Patrick Moloney, Ilona Pärssinen
16 August 2023
SFDR: Getting the sustainability objective right for Article 9 funds
Sustainable investment products have been attracting new capital in a rapid pace. Effectively, SFRD Article 8 and Article 9 products have gained a continuously larger share of the market. But uncertainty remains. In this long-read, our experts share lessons learned and present eight focus areas to gain clarity and avoid downgrading financial products.
Getting the sustainability objectives right for Article 9 is far from trivial. Working with numerous clients in recent months, we have seen this uncertainty first-hand. On top of this uncertainty, the interpretation of the SFDR (Sustainable Finance Disclosure Regulation) and associated RTS (Regulatory Technical Standards) many products have consequently resorted to downgrading from Article 9 to avoid being accused of greenwashing (only to find themselves now being accused of greenhushing!).
But what are the key considerations to ensure downgrading of products will not be required? That key question is the essence of this article. We will go through a total of eight areas divided into two categories. First, let’s look at the SFDR.
Since the introduction of the Sustainable Finance Disclosure Regulation in March 2021, financial market participants (FMPs) have been required to provide entity and product level Environmental, Social, and Governance (ESG) disclosures on investments. Since the beginning of 2023 all remaining SFDR requirements – so-called Level-2 requirements – entered into force, introducing a long list of new product level disclosure requirements, and stricter rules for sustainable investment products.
The SFDR is a transparency regulation supporting one of the main objectives of the EU Action Plan for Sustainable Finance – reorienting capital flows towards sustainable investments by improving transparency and comparability of sustainable investment options and preventing greenwashing.
The SFDR imposes ESG-disclosure requirements based on categorisation of products into three groups in accordance with the Articles 6, 8 and 9 of the regulation: ‘dark green’ products that have sustainable investments as an objective (Article 9), ‘light green’ as products that promote ESG characteristics (Article 8) and other products (Article 6).
The second half of 2022 was characterized by regulatory turbulence and increasing uncertainty on the interpretation of the rules of the SFDR. According to Morningstar, since June 2022 more than 350 funds on its platform downgraded to Article 8 from Article 9 and in Q1/2023 the new inflows to Article 9 funds was at a record low. This was triggered by a combination of clarifications provided by authorities and remaining uncertainties regarding the SFDR rules. As a precaution, many FMPs opted to downgrade their products to prevent any greenwashing claims.
We have identified three main reasons behind the downgrading trend to be aware of:
Three main reasons
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1. Tightened rules for investments that can be held in Article 9 products
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2. Confusion around use of the climate benchmarks as proof of sustainability objective
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3. Weak sustainable investment definitions and approaches
1. Tightened rules for investments that can be held in Article 9 products
In June 2022, the European Supervisory Authorities (ESAs) clarified ahead of the implementation of the Level-2 requirements on 1 January 2023 that Article 9 products need to invest exclusively in sustainable investments, with the only exceptions being liquidity and hedging purposes. As the Level-1 requirements implemented in March 2021 put the emphasis solely on having sustainable investments as an objective of the fund rather that explicitly stating that the underlying investments need to already be considered sustainable, many managers were taken by surprise with this stricter requirement.
Due to the weaknesses in the sustainable investment strategy and objective, or lack of a robust definition of what can be considered as a sustainable investment, the FMPs had to resort to downgrading strategies into ‘light green’ to meet the new stricter rules.
2. Confusion around use of the climate benchmarks as proof of sustainability objective
Climate change mitigation is one of the six environmental objectives at core of the EU Action Plan for Sustainable Finance, and in the attempt of reorienting capital flows to sustainable investments also new EU Climate Benchmarks have been developed. The SFDR links sustainable investments with emission reduction objectives to these climate benchmarks as a way to measure progress towards emission reductions aligned with the Paris Agreement.
Before the end of 2022 many FMPs had considered all passive strategies that track a Paris Aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB) to automatically qualify as Article 9 products. However, confusion was created after the ESAs imposed the ‘exclusive sustainable investment rule’. This rule posed a challenge for passive investment strategies that track the transition towards the Paris Agreement, as they often hold investments that do not yet qualify as sustainable investments. This led to the ESAs requesting clarification from the EU Commission and awaiting the resolution many FMPs ended up downgrading the passive climate strategies to be on the safe side.
3. Weak sustainable investment definitions and approaches
Preventing greenwashing remains high on the agenda of the financial regulatory authorities. Ahead of the implementation of the Level-2 requirements in beginning of 2023, ESG disclosures were under scrutiny of the National Competent Authorities (NCAs) that provided further national guidance for SFDR implementation, but also conducted reviews of the sustainability disclosures.
The Danish and Swedish NCAs, for example, concluded (based on a thematic review of Article 9 funds) that sustainability information was disclosed in an incomprehensible manner and that the disclosures were insufficient in several material aspects.
The main critique was directed at unclear definition of criteria for sustainable investments, sustainability objectives and insufficient measures of contribution, incomplete disclosure of the processes to meet key criteria for sustainable investments and management of sustainability risks.
‘Sustainable investments are investments that contribute to an environmental or social objective, do not significantly harm any other sustainability objectives, provided that the investee companies follow good governance practices’.
Similar patterns are also visible in other countries, as NSAs tighten their expectations for sustainable investments. The French NCA has even proposed changes to the SFDR to set stricter requirements for Article 9 products, which, if adopted, would apply across the EU. Inability to meet the expectations of authorities for Article 9 were an obvious reason to reconsider the classification of the fund, and the results of the reviews were apt to cause uncertainty also wider in the markets.
According to the SFDR, sustainable investments are investments that contribute to an environmental or social objective, do not significantly harm any other sustainability objectives, provided that the investee companies follow good governance practices. This definition leaves a lot of room for interpretation – to the extent that the ESAs turned to the European Commission for further clarification. Asset managers lacking a solid definition for sustainable investments were prone to downgrade the strategies to be on the safe side.
In April 2023, the EU Commission published a Q&A clarifying some of the uncertainties behind the last year’s downgrading trend. The EC provided advice on interpretation of the sustainable investment definition and decided not to introduce any anticipated minimum requirements for allocation to sustainable investments in Article 9 products. However, following these clarifications, ESMA (European Securities and Markets Authority) highlighted in a recent greenwashing progress report that creating such minimum requirements and best practises on measuring contribution to sustainability objectives is crucial and that such definitions could still be created separately by the ESAs.
The EC also clarified that passive strategies tracking the Paris Aligned Benchmark or a Climate Transition Benchmark are exempt from the exclusive sustainable investment rule. Since the news, downgrading of funds seems to have slowed down, and Morningstar stated that they expect the trend to have peaked.
Five key considerations
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1. Create a targeted & robust definition for ‘sustainable investment’ and avoid ambiguous sustainability objectives
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2. Setting the asset allocation right is key – but easy to get wrong
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3. Meeting the EU Taxonomy criteria is easier said than done
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4. Challenges in measuring objectives with KPIs outside of the Taxonomy
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5. Data Availability
Based on our experience we have identified five key considerations to have in place when setting up sustainability objectives for a successful Article 9 strategy – and avoid the need to further downgrading:
1. Create a targeted & robust definition for ‘sustainable investment’ and avoid ambiguous sustainability objectives
It continues to be up to the asset manager’s discretion to define a robust definition for sustainable investments. While the DNSH and good governance practices may also be difficult to assess and prove, the first stumbling block for asset managers will be defining and showing how investments contribute to the environmental or social objectives.
Practical evidence working with the regulation shows that sharper sustainability objectives can save the asset manager from a lot of trouble. Broad objectives, such as contribution to any of the 17 SDGs, leave room for asset selection – but also risk of greenwashing accusations. If the objective is vaguely defined, it will result in ambiguity throughout the process of investment selection, setting KPIs, measuring progress and making disclosures.
Progress on the 17 SGDs is measured with different indicators and may result either in a need to set a broad set of KPIs – or extensive expertise to create credible composite indicators that are transparent and specific enough to manage investor expectations. Competence and understanding of wide sustainability issues and mechanisms is also required in managing a strategy that contributes to a variety of environmental and societal improvements.
The KPIs need to be clear from the start as they are one of the main disclosure requirements laid out in the pre-contractual disclosures, but also to avoid ending up in a situation with too many or no applicable KPIs – both of which are risks if the sustainability objective is vague.
Taking a close look at the assets in the investment universe is essential in avoiding the risk: what kinds of companies and solutions does the investment strategy aim to find – and which sustainability issues can these actually solve? Key is to understand first what assets one wants to invest in and walk backwards from there to set the right KPIs and form the objectives.
Broad investment strategies will naturally result in a broader set of potential sustainability issues, while narrower investment strategies benefit from contribution to a more focused set of issues. In both cases, it should be clear from the start what the contribution is and how it is measured.
2. Setting the asset allocation right is key – but easy to get wrong
Pre-contractual requirements include disclosing the intended asset allocation into sustainable investments, i. e., investments with environmental or social objectives, where the former is a mix of Taxonomy aligned and other environmental investments.
Setting the asset allocation right is essential – but easy to get wrong. One product can target investments in both social and environmental objectives, but as said – aiming to contribute to a broad set of objectives increases the layers of complexity.
Article 9 funds should hold only sustainable investments and according to Morningstar, 92% of the funds on their platform disclose investing minimum 70% in sustainable investments. Over half of the funds have also set a minimum level of Taxonomy alignment, while the numbers remain quite low as only a bit short of 8% of funds target something above 10% of Taxonomy alignment.
Setting the minimum Taxonomy alignment too high may come with a risk of not meeting investor expectations, misselling, or even a fine if it is not well thought through. Even when the Taxonomy criteria are well integrated into due diligence and asset selection processes, high commitments in Taxonomy alignment may come with financial consequences for the investment strategy as alignment with the criteria is hard. On the other hand, investors are continuously seeking sustainable investment opportunities and high commitments to ambitious criteria like the EU Taxonomy may be an advantage in attracting new investors.
3. Meeting the EU Taxonomy criteria is easier said than done
EU Taxonomy provides credible and ambitious criteria for sustainable investments in a variety of economic activities with substantial contribution to six environmental objectives: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to circular economy, pollution prevention and protection and restoration of biodiversity and ecosystems. The first two objectives are already in force, while draft criteria for the remaining four objectives are expected to be adopted in June 2023.
Looking at some industries, the EU Taxonomy already presents a wide set of criteria for many activities. But just because the activities are included in the Taxonomy, don't be fooled that it will mean that assets will also be aligned. Taxonomy alignment is assessed based on activity specific technical screening criteria that describe how activity substantially contributes to one of the objectives and does no significant harm (DNSH) to any others, and company level alignment with the Minimum Safeguards. Meeting the Taxonomy criteria is tricky and focusing only on eligibility or the substantial contribution criteria may make it look just a bit too easy. For some activities the substantial contribution may be relatively easy to meet e. g., wind, solar, while for others, only the best in class will have a chance.
Substantial contribution is only the first step in assessing alignment, and issues often emerge when considering DNSH and Minimum Safeguards requirements. One common stumbling block with the DNSH criteria is on adaptation to climate change, as many companies lack the needed climate risk assessments.
The Minimum Safeguards are part of EU’s actions to step up the game of companies and organisations (including FMPs) when it comes to respecting human and labour rights, applying across companies from large entities to SMEs. Private Equity fund managers need to not only fulfil the requirements themselves, but also ensure compliance at level of assets by conducting pre-investment screening, ongoing human rights due diligence and monitoring of compliance with the Minimum Safeguards requirements on each portfolio company.
‘Taxonomy alignment is assessed based on activity specific technical screening criteria that describe how activity substantially contributes to one of the objectives and does no significant harm to any others, and company level alignment with the Minimum Safeguards’.
Private Equity Article 9 fund managers in particular should keep in mind that nothing is Taxonomy aligned at point of investment. PE managers will have to be ready to work for aligning the assets when relying the sustainability objectives on Taxonomy alignment and consider how long they can wait for the assets to become aligned – and if that will meet the expectations of investors and authorities.
4. Challenges in measuring objectives with KPIs outside of the Taxonomy
While the EU Taxonomy provides a trustworthy criterion, it does not fit every investment strategy, nor objective. Entire economic activities, for example, fall out of scope of the existing climate Taxonomy and not to mention the draft criteria for the remaining environmental objectives that fall short of what was expected particularly on biodiversity. Asset managers should not shy away from defining their own criteria and measures for sustainable investments but need to put substantial consideration on how that can be done in a credible way.
For measuring environmental objectives, the SFDR refers to key resource efficiency indicators but leaves the decision of which indicator to use for the asset manager to decide. Without proper industry specific technical expertise, ecological and sustainability knowledge, choosing the right indicators might be a tough nut to crack. Beyond the Taxonomy, the EU Climate benchmarks are the only other predefined measures that can be used to measure contribution on climate transition. Or rather, it is expected that progress on climate objectives is shown using these benchmarks – or else explained why not. However, these cover only carbon reduction objectives and are applicable only to operational industries but offer little support to measure for example the progress of energy transition. Furthermore, benchmarking cannot serve all investment strategies and is most applicable to passive strategies.
Alongside the green transition, social investments to ensure just transition, poverty reduction or improving the health and living standards of the global population are desperately needed.
A social taxonomy, however, is not yet available and will not be in the short to medium term and due to lack of any other best practises, asset managers are left with pressure to come up with robust KPIs to back up a social objective. Setting a specific objective, measurable and credible KPIs will be a challenge – a risk even if not done properly – although asset managers should not back away as social investments are crucially needed.
5. Data availability
Last but not the least, the sustainability objectives need to be backed up with data. A key aspect to understand when setting the sustainability objectives is the question if the assets have the ability to give the information that is needed to prove it.
Current sustainability reporting practises lack standardisation, and mandatory sustainability and Taxonomy reporting applies only to the largest listed companies hindering data availability and quality. The new Corporate Sustainability Reporting Directive (CSRD) will bring much needed help for the dilemma, expanding the scope to almost all listed companies – while for non-listed companies the requirements stop at large undertakings. While listed equity investors will have continuously better access to material sustainability information, PE investors may face more challenges in getting their hands on the right data.
Taxonomy reporting can be a huge effort for PE assets from assessing and implementing the actions to aligning the business with the strict substantial contribution and DNSH criteria, putting in place and following the ongoing human rights due diligence commitments of the Minimum Safeguards, all the way to calculating revenues, CapEx and OpEx based on Taxonomy activities that often are not one-to-one with existing accounting systems. While use of estimates on Taxonomy alignment is prohibited, investors can resort to external advisors with technical, environmental and sustainability expertise to step in to help with Taxonomy due diligence and reporting support.
One thing we have learned so far is that the SFDR rules are, and will continue to be, evolving over time. For instance, despite the EU Commission cutting some slack for the markets in their recent Q&A, the ESAs continue developing their expectations for sustainable investments.
The next requirements to be expected relate to setting minimum requirements on products marketed as ‘sustainable’, while the markets continue to wait if the authorities decide to introduce further requirements for Article 9 products.
Defining a sharp sustainability objective and backing it up with the right KPIs is crucial for meeting the requirements today and in the future. Asset managers seeking to establish, upgrade or maintain Article 9 strategies should put time and resources in developing their approach for assessing how investments contribute to environmental or social objectives. This can be tricky as backing up the objective with the right KPIs requires extensive technical understanding of industry-specific sustainability aspects.
After the first round of full SFDR disclosures have been published, asset managers should take the time to put their sustainable investment strategies in order – to remain resilient in the regulatory turbulence and avoid the need to further downgradings.
Want to know more?
Patrick Moloney
Director, Strategic Sustainability Consulting
+45 51 61 66 46
Ilona Pärssinen
Senior Consultant
+358 50 465 1212