Market hails ‘surprisingly helpful’ SFDR clarifications from European Commission

Wave of Article 9 fund re-upgrades expected as asset managers given green light to set definitions of sustainable investments.

Market participants have welcomed clarifications from the European Commission on the Sustainable Finance Disclosure Regulation (SFDR) but some concerns remain over standards.

Uncertainty over the definition of a sustainable investment, as well as the exact status of funds that track a Paris-aligned or Climate Transition benchmark, had led to a wave of funds reclassifying from the more stringent Article 9 to Article 8 over the second half of 2022.

However, in its response on Friday to questions posed by the three European Supervisory Authorities, the commission said it was up to managers to set their own definitions as long as investments fulfil the three tests of contributing to an environmental or social objective, not causing significant harm to objectives, and meeting good governance practices.

This ends the uncertainty caused by guidance released in July, which indicated that an Article 9 fund could contain only sustainable investments. This prompted many managers to take a cautious approach and downgrade.

Anne Schoemaker, director of ESG products at Sustainalytics and sherpa for the EU Platform on Sustainable Finance, said the answers provided last week clarify that “first and foremost that SFDR remains a disclosure regulation not a [labelling] standard”.

Raza Naeem, a partner in Linklaters’ financial regulation team, said clarifications were “surprisingly helpful”. “It was thought that they could take a very restrictive view [on what a sustainable investment is] but actually everything was quite industry-friendly.”

If the commission had taken a restrictive view on definitions, he added, it would have been “quite painful” for the market and could well have led to further downgrades.

Philippe Zaouati, CEO of asset manager Mirova, said that stricter definitions would have meant almost all Article 9 funds would have to be downgraded. This would have had “much the same result as the deletion of Article 9”, and resulted in a mass of undifferentiated Article 8 funds.

Permitting managers to set their own definitions also opens the way to including transition assets in Article 9 funds.

Previously, it was unclear whether transition assets could not be considered sustainable. Under the new guidance, firms which fail DNSH tests will not qualify as sustainable investments, even if they have a transition plan in place to address the issue. However, the guidance leaves room for transition assets to be classified as sustainable if they meet DNSH and good governance requirements.

While managers are given relative freedom in defining sustainable investments, the commission emphasised that methodologies should be disclosed and managers should “exercise caution”.

PABs and CTBs

The commission’s answers also clarify a number of uncertainties around funds which track the EU’s Paris-aligned and Climate Transition benchmarks.

These benchmarks are required to show annual emission reductions and a lower baseline than non-climate equivalents, but companies they invest in do not necessarily contribute to environmental objectives.

The Article 9 exodus was driven by passive downgrades, especially PABs and CTBs, due to uncertainty over whether they should contain only sustainable investments as well as delivering emissions reductions. The commission has now clarified that they are considered inherently sustainable investments.

Stephan Kippe, head of ESG research at Commerzbank, said in a note that the clarifications on both climate benchmarks and the definition of sustainable investment “can be seen as an attempt to save the Article 9 category”.

The former, he said, also resolves the “rather embarrassing situation” where products that merely track sustainable benchmarks approved by EU regulation have not had a clear sustainability status themselves.

This was echoed by Naeem, who said it had never made sense to him “why compliance with the EU’s super green benchmarks would not be good enough”.

Clarifications were also issued on a series of other questions around emissions reduction and its place in Article 8 and 9 funds, as well as whether active funds can also seek an emissions reduction.

SFDR ‘boomerang’

With clarity now given on the status of PABs and CTBs, and a restrictive approach to sustainable investment definition avoided, asset managers which downgraded their funds will likely come under scrutiny.

Hortense Bioy, global director of sustainability research at Morningstar, said that while there will be “a sense of relief” in the industry that standards are not being tightened, it raises the “more problematic question” of what will happen to downgraded Article 9 funds.

“Are they going to be reclassified? Do they have to be reclassified or is it up to managers?”

Asked whether he foresaw a classification “boomerang” of downgraded funds moving back up to Article 9, Linklaters’ Naeem said this was on the cards. “Many managers who took a prudent approach will feel competitively worse off compared to those who decided to stick with their guns and just continue on with the position.”

Subject to jumping through the correct regulatory hoops, Naeem said he suspected the re-upgrades might happen “quite quickly”.

If funds are re-upgraded to Article 9 status, the situation “really leads investors to wonder if it’s a complete circus”, Bioy added.

“[They might ask] why managers downgraded funds before getting the clarification. Some managers took a wait-and-see approach and they were probably right. Others were concerned about greenwashing accusations. Some funds were probably unnecessarily downgraded.”

However, Bioy said it was still too early to tell exactly how the answers will impact the market, especially fund classification.

Schoemaker noted that upgrades will probably depend on the ultimate commercial attractiveness of Article 9 products. “There’s a lot of weariness with all the work this has created, particularly for those who have downgraded and spent a lot of time and effort on that,” she said. “It’ll be interesting to see if people will dare to classify back up.”

She added that this will largely depend on where fund managers are based. “For instance, in France, the AMF has been pretty forward in terms of their recommendations for Article 9 and minimum thresholds and taxonomy limits and so on. So perhaps in France, fund managers might be a little bit hesitant.”

Responsible Investor approached several managers with downgraded funds for comment. All said it was too early to pass judgement on the clarifications.

Causing confusion?

The lack of a single standardised definition for sustainable investment has a double impact on investors and managers, the Commerzbank note continues.

For investors, the lack of explicit standards increases the time and effort required to identify products which meet their preferences, while for managers while regulator risk is reduced, there is still legal and reputational risk should their strategies come under suspicion of greenwashing.

To mitigate the risk of greenwashing, Naeem said that there may have to be some tightening. However, the Q&A would not have been the right place to do this, he said.

“There is potentially an issue and there are divergent standards out there, but it’s something that we will have to live with for a bit and investors will need to be more alert to disclosures published by firms to pick up the divergences. I suspect there will still be a fair bit of scrutiny of fund managers and other FMPs.”

Schoemaker agreed that there may remain a lack of comparability and some confusion.

“The onus really is on financial market participants to be cautious, to be responsible in the way they set their definitions. But again, the lack of comparability will remain if people are able to set their own standards.”