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Sammy Cole

Daniel Power

Last week, our webinar ‘SFDR: How to approach Article 8 and 9’, sparked a number of questions from the audience that we did not have time to address. In this piece, we provide the answers to these burning questions.

A big thank you to all that attended. Please click here to access the webinar replay.

Q: For Article 8 and 9 funds, do the mandatory PAIs only need to be calculated once or should FMPs set a benchmark to improve those PAIs over time?

An FMP with an Article 8 or 9 fund must provide a PAI (principle adverse impact) statement on its financial products each year on the 30th June. FMPs will publish their first PAI statement on 30th June 2023 (based on the period 1 January 2022 to the 31 December 2022).

The SFDR’s Regulatory Technical Standards (RTS) also underline the importance of narrative reporting; firms must highlight their plan of action/targets set to improve PAIs over time (the SFDR incorporates a requirement for a five-year historical comparison). Another form of narrative disclosure relates to implementing engagement policies, as well as a description of how these engagement policies adapt where there is no reduction in PAIs. In addition, firms could describe whether they adhere to responsible business codes, international reporting standards, and, where possible, the degree of alignment with the objectives of the Paris Agreement. In looking to improve or optimise their PAI scores, fund managers may choose to divest from companies that are not performing well (e.g. Nordea).

The SFDR does not provide limits, standards or benchmarks for PAIs. It does not specify what constitutes ‘high’ or ‘too high’ for carbon emissions or the number of social violations. Despite this, as soon as reporting commences, the market will inevitably start comparing and benchmarking PAIs.

Q: Please could you explain why both Carnival and Verisure are in breach of the UNGC/OECD Guidelines?

In our webinar, we highlighted discrepancies amongst Article 8 exclusion policies. One Article 8 fund that we analysed excluded UNGC/OECD guideline violators. Despite this, the FMP included both Carnival and Verisure in its fund (both of which have violated the UNGC/OECD guidelines multiple times, according to 9fin’s analysis).

Carnival’s UNGC/OECD Guideline breaches (read 9fin’s Carnival ESG QuickTake):

Environmental (UNGC and OECD Guideline violation): between 2016 and 2019, Princess Cruises (a Carnival subsidiary) was fined for illegally dumping oil in the sea and placed on probation; it was later fined for violating probation six times, including for dumping plastic waste. It was then fined again, for breaching governance requirements related to its probation

Consumer interest (OECD Guideline violation): In 2022, the company was fined $5m by the New York state regulator following four cyber breaches that exposed large amounts of sensitive customer data

Human rights (UNGC and OECD Guideline violation): in 2019, a US Department of Transportation report recorded 20 sexual assaults, two missing people cases, two serious assaults and two thefts on Carnival ships; in 2022, the company was forced to compensate a victim of sexual assault by a crew member on one of its cruises in 2018

If you are not a client but would like to request a copy of the Carnival ESG QuickTake, please complete your details here. 

Verisure’s UNGC/OECD Guideline breaches (read 9fin’s Verisure ESG QuickTake):

Consumer interest (OECD Guideline violation): in November 2021, a Verisure advert was removed from broadcasting by the UK Advertising Standard Authority (ASA). The ASA ruled that the advert breached the BCAP code in terms of both misleading advertising and substantiation

Competition (OECD Guideline violation): in June 2017 the Norwegian Competition Authority (NCA) launched an investigation into the subsidiary Verisure Norway. In November 2020 the NCA made a decision against Verisure for breach of the Competition Act in the form of illegal market sharing (with Sector Alarm)

Competition (OECD Guideline violation): in July 2021, the Alarm Customer Association initiated a class action against Verisure AS and Sector Alarm AS in Norway over the losses caused to customers by the price collusion verdict laid down by the Norwegian competition authority

Potential consumer interest (potential OECD Guideline violation): in April 2022, the Swedish Authority for Privacy Protection initiated an investigation into Verisure, based on reported customer privacy infringements

If you are not a client but would like to request a copy of the Verisure ESG QuickTake, please complete your details here. 

Q: You mentioned Carnival has "failed" UNGC areas. However, MSCI has it as a UNGC "Pass". Is this simply a case of 9fin's view being different from that of MSCI?

It is possible that the company’s environmental and social related controversies prior to 2022 were not evaluated against the UNGC principles as the MSCI ESG Controversies Methodology (which evaluates UNGC violations) was only introduced in 2022. According to MSCI, the methodology is currently only effective for controversy cases reviewed after June 20, 2022.

Q: Can shorting unsustainable companies be considered as a sustainable investment?

The SFDR does not specifically say whether shorting is a sustainable investment strategy. However, based on the SFDR’s definition, it is unlikely that shorting an unsustainable company constitutes a sustainable investment. Currently, derivatives can not be considered when calculating Taxonomy alignment; this would also presumably preclude short specific derivatives from being considered. However, no guidance is provided on short selling (i.e., without the use of a derivative).

The SFDR’s lack of guidance on short positions has been an issue, especially for the hedge fund industry. Article 9 guidance from July 2021 states that hedging and liquidity strategies must meet minimum environmental or social safeguards; exactly how this applies to shorting is unclear.

Regarding short positions and general disclosure, recent guidance from the EU Commission requires that the PAIs of short positions be considered.

ESMA’s recent consultation, which opened on November 18th, is seeking feedback on whether derivatives should be subject to specific provisions for calculating minimum sustainability thresholds. The outcome of this consultation could provide more guidance on shorting’s compatibility with sustainable investing.

Q: Does, and if so how, innovation feature in sustainable investment assessment for the purpose of classification?

Under the EU Taxonomy, research and innovation has been included as an “enabling activity.” An enabling activity refers to one that enables other activities to make a contribution to one or more of the objectives of the EU Taxonomy. This activity should not lead to a lock-in of assets that undermine long-term environmental goals. It should also have a substantial positive environmental impact on the basis of lifecycle considerations. As an example, research and innovation for direct air capture of CO2 would be considered as a sustainable innovation in accordance with the EU Taxonomy.

Q: How much weight is put on the value of outcomes-oriented engagement vis-a-vis asset allocation to qualify for Article 8 or Article 9?

The SFDR mainly focuses on disclosures related to an FMP’s holdings, so asset allocation arguably holds more weight than outcomes-oriented engagement. The SFDR’s required disclosures for both Article 8 and 9 include defining the proportion of assets that are classed as sustainable investments, those that have sustainability characteristics, and those that don’t. NGOs and consumer organisations, including WWF and ShareAction, have written a paper recommending that Article 8 and 9 funds should include a minimum proportion of taxonomy-alignment.

9fin’s view is that outcomes-oriented engagement is also good practice. Simply describing the number of times an FMP has engaged with an issuer does not necessarily translate to progress. An FMP needs to be able to show evidence that this engagement has been successful through defined indicators. Although this is not defined under the SFDR, the aforementioned paper also recommends that engagement should also be included among the minimum criteria for Article 8 and 9 products (with a different level of ambition for each category).

Q: Could the financing of a toll road be compatible with an Article 8? and what would be the "reasonable" minimum "non-ESG" investment % for an Article 8 fund?

This would be dependent on the issuer’s approach to sustainability and what role the debt from this project would play in the relevant fund. If the debt is being used as a sustainable investment (under the SFDR’s definition) then the toll road needs to meet a sustainable investment objective defined by the fund manager or the EU Taxonomy. The EU Taxonomy does include guidance for the construction of roads and motorways (NACE code F42.1.1). For road construction to be Taxonomy compliant the activity needs to: involve the construction, modernisation, maintenance and operation of infrastructure that is required for zero tailpipe CO2 operation of zero-emissions road transport, as well as infrastructure dedicated to transshipment, and infrastructure required for operating urban transport and not be dedicated to the transport or storage of fossil fuels.

If the debt or issuers activities are not aligned with the Taxonomy and the debt is not intended to be a sustainable investment, it still needs to be demonstrated that the issuer promotes environmental and/or social characteristics. This means that at the bare minimum, the fund manager shows that the issuer has good governance practices. This includes “sound management structures, employee relations, remuneration of staff and tax compliance”. In that sense, the governance aspect of ESG needs to be considered for each asset in an Article 8 fund.

There is currently no “reasonable minimum” for non-sustainable investments (as defined by the regulation). However, a recent consultation by ESMA is seeking feedback on whether funds with sustainable/ESG-related words in their name should have a minimum of 80% of investments promoting environmental or social characteristics with at least 50% meeting the SFDR’s definition of a sustainable investment.

Q: Within article 8, the approach seemingly supports a focus on an environmental and/or social factor. The assessment on governance seems to be supported by four factors or pillars, how broad and deep do you think this governance review needs to be?

The concept of “good governance” is not clearly defined under SFDR. The regulation states that it includes “sound management structures, employee relations, remuneration of staff and tax compliance” (example here).

Each portfolio company should be screened across various governance metrics. Some examples include:

Whether the company complies with the UNGC principles and OECD Guidelines

Supervisory board with at least one independent member

Cyber security policy alignment with international standards e.g. ISO 27001, NIST

Effective risk management e.g. based on the Enterprise Risk Management (ERM) framework

An FMP will need to assess each portfolio company across a broad range of factors in order to determine whether they follow good governance practices or not. If the screening comes back with negative answers, the FMP should exclude this firm from its portfolio.

Q: What is the actual mechanism through which SFDR enables the deployment of additional capital?

The main reason for increased capital inflow is increased demand for greener articles. According to data from Morningstar, Article 9 funds experienced €5.9bn inflows in Q2 2022. In comparison, there were €30.3bn outflows for Article 8 strategies and a combined €40.7bn of net outflows in May and June for Article 6 products. However, the risk is that many funds classified under Article 8 and 9 do not meet sufficient criteria. In fact, as many as 23% of funds labelled Article 8 do not meet their criteria as ESG funds.

Q: Do you have any views on SFDR and how this applies to the Leverage Loan market which suffers from lack of disclosure? Are you aware of any SFDR Lev Loans funds?

The main difficulty with classifying leveraged loan funds as Article 8 or 9 is a general lack of ESG data coverage. Importantly, although all 14 PAIs under the SFDR are mandatory, there will probably be a transition period, and it is not likely that penalties for non-compliance will be issued whilst data is unavailable. Despite this, under the principle of ‘best effort’, “best efforts [should be] used to obtain the information”, by using “all reasonable means available”. There are instances of Article 8 and 9 leveraged loan funds. For example, in September, Mandatum Asset Management introduced an Article 9 senior secured loan fund (we have not assessed this fund). 9fin contacts companies directly for data where it is not publicly available, and we are currently exploring a number of other ways to gain access to leveraged loan and private market data. If an FMP cannot obtain any ESG-related information for an issuer, then it should not be allocated to an Article 8 or 9 fund.

Q. What is your view about the SI% formula? denominator: (AuM) or (AuM-cash) numerator: how do you account for derivatives? How do you account for short positions?

On 17th November 2022, the European Commission highlighted that derivatives should not be included in the numerator to calculate the Taxonomy-alignment of a financial product. For example, a synthetic ETF tracking an environmental-focused index cannot be described as having a sustainable objective, whilst a similar product using physical replication of the index will be able to report 100% sustainable investments. Other than this, there is no specific guidance on how derivatives can be used to meet the minimum proportion of investments used to meet social or environmental characteristics or sustainable investment objectives. ESMA is seeking more information about this (as of 18th November 2022). There is also little explicit guidance on how to account for short positions in the SFDR; it does not explicitly outline that short positions can be considered as sustainable investments.

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