Asset managers afforded greater flexibility, but investors left uncertain on what counts as sustainability-focused investment.
The European Commission’s (EC) recent Q&A session on the Sustainable Finance Disclosure Regulation (SFDR) has left investors with more questions than answers, market participants told ESG Investor.
“While the regulations provide more flexibility and put a greater emphasis on the integrity of sustainability-related disclosures, they may end up creating a bit more confusion about what really counts as sustainability-focused finance,” Smita Nakhooda, Head of Impact and ESG at investment management firm ThomasLloyd, told ESG Investor, after the EC declined to provide minimum standards for sustainable investments.
Further, as thresholds for minimum financing with a sustainability objective, and definitions of what counts as pursuing a sustainability objective, “appear to be being relaxed, new mandatory indicators capturing additional principal adverse impacts (PAIs) are being considered”, Nakhooda said.
“The extent to which a data and information-driven approach can effectively mediate the tensions between asset managers’ desires for flexibility, and consumer demand for financing solutions that really deliver a sustainable impact and avoid greenwashing, remains to be seen,” she added.
The EC’s responses were to questions raised by the European Supervisory Authorities (ESAs) on SFDR in September last year, which asked for clarification the definition of “sustainable investments” and what it means to “consider” PAIs.
Overall, the responses were welcomed by asset managers, providing “long-awaited clarity” that financial market participants carry the responsibility of defining sustainable investments but should disclose their approach, Julia Vergauwen, Managing Associate, Investment Funds (ESG) at law firm Linklaters, told ESG Investor.
“However, the EC scopes out transitional activities which cannot qualify as sustainable investments where there is significant harm at the time of investment,” Vergauwen noted.
“The EC does not touch base on the definition of the ‘do no significant harm’ (DNSH) principle, which seems logical as it is being covered by the current ESAs consultation on amending the SFDR Regulatory Technical Standards (RTS).”
Asset managers and other service providers affected by the EU Taxonomy and SFDR regulations have expressed confusion and concern about the varying definitions and applications of DNSH, a crucial component of both regulations.
“Fundamentally much more finance needs to be channelled towards urgent global sustainability challenges, in the places that need it most,” said Nakhooda.
“Achieving this requires devising new investment strategies that take on critical and increasingly existential global sustainability challenges such as climate change – the success of the SFDR and other sustainable finance regulations will ultimately need to be judged on that basis.”
Future of Article 9 funds
In its responses, the EC clarified that Article 9 funds – defined as having sustainable investment or a reduction in carbon emissions as its objective – that passively track the EU Paris-aligned Benchmark (PAB) or Climate Transition Benchmark (CTBs) do not need to additionally ensure compliance with the SFDR Article 2(17) sustainable investments test.
Further, funds with a carbon reduction objective under Article 9 can be actively managed and don’t have to passively track EU PABs/CTBs. “Such actively managed funds would however have to comply with the Article 2(17) SFDR sustainable investments test,” said Vergauwen.
Prior to the EC clarifying its definition of sustainable investment under SFDR, asset managers had exercised caution in their compliance with disclosure requirements for Article 9-labelled funds, including resorting to increased reclassifications.
Global sustainable funds attracted US$29 billion of net new money in the first quarter of 2023, down from nearly US$38 billion in the previous quarter, according to Morningstar’s latest Global Sustainable Fund Flows report.
The report also noted that sustainable product development had “cooled down” in Europe, with a significant reduction of new sustainable fund launches, amid regulatory uncertainty and fears of greenwashing accusations, while the rest of the world has maintained momentum.
“There is a critical need for financial products that seek to directly address the pressing sustainable development challenges of our time, such as climate change, and clearly a need for greater transparency and accountability around how negative environmental, social and governance issues are being managed,” said Nakhooda.
“All things equal, the emphasis on these issues that the SFDR and Article 9 categories have created on these issues is positive, and needs to be retained.”