SFDR classification: ‘Good things take time’

In March 2021, the Level I requirements of the SFDR came into force. Amongst other things, the SFDR requires asset managers to classify their funds according to three Articles of the new pan-European directive. Under this system, a strategy is labelled under either Article 6, 8 or 9:

• Article 6: funds that have no sustainability focus

• Article 8: funds that do not have a sustainable investment objective, but do promote environmental or social characteristics, provided that the companies in which the investments are made follow good governance practices

• Article 9: funds that have a sustainable investment objective.
  
  As of January 2023, new regulatory elements are to be introduced as part of the SFDR Level II implementation, that cover, but are not limited to, the intended percentage of sustainable investments; the minimum intended investment in EU Taxonomy-aligned investments; and the consideration of Principal Adverse Impacts (PAI).
  
  Those elements will also need to be considered in the light of amendments to the MiFID II regulatory directives as an element of the so-called sustainability preferences in suitability assessments for portfolio management and investment advice.
  
  It is expected that the SFDR Level II requirements might alter current classifications, as well as replace the focus on classifications towards the underlying elements, such as the percentages of sustainable investments and Taxonomy alignment prevailing in funds.

The shift in focus from classification to the underlying characteristics of the invested assets aims to improve on the current system. Here, trying to place a variety of funds with unique characteristics into just three groups is considered by many investors to be too simplistic to capture this diversity.

In addition, the focus on this kind of classification might not have been what was originally intended in the pursuit of transparency and disclosure. One of the often-cited challenges is the one that the ‘bucket’ of Article 9 classifications is rather small as it is fully tailored to funds that are entirely sustainable. In contrast, the group of Article 8 funds encompasses a large amount of funds.¹

Some of these Article 8 funds may promote environmental or social characteristics that relate to exclusions only. Others are actively financing companies that are required to transition towards achieving the objectives of the Paris Agreement or those of the 2030 Agenda for Sustainable Development. The disparity is quite wide.

A potential paradox is that certain funds seek to actively engage with companies that are transition candidates, or invest in companies whose current activities are not entirely sustainable, but are allocating significant capex to the transition. These are classed as Article 8 funds, yet they might be considered as more impactful than other funds in the Article 8 bucket

However, so long as significant capital is allocated to transition strategies, and SFDR works as intended, more holdings should eventually become eligible to classify as sustainable investments, and with that, the number of Article 9 funds might grow over time.

In that sense, the consultation of the UK’s Financial Conduct Authority (FCA) outlining the direction of Sustainability Disclosure Requirements (SDR) and investment labels for British funds might offer a clearer distinction. This has five buckets labelling funds as ‘not promoting SI’, ‘responsible’, ‘transitioning’, ‘aligned’ and ‘impact’.²

The likely shift in focus from classifications to sustainability assessments, driven by SFDR Level II and MiFID II implementations, would be welcome. For MIFID II, the underlying sustainable preferences of clients need to be matched with the products they buy, and the subsequent level of Taxonomy alignment will need to be considered. Clients will also need to indicate whether funds should consider PAIs, which can beautifully capture investment preferences with regard to tackling environmental and social issues.

This should help to better articulate what type of sustainability goals the end-investor is looking for, and bring more nuance to the type of product being sought, especially within the range of Article 8 products.

However, there is a catch. Whereas the frameworks for the Taxonomy and PAI leave little room for doubt, the definition of sustainable investments is open to interpretation. This might result in a variety of opinions about which holdings are deemed to be sustainable, and whether this should be considered from a universal or a contextual perspective.

From a universal perspective, an investment is either considered to be sustainable, or it is not. From a contextual perspective – following the principle-based definitions provided – one could argue that an investment can be considered sustainable for one fund but non-sustainable for another.

For example, a fund that aims to finance the transition to a low-carbon world could invest in companies with verified decarbonization pathways, but which may have average practices with regards to diversity and inclusion. A fund which aims to invest in companies with leading diversity and inclusion practices would be unlikely to buy the same companies. It depends on the underlying sustainability objective, with the minimum safeguard that the companies do not significantly harm any other sustainability objectives, and follow good governance practices.

Ultimately, we believe that the full publication and implementation of the EU’s Environmental and Social Taxonomy will work as a proxy for what is considered sustainable, thereby contributing to the intended goals of the Sustainable Finance Framework by increasing comparability between sustainable products, and avoiding greenwashing.

However, until this harmonization and standardization is provided, and the related data challenges have been tackled, we would advise investors to carefully research every product they are considering buying. Be sure to look under the proverbial hood.

Footnotes

¹https://www.morningstar.com/en-uk/lp/sfdr-article8-article9?utm_medium=native&utm_campaign=emea_investors_sites
²https://www.fca.org.uk/publications/discussion-papers/dp21-4-sustainability-disclosure-requirements-investment-labels