SFDR 2.0: Change Is Welcome, but Challenges Remain

Key Insights:

Proposed changes to the Sustainable Finance Disclosure Regulations (SFDR) are currently being debated, with political agreement expected by late 2026 or early 2027. These changes aim to simplify the framework, improve usability and reduce reporting burdens. However, the continued evolution of the regulation can create planning uncertainty for asset managers. Operational complexity and implementation burdens may also require extensive internal coordination which could lead to high transition costs and long implementation timelines.

In a recent webinar with Investments and Pensions Europe (IPE), Morningstar Sustainalytics, alongside EFG Bank and Vontobel Asset Management, discussed how SFDR 2.0 is being interpreted and approached in practice today. They explored where clarity is emerging, where questions remain open and how firms are navigating the transition period. 

Although the panelists welcomed the proposed changes to SFDR and were in broad agreement about the benefits, there were a few sticking points. In this article, we highlight some of the practical challenges raised during the webinar and unresolved questions market participants face as SFDR 2.0 approaches. 

An Introduction of Prescriptive Minimum Standards

The proposed change would move the regulation from a disclosure to a classification regime. As noted by Benjamin Schofield, Director of Regulatory Solutions as Sustainalytics, under SFDR 2.0 previously informal labels would become formalized under three new categories (Transition, ESG Basics and Sustainable), with clear minimum standards introduced. While this is broadly positive, bringing the regulation more in line with how it was originally used (i.e., for classification and labeling, it does create significant change. 

One standard under consideration is the introduction of mandatory exclusions for each category, introducing potential rigidity. Forced exclusions could eliminate companies that are otherwise improving and investing heavily towards net zero, and move the system away from case-by-case assessments.

In parallel, the introduction of a 70% threshold for assets contributing to the fund objective could enable a range of approaches and ESG applications, ultimately allowing for diverse strategies to co-exist and differentiated approaches to shine through.

ESG data, research and tools, such as those provided by Sustainalytics can help firms evaluate exclusions and support product construction in accordance with category alignment requirements.  

Day-One Criteria Could Hinder Transition Investing

Applying end-state criteria as soon as the regulation comes into force may limit transition investing strategies since many funds in their current state could find it challenging to meet the category requirements. Companies could potentially be excluded from portfolios before they have time to transition, which conflicts with the European Commission’s goal of financing the sustainability journey. 

The elimination of the Do No Significant Harm (DNSH) requirement could also potentially introduce unintended consequences. As Stefano Montobbio, Global Head of ESG Governance and Frameworks, EFG pointed out, replacing DNSH with mandatory exclusions may penalize companies with minor legacy exposures to prohibited sectors like coal. It may also lead to a strict black/white assessment instead of a more holistic assessment framework.

Emerging Markets May be Disproportionately Impacted

Rules designed around European markets and transition trajectories may exclude other regions that are at a different point in their sustainability journeys. Emerging markets typically operate on longer transition timelines and under different policies and disclosure rules. Capital may also shift to less restrictive jurisdictions if the EU rules are too strict, which reduces the overall effectiveness of regulation.

Capital May Shift Away From ESG Strategies

Managers may downgrade funds to avoid constraints and could potentially move towards Article 6 products (those that don’t have a sustainable investment objective); this could reduce pressure on companies to improve sustainability. Additionally, overly strict definitions may limit ESG integration to a small subset of assets and reduce market participation and adoption, which may risk making ESG a less attractive or viable option for investors.

As Lara Kesterton, Head of Sustainability Research at Vontobel Asset Management, put it, “What we want to avoid is that we narrow it so much that we're not recognizing that sustainability is on a journey, and putting end goals at the starting blocks can hinder, not help that journey.”

For the full conversation, watch SFDR 2.0: What’s Clear, What Isn’t, and How Asset Managers Are Navigating the Reset. For more insight into the proposed changes to SFDR and what they could mean for investors, read the articles linked below. 

• SFDR 2.0 in Figures: Impact Analysis
• SFDR 2.0: Navigating the Shift from Complexity to Clarity in Sustainable Investing

To learn how Morningstar Sustainalytics can help you navigate regulatory changes, read about our SFDR offering.