Regulators in the EU are in the process of updating the Sustainable Finance Disclosure Regulation, or SFDR, the sweeping regulation that lays out ground rules for sustainable investments and took effect in 2021. Among the goals of SFDR is to fight “greenwashing, where products or services marketed as sustainable or climate-friendly do not in practice satisfy those standards”.
However, SFDR wrongly puts the cost of this effort on funds that set the highest bar in terms of environmental, social, and good governance, or ESG, factors. One observer at European Microfinance Week 2024, a conference held by financial inclusion network e-MFP in Luxembourg in November, likened this to forcing apple growers to pay a fee to teach shoppers that fruit is healthier than doughnuts.
Modest success to date
One of the hopes for SFDR is that it will encourage more investment in sustainable finance by educating investors on the potential positive impacts of their choices. So far, the regulation has helped distinguish investment vehicles that aim to be sustainable from those that do not. SFDR also has brought together investors working in inclusive finance to collaborate on how to comply with the law. This is happening through e-MFP and the Social Investors Working Group of Cerise+SPTF, a collaboration offering tools that help financial actors meet their social and environmental goals.
Among the benefits of these partnerships has been to boost the alignment of reporting practices. This is great news for investees because it reduces their reporting burden by limiting the need to produce different datasets for different investors.
The universe of socially responsible funds is broad: some focus on avoiding harm, while others actively work to improve ESG factors; some pioneer concepts to create new markets, while others are more commercial and focus on scaling up proven ideas. The investment vehicles that are the most innovative are finding that complying with SFDR – while necessary – is not sufficient. That is, these funds seek to create impacts that are not reflected in SFDR reporting, which largely addresses environmental impact, with a relatively light touch on social impact.
While this balance can be a negative for investors focused primarily on social impact, some report having benefited from the nudge toward weighing the environment more heavily in their calculations.
Challenges ahead
In addition to increasing the cost of sustainable finance, one of the major problems with SFDR is its focus on investments placed in Europe.
European investors – including most financial inclusion investors – that are active in other parts of the world, especially in low- and middle-income countries in the Global South, have found it significantly more difficult to comply with the regulation. Some of this simply reflects that the reporting requirements were drafted for the legal and business realities in the EU – realities that often bear little resemblance to countries whose per capita incomes can be just a tenth of even the poorest EU members.
Closely related is the lack of clarity on acceptable proxies and alternative data for smaller enterprises in the EU and in the Global South. It’s probably not the intent of the regulation to have impact investors report on the carbon footprints of millions of downstream clients – smallholder farmers, microentrepreneurs, and other low-income households who are most directly affected by climate change while having contributed nothing to its cause. And yet in the absence of suitable alternatives, those are the requirements of SFDR.
Your voice is crucial
The reality is that SFDR has increased the cost of doing business for impact investors. Frustratingly, this conflicts with the goal of encouraging more investment in the sector. As the EU prepares to revise the law, stakeholders must lobby for this cost to be shared among all funds, not just those that exceed the minimum standards. We need to counter the messaging of traditional investment funds, which have been very vocal in swaying the implementation of SFDR to protect their market share.
Encouragingly, regulators and legislators have been open to input from the Social Investors Working Group and e-MFP. However, more voices are needed, including those of inclusive finance providers, such as banks, cooperatives, microfinance institutions, and others. Now is the time to reach out to the European Commission officials who are reviewing the SFDR.
The SFDR review process is likely to progress to the parliamentary level, and sooner still, the upcoming “Omnibus simplification package” may indirectly affect SFDR reporting requirements. With these legislative initiatives on the horizon, reaching out to Members of European Parliament is also crucial.
You may get involved by joining the Social Investor Working Group, whose next meeting is scheduled for Thursday, February 27.
In the words of a presenter at the most recent European Microfinance Week, “Don’t let others write the law that regulates you!”
Bob Summers documents – in text and video – the impacts of financial inclusion and other efforts to reduce poverty, including at www.mesofinance.org. He also serves on the Board of Directors of the fair-trade cooperative Equal Exchange.
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