In July, the European Commission attempted to set the record straight by issuing a Q&A on its new ESG product disclosure rules, officially known as the Sustainable Finance Disclosure Regulation, or SFDR. The guidance was met with a tepid response – UK law firm Linklaters said at the time: “Overall the Q&A is not very clearly drafted, and in many cases the Commission has not answered the specific question put to it”.
But the guidance did make one thing clear: climate funds sold in the EU will now be benchmarked against the EU’s own Paris-Aligned Benchmark criteria where possible. For reference, such criteria are available for nearly every broad-based index.
Climate funds – those with the key objective of decarbonisation – fall under the scope of Article 9 of the SFDR, a classification for funds with an exclusive focus on sustainability. It contrasts with the less ambitious Article 8, for conventional investment funds with ESG considerations, and Article 6, for non-ESG funds.
The EU’s Paris-Aligned Benchmark criteria was developed as part of the same policy package as the SFDR and provides the basis for the EU’s two new climate index categories: voluntary labels for Paris-aligned Benchmarks (PABs), which target a 50% carbon intensity reduction versus the parent universe; and the less ambitious Climate Transition Benchmarks (CTBs), which targets a 30% reduction. In addition, benchmarks – and therefore, under the new guidance, Article 9 funds – must reduce overall carbon intensity by at least 7% year-on-year, compared with their parent indices.
The EU’s decision to introduce PAB requirements into the SFDR raises significant questions for fund providers. Highly active funds, for example, have more concentrated portfolios, which provides limited flexibility to adjust exposure weightings to meet the benchmarks’ 7% annual decarbonisation target – unlike the diversified index funds, for which the criteria was originally created.
In addition, the target may trip up fund managers focused on engagement, as these strategies often take time to bear fruit; and those using proprietary climate metrics, which may not be aligned to the PAB/CTB criteria.
Prominent sustainable finance academic Andreas Hoepner, who contributed to the development of the PAB/CTB criteria, is not sympathetic to such concerns, particularly in relation to engagement-focused strategies.
“Having studied investor engagement myself, I am confident that top engagers should be able to achieve a 7% emissions reduction average over, say, three to five years. The average fund manager may struggle, but even if they fall short, the amount of rebalancing [of portfolio exposures to meet the decarbonisation requirement] which needs to be done will be a lot smaller compared to someone who does not engage at all.
“If you have a climate fund that can’t decarbonise at 7%, then it’s simply not aligned with Paris, regardless of any commercial reasons,” he says. “That’s even more the case for climate funds sold in the EU, because investors will naturally assume that you meet the European target of Net Zero by 2050 – anything else is just not good enough.”
A number of fund managers that RI spoke to for this article – all of whom asked not to be identified – believe that the PAB/CTB criteria is too stringent, and needs to be more flexible to allow for different approaches. However, others say it might not be stringent enough.
“The 7% decarbonisation requirement was selected because it was in line with a Net Zero by 2050 target, however this was the case some years back in 2017 or 2018,” notes Frédéric Samama, Chief Responsible Investment Officer at Amundi-owned CPR Asset Management, who is conducting research on the topic currently.
“The point that’s been missed is that the 7% is a translation of a carbon budget which will shrink over time, therefore the figure should be revised regularly in line with that.”
CPR claims its Invest Climate Action Euro Fund does just that, and is aligned with Article 9 of the SFDR.
Samama is also critical of the use of a 50% or 30% emissions haircut compared to parent benchmarks for PAB/CTBs, which he describes as arbitrary and having “nothing to do” with the core 7% decarbonisation requirement.
“It’s not a big deal to combine two different approaches but when you are presenting it as a science-based benchmark and making the whole market report against it, it is slightly bizarre”. This matters, he says, because “the less you are aligned with reality, the less credible it becomes and climate change is the biggest threat of our time”.
“For providers of Article 9 actively-managed funds, it would be logical not to necessarily use a PAB, as long as they explain their alignment methodology,” he says.
Still, Samama is sympathetic to the broader aims of the guidance, describing it as having “a very good and important objective”.
The EU’s guidance could also present challenges for thematic investors – specifically those that allocate capital to climate solutions providers, rather than improving the sustainability performance of existing holdings.
London-based iClima recently launched an Article 9 exchange-traded fund dedicated to “companies offering products and services that enable CO2e avoidance”. CEO Gabriela Herculano argues that this approach has a greater positive impact on the climate transition than pushing for improvements at incumbents, because such solutions enable decarbonisation across the economy – even if the providers themselves are not swiftly decarbonising.
“We believe that many of the companies who are trying to decarbonise will need the products and services that the companies in our universe supply, which is very much in line with the intent behind the SFDR,” she says. “We want to tell the story of companies where decarbonisation is a revenue, rather than a cost line item, and welcome the opportunity to be scrutinised by the regulator.”
It’s unclear how these portfolios will be treated under the SFDR, given the new guidance, though. When asked to comment on how thematic funds should apply the guidance, a Commission spokesperson told RI that it did not comment on individual cases, but that Article 9 funds under the SFDR should not ‘significantly harm’ any of the EU’s environmental objectives: climate mitigation and adaptation, biodiversity, the circular economy, water and waste.
The reactions to the guidance so far provide an indication of the scale of the challenge faced by the bloc as it attempts to establish credible and clear climate finance rules. But it also has to avoid spooking asset managers that are committed to green investment by burdening them with excess reporting requirements and restrictions on how they can approach decarbonisation.
Earth Capital is a private equity investor founded in 2008 to focus on sustainable technology, and it has offices in the UK, Latin America, the US, Asia and Africa. It does not yet have any funds registered in the EU, but is keeping close tabs on the SFDR’s development.
“Perhaps at some point in the future, we may consider reporting against the SFDR if we start attracting EU money,” says Neil Brown, the firm’s co-founder and Chief Risk Officer. “We manage an impact investing fund, so it would be wrong of us not to clear the Article 9 hurdles. We probably could do this now already, but do we want to go through the rigmarole if we don’t have to? Probably not.”