A deep dive into SFDR and Article 8
The Sustainable Finance Disclosure Regulation (SFDR) was designed purely to be a series of disclosure requirements, but the reality is that it is also being used by the investment community as a labelling regime. Investors use Article 6, 8, and 9 funds as labels. These distinctions help them understand the ESG performance of the funds they are considering investing in.
An Article 8 fund is one that promotes environmental and/or social characteristics. In a previous blog of the SFDR series, we reviewed the difference between Article 8 and 9 fund classifications. We set out to help fund managers understand which article would be more suitable for their new or existing funds. In this blog, we dive into further detail with regards to Article 8 funds, considering some real-world examples.
Article 8 classification
Earlier this year, Goldman Sachs released a report examining the initial market response one year on from the introduction of SFDR fund classifications.
As expected, given the broad criteria for Article 8 fund classification, many different approaches have been used to justify meeting Article 8 requirements. The report summarised the approaches as follows (ordered from least to most sophisticated):
Exclusion criteria:
This could mean excluding controversial products, fossil fuel exposures, UN Global Compact violations, nuclear weapons, human right violations, etc.
ESG scoring:
This usually involves setting some form of ESG score threshold based on a benchmark, and ensuring that the portfolio in question scores higher.
Engagement:
This typically involves use of the Principal Adverse Impact indicators (PAIs). PAIs are used to measure one or more ESG aspect of the fund (e.g., GHG emissions, gender pay gap etc.). In this case, fund managers will often take active ownership when ensuring portfolio companies work to improve these metrics. Other approaches include Sustainable Development Goals (SDG) alignment and use of the Sustainability Accounting Standards Board (SASB) to identify material ESG-related risks.
Problems with Article 8
The investment community has been frustrated with the ambiguity surrounding Article 8 funds. This has led to the introduction of Article 8+ funds, as discussed in our previous blog.
Without strict and clear guidance outlining what exactly does and doesn’t constitute an Article 8 fund, asset managers have adopted a range of approaches. Given that these funds are declared to be Article 8 by the asset managers themselves, and that to date there have been no sanctions for not following regulations, it is also to be expected to that many self-declared Article 8 funds do not actually meet the criteria outlined by SFDR.
An example of this emerged earlier this year. Morningstar is a highly-reputed ratings agency which maintains its own designation of ESG funds. It removed over 1,200 funds with $1.4tn in AUM from its European sustainable investment list, most of which were Article 8 funds.
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Asset Managers' Approaches
To provide some context to the above discussion, below are some examples of asset managers’ approaches to classifying new/existing funds as Article 8:
Nordea Global Climate Engagement
The Nordea Global Climate Engagement only invests in companies that have business models aligned with Paris Agreement goals. It engages with companies to accelerate the energy transition and drive the path towards net zero.
Flossbach von Storch Multiple Opportunities
This approach applies exclusions surrounding weapons, tobacco, coal, UN Global Compact violations, as well as other criteria.
Aviva Investors-Global Sovereign Bond
This bond focuses exclusions on controversial weapons, as well as using ESG indicators related to a variety of ESG criteria and covering over 400 data points.
JPM US Sustainable Equity
The JPM takes a best-in-class approach. It involves investing a minimum of two thirds of assets in US sustainable companies or companies with improving sustainable characteristics.
These examples reveal the range of funds found under one classification. Without the threat of regulatory enforcement, there is a risk that fund managers may misalign their funds with requirements and mislead investors. However, the enforcement of Level 2 SFDR and the associated PAI requirements is fast approaching (January 2023). Fund managers will soon have to reinforce their fund classification claims with detailed quantitative disclosures from their portfolio companies.
Prepare for SFDR Article 8 with KEY ESG
At KEY ESG, we have incorporated all PAI indicators into our software. This streamlines the process of data collection for fund managers looking to classify their funds under Articles 8/9 in the coming months.
We are entering into a new phase in sustainable investing. Why waste time researching the guidelines when KEY ESG software can set you on the right path from the start? Why stumble through the transition to Level 2 when expert guidance is readily available? KEY ESG's intuitive software provides fund managers with everything they need to make sure they get off to a great start.
For further information or to book a free demo, please get in touch with a member of our team.