Like beauty, responsible investment is something one knows when one sees it but is hard to quantify. This was a rather poetic reflection shared recently by one asset owner. 

When it comes to sustainable investments, however, asset managers are unlikely to get away with such flowery statements when defining their approaches – and defining it is something that has largely been left to them by the European Commission, at least for now. 

In April, the Commission, responding to questions posed by its three financial watchdogs, known collectively as the European Supervisory Authorities (ESAs), stated that it was up to managers to set their own definitions as to what a sustainable investment is. This is as long as they fulfil three tests of contributing to an environmental or social objective, not causing significant harm to objectives, and meeting good governance practices. 

Prior to this intervention, uncertainty around the EU’s anti-greenwashing regulation, the Sustainable Finance Disclosure Regulation (SFDR), had led to a wave of funds reclassifying from the more stringent Article 9 to Article 8 over the second half of 2022. 

The Commission’s position was welcomed by market participants at the time as “quite industry-friendly” – especially given the expectation that the EU’s executive arm would take a more restrictive position.

But just a few months later, in June, speaking on a panel at RI Europe, Brenda Kramer, senior adviser for sustainable finance at PGGM, told the audience that the Dutch investment giant is “struggling” with defining sustainable investment. 

“I’m fighting with my lawyer every day about this because of materiality,” she said. “If you take the whole list of principle adverse indicators (PAI), you get to zero or just a couple of companies even in our most sustainable portfolio. So we need to find ways to get that a bit higher without greenwashing.”  

PGGM is not alone. Also speaking on that panel was Véronique Menou Lieblich, global head of ESG regulatory solutions at MSCI. She said that in 2022 the data giant attempted to define sustainable investment following a request from a client.  

Consultation with the market at that time revealed a desire for a definition that was “extremely stringent, restrictive”, she said. The result was an investible universe of around 300 companies “all in European countries”. 

But a follow-up consultation and client survey around Easter this year, asking whether it was time “to reopen the debate and expand our definition”, revealed a substantial shift. “There was a strong consensus that we should go with something less restrictive,” Menou Lieblich said, including allowing the “transition piece” to be included in the definition of sustainable investments.  

“We decided to extend the definition not only to include companies that have a positive contribution now, but also those that are on the path to be aligned with the net-zero target or working in a transition plan and following a 1.5C pathway,” she said. 

Three months on, and it seems many in the market are still wrestling with these issues.  

Maggie O’Neal, Barclays

“We get asked about it in nearly every meeting, how are we thinking about sustainable investments,” says Maggie O’Neal, global head of ESG research at Barclays.

“I think in the absence of a firm definition, asset managers are searching for a way forward, walking that tightrope between a definition which is defensible but also investible.” 

How are managers tweaking approaches? 

Research published in August by Barclays found that, of 270 investors polled, 80 percent were relying on their own in-house definitions of sustainable investments.   

Cardano’s deputy CIO Keith Guthrie tells Responsible Investor that the Commission’s April Q&A has helped the UK-based investment firm “gravitate towards a definition internally around what is sustainable”.  

This includes greater emphasis on impact. “We felt like we needed to include some positive contribution – although our strictness on that contribution for our sustainable strategies is not as extensive as it would be under our positive impact type strategies.”      

Previously, Cardano’s definition of sustainability focused more on the absence of harm, unlike the EU’s focus on positive contributions. Guthrie gave the example of Microsoft as a company that is neither particularly harmful nor positive to the world.   

“If you had a list of prescriptive rules, there would likely be complaints, but when you’re operating without them, it does create a challenge.”

Maggie O’Neal, Barclays

Another change at Cardano is that, whereas previously some Article 9 funds might have included “adapting companies” if they had good enough transition plans, because of the focus on positive impact and no significant harm this is no longer the case.  

Guthrie says that 35-40 percent of the market would be considered sustainable under its definition.  

“The more you skew towards those positive things, the more you narrow your universe and the less you’re able to really engage with those other [adapting] businesses, many of which have very credible tradition plans,” he says.

He is confident some will come up with definitions of sustainable where more transitioning businesses will be included. “I don’t think that’s necessarily a bad thing, if they consistently argue that they will have a lot of engagement with those businesses and assessing their transition plans,” he says. 

Robeco’s SDG strategist, Jan Anton van Zanten, warns that if each manager creates their own definition there will be a lack of standardisation.

Jan Anton van Zanten, Robeco

The EU, he adds, is trying to introduce standardised approaches through its taxonomy, which “will be very important, but is taking too long and isn’t going to fly anytime soon”. In the meantime, in an attempt to foster some level of convergence, Robeco has made its own SDG framework open source. 

The Dutch asset manager’s bespoke SDG scoring system rates companies on their positive and negative contributions. Issuers with no substantial negative contributions to the SDGs can get a positive total score if they also make a significant contribution to one or more SDGs. But any firm with a negative score on an SDG will get a negative total score and cannot be considered sustainable. 

As to what proportion of companies are investible under Robeco’s framework, Van Zanten says that around 55 percent of the MSCI ACWI are considered to have a positive score. Within that, 13 percent would be considered leaders, most of which provide direct solutions.   

Another asset manager who did not want to be quoted told RI that their firm had added a new threshold to reduce its investible universe and bring it more in line with peers and regulators’ expectations “while maintaining credibility”. 

Other investors, also speaking off the record, said they too had proactively reached out to financial regulators in EU countries to get feedback on their approaches to defining sustainable investments.  

One anonymous asset manager told RI that the firm does not rely on the EU taxonomy in its definition because of a “lack of data” and lack of “activity that aligns with it – although they added that this could change in the next few years. 

How much latitude have managers been given? 

Patrik Karlsson, senior policy officer at EU financial watchdog ESMA, tells RI that the Commission has signalled that there are two basic ways of determining sustainable investments. “One is an activity level where you look at an investee company’s economic activities and derive a percentage-based contribution to the environment or social objectives. The other is that you employ a pass/fail approach at the company level.” 

He adds that the latitude given by the Commission does not make it a “free-for-all”, stressing that the three conditions constitute a “floor” when it comes to defining sustainable investment. 

His colleague Ana Ghita, also a senior policy officer, notes that once investors meet those minimum requirements there is “some flexibility on how you perform the SFDR DNSH test in terms of how you define where you put your thresholds”.  

She adds that this can be a driver of greenwashing “to the extent that market participants, in a worst-case scenario, could select unambitious thresholds”. 

Where investors draw the line also poses “commercial risk”, according to Cardano’s Guthrie.  

Keith Guthrie, Cardano

“For someone like us, the desire is to tread carefully and not go too close to the line, but I think it is quite possible for someone to come up with a definition which says 60 percent of the market is ‘sustainable’,” he says. “If you do that you will get people coming back to you and saying ‘that does not look sustainable to me’.”   

According to Barclays’ survey, most financial institutions are looking for companies with revenue thresholds of 10-25 percent aligned with sustainable outcomes to be included under the rubric sustainable investment.

This was “a little bit lower than expected”, says O’Neal. She notes, however, that going above 50 percent means narrowly defining the investment universe and makes it more challenging to create a very diversified portfolio.   

Notably, O’Neal also reveals there were more investors in the survey setting their threshold above 75 percent than between 50 and 75 percent – although she flags that this was still well below those the proportion that said they were using a minimum percentage threshold of 10-25 percent. 

Two European asset managers who did not want to be named told RI that they have set their threshold at 50 percent positive activity to be regarded as sustainable.  

O’Neal says investors are trying to reach a position that they think is defensible. “If you had a list of prescriptive rules, there would likely be complaints, but when you’re operating without them, it does create a challenge,” she says.  

Her feeling, she adds, is that investors “are looking for greater clarity”, but are also hoping that anything that does come is “not so prescriptive to make it unworkable”. 

Echoing O’Neal, Cardano’s Guthrie says that, while he sees merit in different definitions of sustainable investments being developed, there need to be some “top-level credible thresholds”.  

Measuring sustainability 

Thresholds might be lower than anticipated, but what is being measured? According to Barclays’ research, the most common metric being used to define sustainable investments is alignment with the SDGs. Use of the EU’s “green” taxonomy is “less common”, the study found. 

“The desire is to tread carefully and not go too close to the line, but I think it is quite possible for someone to come up with a definition which says 60 percent of the market is ‘sustainable’”

Keith Guthrie, Cardano 

O’Neal questions the use of SDGs for this purpose, since it was not something they were developed for. She sees the reliance on them as a symptom of the absence of good data.

Market participants also note that the use of the SDGs to define an investment universe potentially opens it up wider than many would be comfortable with, given the number of firms that claim to contribute to them.

O’Neal says that shifting to taxonomy alignment, which is arguably less subjective than the SDGs, can help over time – but adds that she is not sure it will be the only solution because of the sole environmental focus it entails.   

ESMA’s Karlsson says the regulator “is more comfortable with the EU taxonomy as the way to measure sustainability”, given its predefined and detailed criteria on substantial contribution and do no significant harm. 

Another interesting finding in the Barclays’ survey is that most investors are using revenue data to define sustainable investments over more forward-looking metrics such as capital expenditures (CapEx). 

O’Neal says this initially surprised the team, but adds that it makes sense in view of the lack of data on green CapEx being provided by companies. 

Capturing the transition 

Capturing the transition piece has been a major discussion point when it comes to defining sustainability. But Karlsson tells RI that people should not take the Commission’s April Q&A “as a signal that transitional investments are automatically sustainable investments”. 

He notes that investors have complained that transitional investments are sustainable ones and that, without that component, moving to a greener economy cannot be achieved.

While that may be true, Patrik says, “the legal text says that the investment must not significantly harm an environmental or social objective, as measured by the PAI indicators, which remains important”. 

“Is there a credible transition pathway for companies? What do scientists say about it? Only then could you say that it might be a sustainable investment – but I would be very reluctant to do that.”

Jan Anton van Zanten, Robeco

The only exception to this is Climate Transition Benchmarks (CTBs), which can include investments that cause harm if the overall benchmark meets the EU’s benchmark criteria. 

Cardano’s Guthrie tells RI that engaging with “adapters” – companies that are currently having a negative impact but have the potential to transition – “is a very core part of what we believe sustainable investing is and we will continue to invest in these in our Article 8 strategies”.   

Drawing the line between companies that are already sustainable and those that have the potential to be “is a very big concern”, he adds. “Frankly, there’s not enough emphasis on the adapting piece within the EU legislation.”  

The EU has principally focused on making sure people are not misled, but to an extent has forgotten the transition imperative, according to Guthrie.    

He would like to see the EU revisit the issue. “I hope they will consider it and think, ‘what we are encouraging here is clarity around greenwashing, which is a good thing, but what we may miss is that investors might end up thinking the only thing to invest in is green and sustainable businesses’. You’re really not going to solve the whole problem if you only focus on those.” 

Robeco’s van Zanten is sceptical about the possibility of companies transitioning in higher-emitting sectors such as aviation. “The key here is, is there a credible transition pathway for companies? What do scientists say about it? Only then could you say that it might be a sustainable investment – but I would be very reluctant to do that.” 

Advice for managers: don’t greenwash 

Karlsson tells RI that, while there may be some relief among asset managers following the April Q&A, given the Commission’s announcement of a Level 1 review of SFDR, there is also “an awareness that the current situation, whatever it is, may not last forever”.

Asked what he would recommend asset managers do when it comes to defining sustainable investments, he replies bluntly: “Don’t greenwash. At least be transparent about your methodologies so they’re accessible not just to supervisors but also investors.”