Can SFDR Accelerate the Green Transition? – Reflections on Initial Implementation
At the beginning of this year, the Sustainable Finance Disclosure Regulation (SFDR), a central part of the EU’s Sustainable Finance Action Plan came fully into force. The objectives of the SFDR are extremely ambitious; increase transparency, reduce greenwashing, and promote sustainable development by directing financial flows towards activities that support environmental and social objectives. Now almost six months down the line, it is time to take stock.
Is the SFDR functioning as intended?
Is the classification of funds into Articles 6, 8 and 9 making investor choices clearer? Are the first disclosures under the SFDR of better quality than what we have had previously? Unfortunately for the EU, and everyone interested in a more sustainable financial sector, SFDR implementation has so far been hesitant and uncertain at best.
The classification of funds
One of the major challenges in implementation has been the market’s perception of the SFDR’s requirement to label funds under one of three reporting categories, Article 6, 8 or 9.
Article 6 funds either manage sustainability risks only, or with the help of a disclaimer, and have very few reporting requirements at all. Article 8 funds actively promote environmental or social characteristics, and Article 9 funds that have sustainable investment as their primary objective.
Unfortunately, much of the discussion in the market has orbited around the requirements for being an Article 8 or 9 fund. While this may be a useful exercise for Article 9, with its clear expectations for 100% sustainable investments and use of ESG benchmarks, it has muddied the waters around Article 8.
Article 8 is so broad in its design that it is misleading to call it a classification. Rather it is a set of reporting requirements for all funds that promote environmental or social issues in some way.
Matthew Smith, Director
This includes strategies of exclusion, active ownership, exercising voting rights and positive selection based on sustainability criteria. Funds under Article 8 may have 0% to 99% guaranteed sustainable investments, they may or may not take negative impacts into accounts and they may employ all the above-mentioned strategies or only one or two. The variety allowed is enormous. Therefore, the question for many fund managers is not whether their funds qualify, but whether they are willing to classify their funds under a regime that requires a significant investment in reporting and transparency. The conclusion of a surprisingly large portion of fund managers has been to err on the side of caution.
Mass downgrades and the rise of “green-bleaching”
In late 2022, the financial industry witnessed a mass downgrade from Article 9 to Article 8 and from Article 8 to Article 6. According to Morningstar, 40% of funds shifted categories from Article 9 to 8 in the last quarter of 2022. Undoubtedly both the sheer scale of reporting requirements and confusion surrounding the definition of “impact” and “sustainable investment” has spurred concerns as fund managers are afraid of being accused of greenwashing. This trend, of understating a fund’s ESG characteristics to avoid possible negative perceptions, has recently been referred to as “green bleaching”. In other words, the EU has perhaps been too successful in its war on greenwashing and inflated sustainability claims. Fund managers have heard this loud and clear and see little upside in reporting more than necessary. Fortunately, clarification from the EU on definitions of sustainable investment in the SFDR legislation in April of this year slowed the trend and it now shows some signs of reversing.
A multifaceted legislation
When assessing the success of the SFDR it is important to consider the actual quality of the disclosures being made. In this regard the regulation has so far been a mixed bag. On the one hand the inclusion of a mandatory set of Principle Adverse Impact (PAI) indicators is undoubtedly a positive development. These indicators cover a wide range of issues from climate footprints to exposure to fossil fuels, anti-corruption and gender equality. The very fact that there are a set of indicators that most Article 8 funds and all Article 9 funds must report on, and that the indicators are to be measured and calculated in the same way, ensures a comparability across funds that we have never experienced. The adoption of PAI indicators also has knock-on effects in the wider market as companies are likely to increasingly standardize their disclosures around these indicators. On the other hand, SFDR disclosures are also qualitative and require descriptions of how fund managers work to fulfill their SFDR commitments. Here the SFDR has developed templates meant to ensure standardization. Unfortunately, many fund managers regard the templates practice as inaccessible and overly detailed for many clients and responses from managers have varied greatly.
Where to now? Moving forward with the SFDR
While the SFDR has brought much needed attention to reporting on sustainability by financial products, its teething problems have been significant. However, the future of SFDR is likely to be much brighter than its problematic inception. The EU supervisory bodies responsible for the development of the regulation have shown themselves to be responsive to market sentiment and able to provide enough clarification to reverse worrying “green bleaching trends”. There is every reason to believe that templates will also be simplified once they have been tried and tested by the market. In addition, the parallel development of the EU taxonomy, and its integration as a key indicator for fund managers to report on for Article 8 and 9 funds, will be useful. The taxonomy’s ever-widening scope, both in economic activities covered and size of companies subject to reporting, should provide SFDR reporting with a much-needed quality assured and credible measure of positive environmental impact. Inevitably, with time and testing, the SFDR will be improved and has the potential to play a key role in channeling private capital into accelerating the green transition.
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