SFDR Q&A “Lowering the Bar” for Article 8 Funds

Six-month delay to Level 2 gives European Commission time to address continued confusion, says law firm Fieldfisher.

The European Commission’s attempt to clarify requirements for funds under the Sustainable Finance Disclosure Regulation (SFDR) is potentially “lowering the bar” for Article 8 funds, according to James Tinworth, Funds and Financial Services Partner at law firm Fieldfisher. This follows the publication of the SFDR Q&A by the Commission last month, responding to questions posed by the European Supervisory Authorities (ESAs).

SFDR Level 1, which came into effect on 10 March, asks asset managers to sort their ESG funds and other investment products into Article 8 (promoting environmental or social characteristics) or 9 (having an environmental or social objective). All other funds fall under Article 6. Level 2, which will ask asset managers to provide the underlying evidence supporting these categorisations, has been delayed by six months until 1 July, 2022.

However, the Q&A doesn’t specifically outline the minimum sustainable investment thresholds for prospective Article 8 funds, Tinworth told ESG Investor.

This effectively affords asset managers with Article 8 funds even more freedom in how they employ investment strategies to promote environmental or social activities. Strategies can therefore be incredibly varied, ranging from implementing ESG screening criteria and sector exclusions, to best-in-class or thematic investing.

Such flexibility could also be seen as “lowering the bar for Article 8 funds”, allowing for an even wider spectrum of ESG-labelled funds to be identically categorised, Tinworth warned.

The Commission further confirmed that Article 9 funds can include non-sustainable investments, but only for hedging or liquidity purposes. This will allow asset managers to better diversify fund portfolios, but the extent to which non-sustainable investments can be included has not been clarified.

The Q&A further noted that non-sustainable investments for Article 9 funds must also “meet minimum environmental or social safeguards”, meaning that these investments need to also undergo a degree of ESG-related screening and analysis.

However, the renewed strategy for sustainable finance – published 6 July – outlines that the Commission will consider the introduction of minimum sustainability criteria for “financial products that promote environmental or social characteristics”, meaning this current SFDR ruling could change.

The Q&A also responds to requests for clarification on what it means for an Article 8 fund to “promote” environmental or social characteristics, but its comments have been described as “unhelpful” by Linklaters.

A recent Morningstar report highlighted that Article 8 and 9 funds typically have very similar sustainable investment strategies – for example, fossil fuel exposures.

The report further noted that Article 8 is currently operating as a “catch-all” category, with a wide spectrum of funds ranging from minimal ESG-based exclusions to the more sophisticated funds that could qualify as Article 9.

Level 2 delay is welcome

Confusion also remains around the SFDR Level 2 Regulatory Technical Standards (RTSs), Tinworth said.

The RTSs outline the reporting of principal adverse impacts (PAI), which span a range of social and environmental factors, requiring asset managers to publish a PAI Statement on their websites concerning the impact of their investment decisions on a range of those sustainability factors on a quarterly basis. Originally, Level 2 specified that asset managers should be reporting on 34 PAIs, but this has since been reduced to 18 indicators.

“Asset managers need to become familiar with the draft RTSs but note that they are subject to change. It is that uncertainty that [the Commission] needs to remove as soon as possible,” he warned.

Tinworth said that the six-month delay to Level 2 of SFDR is “very welcome”, noting that the implementation deadline will therefore be closer to a number of other EU legislation expected to come into effect from October 2022 and January 2023. This includes the EU Taxonomy Regulation delegated acts and the Corporate Sustainable Reporting Directive (CSRD).

“The delay does raise more questions as to why SFDR Level 1 was rushed into force in March,” he added.

“Given the fact that the implementation timeline of the EU’s ESG rules is still a bit of a mess, the industry should probably hope for further delays and transitional periods. In reality, however, providers will likely get increasingly impatient about not being able to use Article 8 or 9 funds to access the immense ESG investment capital that is available,” said Tinworth.

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