SFDR Level 2 Uncertainty Unnerves Managers

Asset managers are exercising greater caution by downgrading their Article 9 funds in lieu of clear guidance.  

Until the European Commission clarifies its definition of ‘sustainable investment’ under the Sustainable Finance Disclosure Regulation (SFDR), asset managers will continue to exercise caution in their compliance with disclosure requirements for Article 9-labelled funds, including resorting to increased reclassifications.  

The much-delayed Level 2 of SFDR went live on 1 January, requiring asset managers to provide more detailed disclosures to justify the categorisation of their Article 8 (environmental and/or social characteristics) and Article 9 (environmental and/or social objectives) funds.  

The European Supervisory Authorities’ (ESAs) call for clarity following the Commission’s assertion that Article 9 funds “should only make sustainable investments” has yet to be answered, causing problems for managers grappling with Level 2 disclosure requirements.  

“This [continued confusion] has a direct impact on fund classifications and the level of disclosure,” Hortense Bioy, Global Director of Sustainable Research at research and data provider Morningstar, told ESG Investor.  

The Commission has been asked to outline whether an investment in a company that generates only a portion of its revenue from sustainable activities can be considered a sustainable investment as a whole, or whether any economic activity can contribute to an environmental or social objective if it is carried out in a sustainable manner.   

“Let’s say you have an Article 9 fund which must invest (almost) all of its assets in sustainable investments. Imagine one of the investee companies has five different economic activities, three of which are sustainable activities and two are not. Is the entire holding in the investee company a sustainable investment or only 60%? If only 60%, then we have an issue, as all of the fund’s investments must be sustainable investments,” said Julia Vergauwen, Managing Associate of law firm Linklaters’ investment funds practice.  

Further, the ESAs called for the Commission to explain whether any company with a climate transition plan can be considered sustainable, or if passive funds tracking EU Paris-Aligned and Climate Transition Benchmarks can be classified as Article 9. 

On the latter, DWS noted that its exchange-traded funds would disclose in line with Article 8 instead of Article 9 until further clarity can be provided. 

SFDR Level 2 adds to funds’ disclosure requirements, outlining a set of 14 core indicators and 31 additional indicators for their principal adverse impact (PAI) statements. Asset managers are expected to report on all 14 core indicators and two additional (at least one climate-related and one social-related). 

Better safe than sorry 

In the months leading up to Level 2, some asset managers chose to err on the side of caution. 

“While the notion of sustainable investment is still subject to interpretation and no guidance had been given so far by the European regulator, these managers have taken the proactive decision to act ahead of the implementation of SFDR Level 2 by reviewing the classification of their products, to avoid being accused of greenwashing,” said Morningstar’s Bioy. 

In some cases, this is because managers know their Article 9 strategies won’t meet the 100% sustainable investment criteria, Bioy noted, “regardless of how a sustainable investment ends up being defined”.  

“However, other managers are still unsure about what to do. They’re weighing the pros and cons. They still think their funds do and will continue to meet Article 9 requirements and, at this point, they don’t want to have to explain to their clients that they may have got it wrong. Some managers have decided to take a wait-and-see approach. They’re waiting for the answers to the questions asked by the ESAs to the Commission.” 

AXA Investment Management recently downgraded 21 strategies to Article 8, with plans to reclassify a further 24 in the coming months. Amundi, Europe’s largest fund manager, downgraded 100 funds worth €45 billion. In the past few weeks, Carmignac reclassified three of its sub-funds. 

Others, like Robeco, have made fund reclassifications according to their own internal definition of sustainable investment, with their Article 9 funds investing 100% in sustainable securities. 

“To avoid any mis-selling allegations, many asset managers also end up with very detailed disclosures, i.e., explaining exactly how things are done – in this case, how sustainable investments are qualified,” Vergauwen added.  

“The question is whether over-disclosing is always investor-friendly. Especially when it comes to retail or non-sophisticated investors.” 

Despite managers’ need for clarification, SFDR Level 2 is considered a welcome step closer to full transparency, which will both reduce the potential for greenwashing and supply asset owners with the decision-useful information they need.  

“Level 2 goes beyond mere disclosure as it requires pulling together information, setting up policies and procedures, discussions with stakeholders, all of which requires a tremendous amount of resources,” said Vergauwen, warning that “this is only the beginning”.  

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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