*On the 4th of December, the European Supervisor Authorities published a report containing proposed amendments to SFDR’s regulatory technical standards.
The proposals are:
The European Commission will now take until March 2024 to decide on the proposals. To find out more, read the report or contact a member of our team. The information in this article is up to date as of December 2023.
The primary aim of the Sustainable Finance Disclosure Regulation (SFDR) is to tackle greenwashing in the financial sector. As part of this mandate, the regulation requires fund managers to classify their funds based on their sustainability performance. The three classifications are Article 6, 8, and 9 funds. We outline the differences between these fund types in the first article of our SFDR blog series. Today’s article explores these differences with a focus on Article 8 and Article 9, in light of recent legislative clarification.
SFDR Level 1, implemented in March 2021, required fund managers to classify their existing funds according to Articles 6, 8, or 9.
Level 2 of this regulation is due to be enforced from January 1st 2023. It requires managers to disclose detailed information to reinforce these initial classifications. The first draft of the Level 2 requirements, known as the Regulatory Technical Standards (RTS), was originally published in early 2021. Since this initial publication, there have been a number of redrafts. Q&As have also been published by the European Commission (EC), clarifying technical details with regard to the implementation of Level 2 regulations. Part of the supplementary information provided pertains to the requirements for Article 8 and 9 fund classification. These requirements, until recently, have been unclear.
In this blog, we outline the key takeaways from these recent publications. We provide fund managers with a clear understanding of the requirements for Article 8 and 9 classifications. We also introduce the concept of Article 8+ funds.
Before we dive into these requirements, there are two elements of SFDR that are worth emphasising.
Firstly, whilst this blog focuses on fund-level disclosures and the associated asset-level disclosures, there are other firmwide disclosures required for SFDR compliance. Please refer to this earlier blog in our series for further detail.
Secondly, it is important to note that there are still minimum disclosure requirements associated with being classified as an Article 6 fund. This blog, however, focuses on the additional disclosures required for Article 8 and Article 9 classification. Funds are automatically classified under Article 6, unless proven otherwise by the fund manager.
The remainder of the blog is structured as follows: firstly, disclosures specific to Article 8, 8+, and 9 funds are outlined. Secondly, disclosures common to all of these funds are then summarised. This should not be treated as a comprehensive list for compliance purposes. It aims to cover the key disclosure areas for fund managers in a succinct manner.
As suggested by its definition, disclosures for Article 8 classification centre around the environmental/social characteristics promoted by the fund. These details must be provided in pre-contractual and periodic documentation.
Characteristics can be expressed in the form of investment policies, goals, or targets. The fund manager must select the particular fund characteristics and provide detail on how these are attained. Sustainability indicators must therefore be defined, in order to measure these characteristics. The EC recommends the use of relevant principal adverse impact indicators (PAIs) to act as sustainability indicators. For more information on the PAIs, head to our previous blog on 'Introducing the Principal Adverse Impacts (PAIs)' and download the Full List of PAIs we have put together. PAIs provide objective, comparable measures that can be tracked over the lifetime of the portfolio. These protocols are also easy to implement, as they are already required for other SFDR disclosures.
When defining an Article 8 fund, the use of the term “promotion” can be widely interpreted. In 2021, the EC clarified that promotion can encompass claims, information, reports, disclosures, or even impressions that portfolio assets consider the prescribed environmental/social characteristics.
The Commission goes on to list a wide range of document types in which these “impressions” could be stated. (Click here for the full list). The range of possible disclosures has become a cause for confusion for fund managers. For example, one suggested format for promoting environmental/social characteristics is an exclusion policy relevant to these characteristics. This could involve the exclusion of coal-generated power, for instance. However, it is unclear how the PAIs can track progress towards this “characteristic”.
There has been a general market consensus that Article 8 classification requirements in their current form are not sufficiently stringent. This has led to a wide range of financial products, all self-classified under Article 8.
These range from funds with minimal exclusion policies to funds defining their investment strategy according to environmental or social concerns. In response to this, the concept of Article 8+ funds was developed by the financial sector, rather than the regulators. Article 8+ funds (or mid-green funds) differ from Article 8 funds (or light-green funds) in that a proportion of the portfolio must be classified under “sustainable investments”, as defined by the SFDR.
There are the three key requirements for this type of investment:
For Article 8+ funds, a classification process must be embedded into pre-contractual and periodic disclosures to determine whether or not portfolio assets classify as sustainable investments under SFDR regulation. Fortunately, there is significant overlap between sustainable investment classification and alignment with the EU Taxonomy. Given the detailed technical screening criteria available to assess Taxonomy alignment (discussed in a previous blog in the SFDR series), the process of classifying an investment as sustainable is made easier if the activity falls within the Taxonomy.
Now that the distinctions between Article 8 and 8+ funds have been outlined, it is relatively easy to establish the requirements for Article 9 fund classification. As discussed, Article 8+ funds differentiate themselves from Article 8 funds by containing a proportion of “sustainable investments” in their portfolio.
Article 9 funds take this one step further by requiring that all assets be sustainable investments (with certain exceptions related to hedging or liquidity). As such, additional disclosures that are required for Article 9 classification take a similar form to Article 8+ disclosures, with the additional requirement that investments are exclusively classified as sustainable.
Though there will be some variation between Articles 8 and 9, the information that must be published on the fund manager’s website is similar for both fund types. Both in terms of content and format. Website disclosures overlap with the pre-contractual disclosures described above, as well as further detail regarding data management and due diligence processes.
All funds regulated under SFDR must detail, in both periodic and pre-contractual documentation, how the principal adverse impacts on sustainability factors are considered. Beyond an explanatory disclosure, fund managers are encouraged to use quantifications in the form of the PAI indicators.
Technically, consideration of the PAIs is a firm-wide disclosure. However, in May 2022, the EC clarified that the PAI indicators could be applied to individual financial products, without the requirement for firm-wide compliance.
Both Article 8 and 9 funds require disclosures detailing fund composition, presented in the form of investment proportions. This is intended to provide investors with a clear understanding of the fund’s profile.
Article 8 classification requires the disclosure of the proportion of investments aligned with its promoted characteristics, and both Article 8+ and Article 9 classifications require the disclosure of the proportion of investments aligned with environmental/social objectives, as well as Taxonomy alignment.
A final requirement for both Article 8 and 9 classification is the implementation of a screening policy to ensure that all portfolio companies practice good governance. It is worth emphasising that this does not apply to other asset classes, such as real estate assets.
The RTS states that this policy should broadly cover sound management structures, employee relations, remuneration, and tax, but this is not further defined. Once again, this leaves this requirement largely open to the interpretation of fund managers. We recommend that policies are drafted with the portfolio companies in mind to ensure relevancy. Possible starting points for drafting this policy can be found in the OECD Guidelines for Multinational Enterprises.
It is worth noting that only Article 8+ and 9 funds can use the term “sustainable” in the fund name. Similarly, the terms “impact” and “impact investing” should only be used by funds that intend to generate measurable and positive social/environmental impact.
As further SFDR clarification is provided, and as ESG measurement regulations continue to evolve, every asset manager must take action to adapt to these changes. Managers and investment decision makers that fail to integrate these new rules in their business plan risk failing to meet European - or even global - standards.
ESG management is an emerging topic, and governing bodies are responding to calls for further clarification. We review and report on every new update in the field to help market participants better understand sustainable finance. Follow our SFDR blog series to find out more.
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