Fund Solutions

Managers Could Hedge Transition Bets Under SDR

Fourth UK sustainability fund label could capture assets from Improvers category, as EU told to heighten SFDR transition focus.  

Focus on climate transition funds is likely to increase this year, as the UK’s Sustainability Disclosure Requirements (SDR) and EU’s Sustainable Finance Disclosure Regulation (SFDR) drive greater integration of transition-related assets.

A recent report from Morningstar identified 1400 open-end and exchange-traded funds with a climate-related mandate as of June 2023, compared to a mere 200 in 2018. Assets in these funds have surged 30% over the past 18 months and now represent US$534 billion, with climate transition funds accounting for more than US$200 billion.

In November last year, the UK’s Financial Conduct Authority (FCA) unveiled its long-awaited SDR regime after two years of consultation, defining four different labels for investment products. These included Sustainability Impact, Sustainability Focus, Sustainability Improvers and Sustainability Mixed Goals, which asset managers will be able to use as of July 31.

While the Improvers label will refer to funds containing assets aspiring to become more sustainable, the Mixed Goals one was created to accommodate those vehicles investing in a blend of strategies within the regime. Those funds will need to demonstrate that at least 70% of their assets are invested across sustainability objectives aligned with the other three categories. 

“Improvers may not be one of the biggest SDR labels, because Mixed Goals gives more flexibility [and] many options to asset managers,” Hortense Bioy, Global Director of Sustainability Research at Morningstar, told ESG Investor. “The latter is more attractive because it gives you flexibility. If you go for portfolio-level improvement, you’re more likely to choose the Improvers label.”

Increased investor appetite

In a separate report, Morningstar estimated that approximately 300 UK open-and closed-end funds would opt for one of the four SDR labels by the end of this year.

The Improvers label is predicted to be the third most prominent label, accounting for 12% of labelled funds, while the Mixed Goals one is expected to be the most popular (31%).

Under the Improvers label, firms will need to identify the period of time by which the fund and its assets are expected to meet standards selected by the asset manager, including short- and medium-term targets.

“If you see more investors expressing a growing appetite for these types of strategies, this is what asset managers will create,” Bioy said.

Maximilian Kufer, Head of ESG for EMEA Client Strategies and Private Markets at Invesco, reported that his firm’s engagement with institutional investors had demonstrated “meaningful appetite” to finance credible transitions across public and private markets – both in developed and emerging economies.

“The investment community has vocally advocated to emissions-intensive firms that their transition is an opportunity and a necessity,” Kufer added.

As more companies become sustainable, the number of Improvers funds, and Mixed Goals funds with an Improvers sleeve, may decrease.  

Under the FCA’s regime, managers will be required to review their labels every 12 months.

Defining transition under SFDR

According to Morningstar, European investors particularly favour climate transition funds, which account for almost half of all EU climate fund assets. Similarly, climate transition strategy funds represented nearly half of new launches in 2022, and more than 50% in H1 2023.

A recent SFDR consultation asked if the existing framework effectively captured transition asset investments and proposed a category for “transition focus” products, mirroring the three product labels originally proposed under SDR.

Similar to the UK regime, this new category would aim to highlight investments in companies that are not yet sustainable, but plan to become so. Its introduction has been supported by the International Capital Market Association, which said in a statement that the current SFDR regime was no sufficiently incorporating transition products.

Asset management group Mirova has also welcomed the consideration of transition investments under SFDR, while the European Fund and Asset Management Association has argued that the concept of transition finance would need to be clearly defined to incentivise investments.

Recent research from PwC Luxembourg showed that ESG funds in Europe managed €4.8 trillion (US$5.3 trillion) of assets in Q2 2023, €2.8 trillion of which were domiciled in Luxembourg. According to Morningstar, climate transition is one of the largest climate fund groupings under SFDR, accounting for 61% of Article 8 and 28% of Article 9. 

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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