last years in these other related disclosure and classification regimes.
- [10:03]
A
So I know you spoke to the aligning with the other EU policies such as CSDD and CSRD and ESMA's guidelines, but what about interoperability between other global product categorizations such as the SDR or other global proposals that are on the table in other jurisdictions? Do we see interoperability among those as well?
- [10:32]
B
Yeah, I think there is a clear understanding also emphasized by the many consultations we have had and where I think most of the market has just said don't make it too different from each other. We have csrd, we have the ISSB standards, we have different markets with different sustainable finance disclosure and categorization regimes. The UK was interesting because it basically introduced first the labels, then the disclosures, while the EU did exactly the opposite. Australia has just consulted last year on a similar categorization. And what you can see emerge from all these is that you have very similar building blocks. And I think this is a clear, there's a clear understanding that there needs to be some common ground to allow for a product to be cross marketed in different markets, but also to be not seeing hurdles added. You'll always see differences in the implementation. But from what is emerging is that there are these three building blocks. One is a sustainability category which comes with certain minimum percentage thresholds for what should be covered from a portfolio fund in the EU is 70%. I think in the UK it's slightly higher, but it's all in that category of two thirds of the product should follow the same criteria. Then you have another category which is a transition category which makes a lot of sense. If we think about certain sectors that are just emission heavy and that need to transit out of their current business model into lower carbon or lower emitting activities. That is then transition category which comes with credible transition targets, science based pathways, et cetera. So there are measures to allow you as an investor to assess whether or not the path that the company's on is actually making sense and sufficiently ambitious. And the third category is related to esg. Again it's a bit differently formulated in each markets. In the EU they call it ESG basics. You can also think of ESG integration where you essentially focus on financially relevant sustainability risks that are typically expressed by. You still keep your. You still keep an exposure to all the sectors in the market, but you choose the best performers on a variety of metrics related to Environment, social and governance indicators. And then I think there is an additional category which was also added here, which sort of sits across all the others, or at least across sustainability and transition. In the eu, that's the impact category, which allows impact products to differentiate themselves from the rest of the market by coming forward with theory of change, intentionality and measurable progress. And so, all in all, I think this is building blocks we're seeing in each market. Then, when it comes to the implementation, do you have to apply for your label or is it a default label and you basically have to just disclose what you do? Or is it in other markets? It might be that the hurdle is higher because the regulator has more restrictive understanding while the rules are principle based, which we have seen in the uk, where everybody thought it's actually easy and it wasn't. And then in other markets the regime is too new or not yet implemented, so it's too early to tell, which is, I think, the case in Australia, for instance. But what we're seeing is that everywhere countries are, all the jurisdictions in the world are somehow working on something that is similar to what the EU has started to put in place a few years back. And I think this is interesting as the EU is a little bit hesitating on the way forward. Should we include more companies or fewer companies? Do we do too much? Do we need to do more burden reduction? I think it's interesting to see that other jurisdictions are copying the EU's based rules and making their own rules out of it, sometimes much more market oriented and practice oriented. And the EU again now in these revisions, can copy some of the improvements that we have seen in other markets, which I think they are doing right now, looking very closely, especially at what's happening in the uk.
- [14:24]
A
Yeah, no, I agree with you and that interoperability among the different jurisdictions is very important, especially for asset managers, global asset managers that are creating products and designing strategies that they're going to cross market to different jurisdictions. And it's good to see that the revised SFDR has looked into, you know, what SRD in the UK has put forth and others to help shape the new guidance and rules for their product classification.
- [14:57]
B
So just one additional thought. I think that there is clearly a bit of maybe a tension to the regulator needs to address, and that is the one between rigor and ambition and sort of telling the market what sustainability really means from their angle to make it easier maybe on the supervisory side to do the checks. Is it implemented in the right way? Is it what we expect? Does it meet consumer needs and expectations towards do you want this to remain a broad market that can accommodate it, accommodate different strategies, or do you want us to become a very niche market that is super green, but maybe only meets the needs of a very small subset of clients? And that is the dichotomy, the tension that every policymaker, every market will have and needs to navigate. Maybe half of the fund universe in the EU is now called sustainable and that might decrease with the new categories as they increase robustness of the categories. But I think we also don't want to end up in a market where we have just the assets that are covered by the current EU taxonomy, which is much smaller subset coverage. So there is this sort of you want it to be right, but you don't want it to be zero.
- [16:09]
A
Exactly.
- [16:10]
B
I think that's, that's where everyone has to, has to handle it.
- [16:14]
A
You raise an important point regarding funds that won't be categorized if they lack robustness or ambition to meet the criteria for the proposed categories. It's likely many EU sustainable products will end up in the ESG basic category if they fail to meet the requirements of the transition or sustainable categories, such as the 70% threshold for holdings aligned with transition or sustainability objectives and the exclusion criteria. And there's also the question of how disclosure will appear for those uncategories funds, meaning those that don't fall under the ESG basics, sustainable or transition categories. And ESMA issued guidelines back in May of 2024 with criteria for funds using ESG or sustainability related terms in their names. So it's worth considering whether this guidance will remain or will be revised in light of the new SFDR 2.0 proposal.
- [17:17]
B
So how I understand this. So I'm a member of the ESMA Working Group on Sustainable Finance since, since its inception, I think three years ago. And we had long discussions always on this topic with the work. The working group is composed of different members from academia, NGOs, but also finance and data providers and corporates. And in that group we have had these discussions back and forth. But I think an important element now is that Most likely the SFDR20, if the labels are sufficiently robust from a regulator's perspective, from supervisors perspective, the ESMAR fund name rules will be repealed, replaced by these new rules which are very much building on the ESMA fund name configuration. And when we look at how the ESMA fund name rules which were introduced last year, came into effect, which were introduced two years ago now and came into effect for all existing products in May last year. So in that period was about 12 months. We have seen a lot of changes in the fund names. According to our analysis, thousand 400 funds have changed the name. ESMA has just released an analysis of their own from December that shows that in the subset they analyzed 4000 funds, 2/3 changed the name and a half changed the policy. So kept the name, but changed the policy. Wow. And in fact a lot of the fund names, yes, it's interesting. And a lot of the funds that changed the name had already some fossil fuel exclusions, which is the most impactful addition from the fund name guidelines that you had to get out of the fossil fuel based on certain revenue thresholds for coal, oil and gas. And those that didn't have, have that had a relatively high exposure, say a normal exposure. If they track a benchmark, it's just a benchmark sector weight, they were more reluctant to change policy and were more likely to change the name. Now Esmart thinks of this as a success, successful strategy. We have also done an analysis at MSCI where we looked at the name changes. So the,400 funds that changed the name and a lot of them have stick to the exactly same strategy as they had before. So they didn't move away from their sustainability focus or ESG tilt or whatever they did before. So they kept the same strategy, which means they didn't withdraw from a sustainability strategy, but they just didn't want to have that large of a tracking error. They didn't want to kick out all the fossil fuel investments. So if you track a benchmark and you want to make sure your performance continues to be accessible compared to that benchmark, it's not so easy to just go out. And I think that's a factor we need to consider and it will be coming back because now with the SFDR labels, they choose exactly the same exclusion categories, even adding on top of these revenue weight exposures to fossil fuels, plans to expand fossil fuels or plans to, or no plans to phase out coal. So there are additional criteria where the data is not as established as it is for the fossil fuel revenue exposure. So we'll really have to see how this plays out and how much of a, you know, how much of a restriction it is perceived to be by the market. So if at the end all the products change their name, I don't think you can call it a success. Ideally they do not change the name, but make their strategies more robust.
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A
Right.
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B
So that should be the objective, I think in the end.
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A
Yeah. No. Thank you for providing that insight. Based on your consultation experience with ESMAA so many of our listeners are keen to learn about the practical steps for implementation. So for asset managers Preparing for SFDR 2.0, what should they prioritize over the next 12 to 18 months to ensure compliance, especially regarding the substantiation of claims and exclusions, data quality and product level documentation. And what do you see maybe as some of the main challenges arising?
- [21:11]
B
Yeah, I think much advice is to not overdo it in the first months and to watch a little bit what's unfolding now. I think it's 12 to 18 months at least. We would expect this to only enter into force in 2028. So we have quite some time ahead. What definitely makes sense right now is to emphasize data, good data. There is clear reference also to the use of estimates. So assess that you, when you don't have the data, make sure you, you have something else in place. Cover it. No gaps. Governance, robust governance of the processes, traceability and substantiation. Because one thing of this, sorry, substantiation of the sustainability claims. Because I think one thing is pretty clear. Even though it might look to some as a backtracking in terms of simplification, disclosure reduction, burden reduction, whatever policy, maybe not being the policymakers, not being super involved or not as pushy, at least on the need to be green or to greening your investment processes. I think the supervisors are still expecting you to walk the talk and more so. So I think the robustness of the claims and also related disclosures will be, will be even more important going forward. And I wouldn't wait for the implementation of this change to look at governance and robustness of claims. I think this is something you should do now. So there is this emphasis also on the disclosure side. You have no entity level disclosures potentially when this new rule is in force. However, until then there are still at least two periods where we'd expect the disclosures to happen. And on the product level there is going to be more emphasis on saying how do you do the harm assessment? This was just a consideration, so you had to consider it. But nobody told you you had to disclose it. And few, I mean some did, but not all. And the disclosures were not comparable. So the comparability will be more in front. So you will want to, you will want to be sure you have something that is, stands the test of scrutiny both from a supervisor and your investment community. So your, you know your clients and that is the challenge. I think that's what you, what you will have to focus on. So it's, it's really this wait and see on the one side, but make sure you have your back covered on the other side.
- [23:26]
A
Yeah, and you made a good point on that. Now the entity level PI's are no longer applicable and it's me more looking at it from a product standpoint. So I think that would help with some of the compliance costs and complexity of a lot of the data that's needed at that entity level that maybe wasn't used as much or as helpful as it would be if it was looking at it from a product standpoint.
- [23:51]
B
And when it comes to assessing harm, I think one change we'll see on the assessing harm is that it will be more flexible which indicators you use. So you will probably see a higher reliance by asset managers on indicator based approaches and that aligns quite well with the tools and data sets that data providers have. But at the same time you'll have the regulator come forward with a new list of adverse impact indicators. And so while they become voluntary to use, you could also use other suitable indicators. They will still be sort of a big thing because the regulator has basically signed them off. You can be sure if you use them, it's easier to basically make your your claim. So I think they will not disappear. But the list is expected to become a lot smaller, more focused on data availability. And I suppose there's going to be some more consultation, interaction with the market to see what, what indicators are best making sense. And I think given that there is already an overlap between the adverse impact indicators and the exclusion coming from the principal, so from the Paris benchmarks or the pabs, notably when it comes to controversial weapons, when it comes to fossil fuel exposures, there is probably going to be redundancy that will be removed with the revised PAIs, focusing especially on those indicators that are not covered already by the pabs. That would be my expectation. Whether it will play out this way or not, we'll have to see. Interestingly, it's not ESMA who will come forward with the Delegate act or the technical criteria for assessing sustainability, harm, transition, impact, et cetera, but it will be the commission. And we expect that to happen sometimes next year, most likely by the end of the year we will have a delegated act that will then allow us also to start our work on the data inventory and making sure we have what is required for asset managers to report on.
- [25:42]
A
So one common critique of SFDR is that it blurred the line between product with sustainability characteristics and those that had genuine impact. And in our research that we've done and guidance that CFA Institute has put forward, we had two different papers labeled how to build a Better Yi Shifong Classification System and our impact investing guidance for designing listed equity strategies that generate real world outcomes. And we showed that the Regulation Group products by their sustainability characteristics rather than by intentionality and contribution and impact measurement and outcomes, which really are cornerstones for impact investing. So do you believe that SFDR 2.0 meaningfully accommodates impact strategies and creates more of a clearer framework for impact investing? And what do you think credible impact would look like under these new categories?
- [26:44]
B
Yes, thanks for that and also sharing your paper. I think you make some really important points in there. And one of course is around the question of engagement and how close do you get to the companies you invest in. And I think this is. If you ask me what the framework is for impact investing, I would say it's not really a framework they put forward here, but they leave the door open and the delegated act will bring the framework. So I think there is a big relief from the impact investing community, which is not our typical clients, I have to add, but I know that there is a lot of sort of interest of this community to be able to differentiate the products they spend a lot of time building and that's possible. So there is this explicit recognition of impact permitted recognized approach for products pursuing either sustainability or transition objective, which means it's no longer shoehorned into an Article8.9 disclosure box where it was never really, you know, comfortable sitting. And so that's really a big conceptual change. And then I think on the question of the framework and how it's going to play out, there is three elements that will be key here. One is the way that the theory of change and the intentionality is formulated. So that has to be really clear articulation of an intended impact goal. Then also the question about contribution, so how your investment activity contributes to the, to the outcome, then measuring progress. And that's going to be part of the new disclosures. And we'll have to see how they are asking for this, whether it's sufficiently clear and sufficiently detailed. Because one of the other maybe conflicting aims is of course to reduce the reporting, bring it down to just, I think it's three pages for impact, two pages for transitional sustainability. So there is a recognition that impact may need more room to be described. And there is a clear understanding that also for the sustainability category and specifically for the transition category, that engagement is necessary and that it should be well documented. So I think for these two areas, transition and impact, you would see A big emphasis from the regulator to showcase your engagement with the companies you invested in.
- [28:56]
A
I was happy to see that impact products aren't limited to the sustainable category and that they can also fall under the transition category since much of the impact really arises from companies actively working toward becoming more sustainable. For example, those highly emitting companies are now lowering their emissions and engagement was emphasized in the transition label, which I agree is a way for investors to influence and really contribute to the company's change. Credible engagement strategies should feature specific milestones and have measurable indicators to track progress on those sustainable outcomes. Also important is monitoring transition plans and disclosing science based targets are highly relevant for the transition category.
- [29:47]
B
And of course for us as a, I mean MSCI also has some, some indexes so we have a lot of passive investor clients and of course for them it's also important to to see that the that climate aligned benchmarks are another road because there you wouldn't be able to do the engagement that you might do on an active fund.
- [30:05]
A
Right.
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B
So you have both recognized both investment strategies as are fine in that current context of the proposal at least.
- [30:14]
A
So now let's shift more onto some of the risks. So what risks do you see with SFDR 2.0? So for example, could there be unintended consequences such as potentially over simplified labels or inconsistent market adoption or different confusion between the different types of labeled products?
- [30:36]
B
I think it's a good question and one that probably is almost impossible to answer now because we will see a lot of the details only coming down in the delegated act and that that is just the first part. And the second part is then really the application, the supervisory practice because you might well see that the categories are nearly identical from one market to another, yet the supervisory implementation differs greatly. And we have seen this on SFTR even within the EU where no market handle it the same way. And to give you one example is the use of estimates. So ESMA would say you need to make sure you have no gaps. You don't assume no address impact just because a company doesn't report their emissions. So you need estimates and the next is another country and I won't name names here, but that would say no way, you don't use estimates, it's not allowed. And the next saying well we are totally fine with estimates. So I think that sort of practice changes. And the commission might say in the proposal supervisors shouldn't do gold plating. There is no room for that here. But there are such small nuances in the way that supervisors interpret the rules. It's just very difficult to say it's gold plating or it's simply national preferences or you may call it differently. But I think that will be an important test of practice and that is of course the same from jurisdiction to jurisdiction comparing the EU and the uk. It will be practical matter of convergence over time. I think as well as these supervisors talk to each other and making sure the market associations like Youssef is doing their role to it. And I think they've done a fantastic job also with a good podcast and just trying to get supervisors and regulators to be more sensitive to these differences in market implementation and the impact it has on capital allocation.
- [32:24]
A
Okay, so we're almost out of time, but I'd like to end with kind of your opinion and view on some of the forward looking future landscape. So when we look five years from now, how will we know whether SFDR 2.0 has worked or been successful? What do you expect to see? Would you expect to see changes in product design, data usage, investor behavior or capital allocation as a success?
- [32:52]
B
Yes. So we, we recently had our advisory panel where we have 15 of our largest clients or 15 clients, not the largest one, but just a good variety of regional and type of institutions. And one, one was just sticking to my head, which was saying when we were discussing how many adverse impact indicators do we need? And they were saying well basically we need five, because five is something I can explain to my retail clients and they will remember. Maybe it's even three.
- [33:20]
A
Just.
- [33:20]
B
Yeah, but I think that's the test of success for SFTR is that I can actually explain it to my neighbor, my father, the man on the street. It's easy, it's understandable, it sticks. And article eight, nine just the names don't really lend themselves to such a conversation. People don't understand what it means. So I think recognizability, ease of access, comparability, allow me to compare different products and understand what it means. And SFDR could now go many directions. But I think this is really the litmus test in the end is can I explain it to someone who is not working in finance, who's not exposed to these topics, who doesn't understand all these abbreviations but wants to make a change, wants to invest sustainably and maybe without losing out in the long term, but. But clearly having a robust return and a sustainable return. I think that mix is anyway what we're seeing now. The whole conversation with all this backtracking by policymakers is now fostering, centering so much on what is actually financially material. How can we explain this in a simple way to our board that sustainability counts, that sustainability matters, that it makes a difference to your baseline performance, and that this is where we put a lot of time in our studies and research now at MSCI as well as to explained that sustainability is a factor in financial performance and should be understood as such.
- [34:46]
A
Your last statement is an important one to repeat that sustainability is a factor in financial performance and should be considered as such. So Simone, thank you so much for joining us today and for sharing your thoughtful insights on SFDR 2.0. You helped clarify what this redesign is really trying to accomplish from Moving beyond Article 8 and 9 framework toward clear, more credible product categories. I think a key takeaway is that while the framework may be evolving and expectations around transparency and comparability and robustness are only increasing, so we're certainly keeping a close eye on how this develops and I look forward to continuing the conversation with you as FTR 2.0 moves closer to implementation.
- [35:41]
B
Thank you Nicole. It has been a pleasure.
- [35:43]
A
Thank you so much.