A Detailed Framework and Clear Methodology for Fund Managers: Choosing Between Articles 6, 8, and 9 for Compliance and Credibility in ESG Investing

Greetings, fellow ESG enthusiasts! ??

Welcome to the 25th entry of our ESG Hot Topics blog series.

SFDR has been in force since March 2021, and there's way too little discussion about how to properly interpret the three product classifications and what the compliance requirements mean for financial market participants (hereafter, FMPs / undertakings / Fund Managers) that fall under the scope of SFDR. The risk is that many Fund Managers have wrongly classified their products, but let's bear in mind that SFDR applies to more than just funds.

Here is the list of all products that fall under SFDR:

• (a) portfolio management;
• (b) an alternative investment fund (AIF);
• (c) an IBIP;
• (d) a pension product;
• (e) a pension scheme;
• (f) a UCITS; or
• (g) a PEPP.

Under the scope of SFDR, there is quite an?extensive universe of financial products. In other words, it should be the "big talk of the town," yet discussions have primarily revolved around funds. At the beginning of 2021, there was a significant emphasis on UCITS funds, which is no surprise since UCITS funds are the largest by AUM.

Here's a simple breakdown of the value in terms of money related to these products:

• UCITS (Undertakings for Collective Investment in Transferable Securities): UCITS funds are among the largest and most popular investment vehicles globally, particularly in Europe. As of 2023, UCITS funds had approximately €11.3 trillion in assets under management.
• Alternative Investment Funds (AIFs): AIFs have grown significantly recently. While exact global figures are challenging to determine due to their diverse nature, they represent a substantial portion of the investment landscape. In Europe alone, AIFs managed about €7.1 trillion in assets as of 2021.
• Pension schemes and pension products: Pension funds manage trillions of dollars globally, but they are typically fragmented across different countries and systems. The exact global figure is difficult to pinpoint, but it’s substantial.
• Insurance-Based Investment Products (IBIPs): While IBIPs are significant, they generally don’t reach the scale of UCITS or major pension systems globally.
• Pan-European Personal Pension Product (PEPP): PEPPs are relatively new and not yet as widely adopted as the other options, so they likely have the smallest total investment amount among these choices.

If we continue discussing SFDR, the risk is that Fund Managers either overestimate or underestimate the implications of the various SFDR product classifications for their funds.

In simple terms, Fund Managers must understand that it’s not only about meeting compliance requirements and performing the necessary disclosures. These categories are dynamic and exist within a universe of aspects that impact the products' quality.

What I mean is that there are horizontal and vertical aspects that influence whether a fund qualifies as Article 6, 8, or 9, and how strong it is within its own category.

The first questions one has to ask are: Which of these categories actually applies to my fund?

Can I label my fund as Articles 6, 8, or 9?

And what are the most pertinent and important factors to consider?

In other words, when does an Article 6 fund start and end? The same logic applies to Articles 8 and 9.

That’s why I have produced a matrix for assessing whether and to what extent a fund can be categorized under Articles 6, 8, or 9. This matrix provides key elements portfolio managers must consider when creating an Article 6, 8, or 9 fund. I want to emphasize that this is truly a desktop exercise at the beginning, and therefore, I’m happy to share this matrix with my network. It offers a conceptual framework and language that facilitates fruitful discussions about what an Article 6, 8, or 9 fund is.

If we lack a mental and conceptual model for what something is, including its stages, requirements, scenarios, and definitions, we remain in ambiguity and risk falling into endless disputes. Without clarity, there can be no productive discussion about whether a product qualifies as Article 6, 8, or 9. Once we establish a level playing field for each category and its unique characteristics, we can challenge, amend, develop, and create something substantial within each classification. For me, that’s the true purpose of SFDR—it’s a creative toolbox for Fund Managers to work with rather than a rigid framework.

SFDR is flexible and allows various approaches to achieve outcomes within the legal framework, benefiting a range of asset classes, financial conditions, market appetites, and ROI expectations without binding portfolio managers to a one-size-fits-all approach. This freedom is beneficial, especially in a world where labels and prepackaged information are increasingly in demand. However, the world is constantly evolving. What we view as impactful today may look entirely different tomorrow. For example, the impact might mean sector-specific investments in one region, charity-like contributions in another, or considerations of additionality based on sector or geography elsewhere.

We must also contextualize these?three product classifications?when we?clearly define them. In other words, we need reasonable assumptions or meaningful travel directions that someone would consider if they want their money to be used for the greater good. This ties back to the primary purpose of SFDR, which is to allocate capital towards green and sustainable companies and projects. Beyond compliance requirements and definitions, we need indications of purpose and direction for Articles 6, 8, and 9 products.

This can be done by creating a framework for where these products typically fit and where they best serve their intended purposes; please see below:

Category A: Products investing in assets that specifically strive to offer targeted, measurable solutions to sustainability-related problems that affect people and/or the planet, e.g., investments in firms generating and distributing renewable energy or in companies building social housing or regenerating urban areas.

Category B: Products aiming to meet credible sustainability standards or adhering to a specific sustainability-related theme, e.g., investments in companies with evidence of solid waste and water management or strong representation of women in decision-making.

Category C: Products that exclude activities and/or investees involved in activities with negative effects on people and/or the planet.

Category D: Products with a transition focus aiming to bring measurable improvements to the sustainability profile of the assets they invest in, e.g., investments in economic activities becoming taxonomy-aligned or in transitional economic activities that are taxonomy-aligned, investments in companies, economic activities or portfolios with credible targets and/or plans to decarbonize, improve workers’ rights, reduce environmental impact.

Please find the analyzed presentation of Categories A to D and how they align with the above SFDR requirements, as previously outlined in the table:

1. Category A – Impact-Oriented Investments: SFDR Alignment: Article 9: Category A aligns closely with Article 9 requirements, as it specifies a clear, measurable sustainability objective — providing targeted, measurable solutions to sustainability-related problems affecting people and the planet. Article 9 products must have sustainable investment objectives, and Category A’s focus on renewable energy, social housing, and urban regeneration fits this requirement. Transparency Requirements: Article 9 requires these products to disclose how they assess, measure, and monitor their sustainability impacts. Category A’s focus on measurable outcomes aligns with these SFDR requirements, supporting the product’s objective with specific metrics and targets.
2. Category B – Credible Sustainability Standards: SFDR Alignment: Article 8: Category B fits Article 8 requirements, as it promotes environmental or social characteristics rather than strictly sustainable objectives. It emphasizes credible sustainability standards or themes, like solid waste management or gender representation, but does not make these the primary investment purpose. Transparency Requirements: Article 8 requires products to disclose how they promote environmental or social characteristics and how these are monitored. Category B aligns with these requirements by aiming for a high sustainability standard or alignment with specific themes, which meet Article 8’s expectations for promoting E/S characteristics.
3. Category C – Exclusion-Based Investments: SFDR Alignment: Article 6: Category C products do not specifically promote environmental or social characteristics nor have a sustainable investment objective; instead, they apply exclusion criteria, avoiding certain activities or investees with negative impacts. This exclusion-based approach aligns more with Article 6 requirements, where products focus on risk management and do not explicitly promote ESG goals. Transparency Requirements: While Article 6 requires transparency on how sustainability risks are integrated into investment decisions, it doesn’t mandate ESG promotion. Category C’s exclusion-based criteria align with this, as it does not promote or target specific E/S characteristics but rather minimizes potential ESG risks by excluding harmful investments.
4. Category D – Transition-Focused Investments: SFDR Alignment: Article 8 or 9: Category D could fit under Article 8 or, in some cases, Article 9, depending on the extent of the transition and improvement goals. It has a clear objective of improving the sustainability profile of investments over time, aligning with Article 8’s promotion of E/S characteristics and potentially Article 9 if the product focuses explicitly on transitioning to sustainable assets with measurable, sustainable outcomes. Transparency Requirements: Article 8 and Article 9 require disclosure of how these transition goals are achieved, including specific methodologies, targets, and monitoring strategies. Category D’s emphasis on setting credible targets for decarbonization, workers’ rights, and environmental impact fits well with these requirements, as it requires ongoing measurement and progress tracking.

Recommendations for Enhancing SFDR Compliance:

• For Category A: Ensure detailed documentation on sustainable objectives, methods of impact measurement, and alignment with Article 9 requirements, especially for tracking and reporting outcomes.
• For Category B: Maintain transparency on the sustainability standards being promoted and ensure they are measurable and monitored, to strengthen Article 8 alignment.
• For Category C: If aiming to meet only Article 6, focus on clearly explaining exclusion criteria without implying specific E/S promotions.
• For Category D: To meet Article 9 standards, focus on more explicit, measurable sustainability targets and provide detailed impact assessment and monitoring; for Article 8, ensure the transition goals are well-defined and achievable.

To wrap up this ESG Hot Topics piece, it's crucial to underline that the primary purpose of SFDR is to foster genuine awareness and enable Fund Managers to make conscious, thoughtful decisions about product classification. This isn’t about superficial marketing or catering to the rising demand from LPs looking for Article 9 funds; it’s about ensuring that each fund's investment thesis and strategy authentically stand out. The goal is to add real value, allowing Fund Managers to demonstrate, on an ongoing basis, how well their unique approach performs in relation to other Article 6, 8, or 9 funds.

There’s no need to simply replicate the strategies of other funds or rely on wishful thinking about the performance of certain asset classes. Instead, Fund Managers should cultivate a deep understanding of the assets they hold, the carbon emissions these assets drive (including financed emissions), and their standing in terms of Scope 1, 2, and 3 emissions. This transparency and data-driven insight aren't just nice-to-haves; they’re essential hygiene factors in today's market.

From there, the focus can shift to a more strategic and credible use of LP capital—investing purposefully and within the disclosure framework set by Articles 6, 8, or 9. Only then should Fund Managers think about how to communicate their fund’s direction and purpose, whether that aligns with one of the categories or the unique positioning described in the earlier framework. By approaching SFDR compliance thoughtfully, Fund Managers can not only meet regulatory standards but also truly differentiate their funds and drive meaningful, lasting impact.

Looking for expert ESG support? Whether you need an ESG Advisor or help with ESG data collection to streamline your workflows and ensure compliance, we’ve got you covered!

At A Triple C Consulting, we combine?ESG legal expertise?(partnering with a top Magic Circle law firm in Luxembourg), a?cutting-edge ESG data platform, and?climate and carbon accounting capabilities?in?one?seamless solution.

Let’s make ESG reporting easier, smarter, and more impactful. Reach out today! ??????

Best regards,

Albin Axelsson

Founder of A Triple C Consulting

[email protected]

www.atriplecconsulting.com

Note: The content provided in this newsletter is for informational purposes only and should not be construed as financial or legal advice.