The naysayers

Let’s first address the criticism. In 2022 we witnessed the great reclassification, when more than 350 funds reclassified from Article 9 to 8 due to confusion over the definition of sustainable investment. The SFDR has also drawn scorn with investment managers accused of advertising their products as sustainable, while their portfolios include carbon-intensive businesses that are not aligned with the Paris Agreement.

Some have called for the removal of Article 8 and 9 altogether. The Institute for Energy Economics and Financial Analysis (IEEFA) has taken this stance and said that cracks in the current system have become “increasingly obvious”.

Others have called for the SFDR to be scrapped entirely. Ex-DWS sustainability head Desiree Fixler has described it as “a waste of taxpayer money”. Fixler famously called out her former employer for greenwashing back in 2021.

Moving towards real world impact

The European Commission has not been particularly clear whether transitioning companies can be considered as sustainable investments under the SFDR.

As a result, ‘sustainable’ Article 9 funds have generally been focused on companies with a low carbon footprint, rather than companies that are actually transitioning their business models to be in line with a 1.5°C world.

Ashurst partner Lorraine Johnston told Sustainable Views that transition activities are an important means towards achieving a net zero carbon economy, but that Article 9 does not permit this.

In contrast, the UK’s fund labelling regime, the Sustainable Disclosure Regulation (SDR), puts a much greater emphasis on transition. One of the potential fund labels is “Sustainability Improvers”, which is a fund investing mainly in assets that may not be sustainable now, but have the intention of improving sustainability for people, or the planet, over time.

Despite the lack of focus on the transition in the SFDR, it has spurred on conversations surrounding the transition. Some managers, for example abrdn, offer funds that include companies in heavy industries that are transitioning, while at the same time carrying the Article 9 status.

The European Commission has also expressed a desire to support transition finance and 80% of the respondents to the SFDR consultation said a category for transition-focused products would be “useful to a large or very large extent”.

Let’s be clear, there is still confusion around whether a sustainable investment can encompass transitioning companies, but the discourse is growing and regulatory authorities are learning.

SFDR put to the test

Since the SFDR entered into force, there has been a huge discrepancy in the approaches taken to structuring Article 8 and 9 funds.

When analysing an array of funds for 9fin’s webinar on the SFDR back in November 2022, we found that a number of Article 8 funds had simply formalised ESG exclusions in response to the SFDR, without actually changing a single characteristic of their investment strategy.

However, through introducing mandatory disclosure, the SFDR has helped shine a light on these issues and encouraged conversations about what best practice looks like.

There is a plethora of resources and webinars on Article 8 and 9 best practice and the European Securities and Markets Authority’s (ESMA) SFDR consultation in April 2023 led to extensive feedback from stakeholders.

Hugh Wheelan, co-founder of Responsible Investor, argues the disclosure-based regulation has become a “huge, costly administrative burden for compliance, legal and reporting teams”, but these “onerous” reporting requirements have given us valuable insights.

For example, scope 1 emissions from companies held in Article 8 and 9 funds have fallen 13.7% more than other fund types following the introduction of the SFDR, according to the European Corporate Governance Institute.

“Overall, our results support the notion that mandatory disclosure can incentivise decarbonisation by asset managers,” the group said.

It’s fine to redefine

Now, back to the definition problem. The SFDR’s definition of a sustainable investment is far from perfect. In fact, the SFDR doesn’t actually provide a workable standardised definition of a sustainable investment at all.

According to the European Commission, “Financial market participants must carry out their own assessment… and disclose their underlying assumptions.”

So, basically, sustainable investment is whatever a fund manager says it is. This has led to fund managers labelling investments as “sustainable” even if they do not meet ESG criteria.

But regulation is about trial and error. And enforcing the SFDR has revealed the market needs more clarity on what equates to a sustainable investment. The current consultation could lead to the European Commission scrapping the Article distinction and designating descriptive categories with 70% thresholds for sustainable investments. Or the commission could decide to keep the Articles as they are.

Whatever happens, it is vital that investors are absolutely clear on what constitutes a sustainable investment and what doesn’t. It is also important that this definition allows scope for transitioning companies to be considered sustainable.

Even if the European Commission does change course and introduce fund labels akin to those of the SDR, this doesn’t mean starting from scratch. It just means that there will need to be discussions surrounding how best to use this data to generate real world impact.