ESG Hot Topics: Navigating SDG and Impact Fund Classification Under SFDR to Mitigate 'Impact Washing' Accusations

Greetings, fellow ESG enthusiasts! ??

This post concerns the new findings by the European Securities and Markets Authority (ESMA) in their recent publication titled “ESMA TRV Risk Analysis Sustainable Finance Impact Investing – Do SDG Funds Fulfill Their Promises? ” issued on 1 February 2024. ESMA has conducted a thorough analysis of the growing sector of public funds claiming to be aligned with the Sustainable Development Goals (SDGs) and, therefore, entering the domain of impact investing. ESMA critically evaluated whether these funds actually and genuinely contribute to the SDGs as they claim, for example, in their fund documentation and similar materials. This analysis made by ESMA should be viewed in light of the surge of SDG funds that have emerged mostly in response to the general increased appetite for ESG funds across the market.

Investment funds’ documents, namely key investor information documents (KIID)/key information documents (KID), investment strategy extracted from prospectuses and funds’ name indicated by Morningstar, which provide information on the funds’ strategy and if/how alignment with the United Nations SDGs is ensured.

ESMA’s report scrutinizes various SDG funds and their tangible impacts, unveiling a troubling overlap in the SDG alignment between SDG funds and their non-SDG counterparts. Such findings necessitate an expansive discourse on the core of sustainable investing, with a particular emphasis on its implementation under the Sustainable Finance Disclosure Regulation (“SFDR”).

Progressing from these findings, the discussion will extend to how sustainable investment methodologies should be refined and uniformly applied across all funds governed by SFDR. This segment will detail the approach for accurately identifying authentic SDG funds, underscore the significance of clarity in their sustainability claims, and emphasize the pivotal role of investors in ensuring these funds’ accountability.

Impact investing, the practice of investing to generate social and environmental benefits alongside financial returns, is gaining traction. This trend is crucial for advancing the EU’s sustainability goals, yet it’s also where the risk of misleading claims—a concern known as greenwashing—looms large. Therefore, the focus will be on how impact investing, particularly within the realm of SDGs, demands meticulous scrutiny to ensure authenticity in its contributions toward sustainability in compliance with SFDR.

The allure of impact investing and its broader category, ESG investing, is undeniable. These strategies are pivotal for steering us towards a sustainable future. However, the report is centered on the integrity of various fund impact claims, often pegged to well-established frameworks like the United Nations SDGs, a cornerstone of the global development agenda. Such claims suggest a beneficial role in achieving the SDGs, necessitating significant financial inputs partially met by private sector investments through dedicated financial products.

Growing interest in sustainable financial products has fueled the growth of SDG funds. Yet, this surge brings to light the potential risks of “impact-washing,” a concern underscored in ESMA’s focus on greenwashing. Despite their noble intent, SDG funds are particularly vulnerable to such risks without a unified definition or stringent criteria.

As of September 2023, SDG funds, though only a tiny fraction of the EU fund industry, have seen their size triple since 2020. This growth underscores the financial sector’s critical role in bridging the sustainability financing gap. Yet, the increased popularity among investors beckons a cautionary tale of potential discrepancies between the funds’ sustainability claims and their actual contributions.

In pursuit of clarity, a methodological approach was proposed to identify SDG funds and assess their alignment with the SDGs, leveraging a unique amalgamation of data sources.

The ESMA findings, however, reveal a stark reality:

SDG funds don’t significantly outperform their non-SDG or ESG counterparts regarding SDG alignment. This revelation raises fundamental questions about the authenticity of funds claiming to aid in achieving the SDGs.

The analysis highlighted two key challenges:

1. There is difficulty in discerning how SDG funds’ strategies concretely align with specific goals and their comparative lack of alignment with the SDGs against other funds. Despite slight tendencies for SDG funds to invest more in sovereign debts of countries scoring high on the SDG index, the differences are minimal and inconsistent across all goals. This observation prompts a critical reevaluation of what it means to claim a contribution towards the SDGs. Genuine commitment should transcend mere exclusion based on sectoral or geographical criteria, demanding a proactive and discerning selection of assets contributing to specific SDGs. Given the SDG framework’s global recognition, concerns of impact-washing are particularly pronounced. The credibility associated with the SDGs makes funds based on these principles beautiful to investors keen on sustainability. Yet, these funds risk undermining investor trust without significant differentiation in their approach to contributing to the SDGs.
2. The SDG fund market, still in its infancy and lacking standardized reporting norms, presents challenges and opportunities for more straightforward regulatory requirements. Despite the absence of significant differences in holdings between SDG and non-SDG ESG funds, the path forward should focus on establishing transparent criteria and ensuring that superficial sustainability claims do not compromise the noble goals of the SDGs.

The Evolution of Sustainable Development Goals and Investor Engagement:

The adoption of the 2030 Agenda for Sustainable Development at the United Nations Sustainable Development Summit in 2015 marked a pivotal moment in global efforts to address pressing challenges such as water scarcity, health issues, poverty, gender inequality, and biodiversity loss. The Agenda introduced the Sustainable Development Goals (SDGs), a comprehensive framework of 17 goals, underpinned by 169 targets and 232 indicators designed to monitor and drive progress across a broad spectrum of critical global issues. The SDGs are not merely aspirational; they are anchored in extensive global agreements, including human rights and climate change conventions, and call for collective action from all societal sectors, including the investment community.

Investor Approach to SDGs Since 2015:

Initially, public funds took the lead in aligning investments with the SDGs, leveraging their visibility and scale to promote sustainable investment practices. These entities focused on creating portfolios that not only offered financial returns but also contributed positively to the SDGs. Public funds often utilized green bonds, social bonds, and thematic funds targeting specific SDGs, setting a precedent for responsible investment and showcasing the feasibility of aligning financial objectives with global sustainability goals.

Following the trail blazed by public funds, private investors began to integrate SDG considerations into their investment strategies. This shift was motivated by a growing recognition of the intrinsic link between sustainable development and long-term financial performance. Private funds have increasingly adopted impact investing, ESG (Environmental, Social, and Governance) integration, and SDG-aligned asset allocation as methods to contribute to the goals while seeking financial returns.

Methodologies for Measuring Contributions and Alignment:

Investors employ various methodologies to assess their contributions to the SDGs and ensure alignment, including:

• Impact Measurement and Management (IMM): IMM frameworks enable investors to quantify the social and environmental impacts of their investments, facilitating informed decisions that align with specific SDGs.
• ESG Integration: By incorporating ESG factors into investment analysis and decisions, investors can identify companies that not only perform well financially but also contribute positively to the SDGs.
• SDG Mapping and Reporting: Investors map their investments against specific SDGs to track alignment and progress, often using standardized reporting frameworks to enhance transparency and accountability.

Challenges in SDG Alignment:

Despite these methodologies, investors face challenges in aligning with the SDGs, including:

• Data Availability and Quality: Reliable and standardized data on SDG-related outcomes is often lacking, making it difficult to assess the true impact of investments.
• Short-termism: The focus on short-term financial returns can conflict with the long-term nature of SDG targets, hindering sustainable investment strategies.
• The complexity of Measuring Impact: Quantifying the social and environmental impact of investments is complex and often requires sophisticated methodologies that are still in development.

Marketing and Positioning Strategies:

Investors market their SDG-aligned strategies by emphasizing the dual benefits of achieving competitive financial returns while contributing to global sustainability goals. Through impact reports, case studies, and sustainability indices, they demonstrate their commitment to the SDGs and differentiate themselves in a crowded market. This approach not only attracts like-minded investors but also responds to the growing demand from consumers and stakeholders for responsible business practices.

Positive Use Cases of SDG Investments:

1. Renewable Energy Projects: Investments in renewable energy projects, such as wind and solar power, have significantly contributed to SDG 7 (Affordable and Clean Energy), driving the transition towards sustainable energy sources and reducing greenhouse gas emissions.
2. Access to Education: Private funds investing in educational technologies and infrastructure have advanced SDG 4 (Quality Education), enabling broader access to quality education and lifelong learning opportunities, particularly in underserved communities.
3. Microfinance and Financial Inclusion: SDG-aligned investments in microfinance institutions have played a crucial role in advancing SDG 1 (No Poverty) and SDG 10 (Reduced Inequalities). By providing financial services to underserved populations, these investments have empowered millions of people, especially women, enabling them to start businesses, improve their livelihoods, and contribute to economic growth.

These use cases underscore the tangible impact that SDG-aligned investments can have on advancing global sustainability goals while also providing financial returns to investors. The evolution of SDG investments reflects a growing consensus that financial success and societal progress are interconnected, paving the way for a more sustainable and equitable future.

How to correctly map SDG funds or impact funds under the SFDR:

Our view at A Triple C Consulting is that Fund Managers and/or FMPs can concretely demonstrate how and in what form their funds contribute to SDGs by mapping it under Article 2(17) of the SFDR. This approach creates both transparency and credibility and avoids accusations of greenwashing or impact washing, as mentioned in the ESMA report. We encourage ESMA and all the European Financial Supervisory Authorities to approach this from a strict disclosure perspective based on the two relevant product classifications under the SFDR, which are either Article 8 or Article 9 - regarding SDG or impact funds.

Why, one might ask? This is because SFDR is strictly a disclosure regulation, and there are no methodologies for either SDG reporting or impact reporting under the SFDR on either level 1 or 2. The only environmentally strictly evidence-based reporting framework introduced by the EU Sustainable Finance Package is the EU Taxonomy and its six environmental goals. However, these six environmental goals are much more limited than the 17 goals introduced by the SDGs. Therefore, Fund Managers must map their SDG contributions under their objective, using their methodologies for measuring alignment.

We think that Goldman Sachs’ report from 18 October 2022 provides a credible and coherent approach to applying Article 2(17) of the SFDR. This structure clarifies how funds and/or financial products can contribute to an Article 9 fund by performing sustainable investments. This framework elucidates how Fund Managers can seamlessly align with the requirements of Article 2(17) and Article 9 of the SFDR by demonstrating their SDG alignment as either ‘Leaders’ or ‘In Transition,’ as visually depicted in the ensuing illustrations from GS below.

Objective and Intent of the SFDR:

SFDR is designed as a cornerstone in the European Union’s efforts to enhance transparency and disclosure within the financial market, particularly concerning ESG strategies. This regulation aims to set a clear framework for financial market participants, guiding them in disclosing the sustainability of their investment products. Significantly, both the EU Commission and the European ESMA have clarified that SFDR should not be misconstrued as a labeling scheme for funds. Instead, it aims to maintain a ‘disclosure and transparency’ regulation, ensuring that investors are well-informed without the impression of Article 8 and 9 funds being a ‘label.’

Recent guidance and clarification documents have underscored the regulation’s flexible approach, allowing financial market participants significant leeway in defining and promoting Environmental and social (E&S) characteristics and sustainable investment objectives. This flexibility, however, is contingent on the quality of disclosures provided in the SFDR templates, with the potential for more prescriptive guidance should these disclosures not meet the required standards.

Interpreting Sustainable Investments and Article 2 (17):

A crucial element of the SFDR involves defining what constitutes a ‘sustainable investment,’ particularly in the context of Article 9 funds. Our perspective aligns with the regulation’s broader aim of avoiding rigid labels and fostering diverse investment strategies that positively contribute to environmental and social outcomes. We advocate for a pass/fail method in qualifying the percentage of sustainable investments (SI), where companies meeting specific criteria set by Financial Market Participants (FMPs) can be considered 100% SI. This approach is instrumental in mitigating greenwashing and aligns with the SFDR’s objectives of promoting transparency and accountability in the financial sector.

A Framework for Sustainable Investments:

Our discussions with various players in the industry have led us to propose a three-tiered framework for defining sustainable investments, balancing the need for structured criteria with the flexibility to pursue innovative investment strategies.

This framework encompasses:

1. Leadership Strategies - This approach selects companies that are recognized as leaders based on specific criteria set by the FMPs. These criteria include alignment with the EU Taxonomy, contributing substantially to the SDGs, and leadership in reducing carbon emissions. Companies can be evaluated as leaders either by comparing them to the entire market or by looking at how they stand out within their own industry.
2. Transition/Improvement Strategies - This method focuses on companies that are not currently leading in their field but have the potential to improve in the future. It looks at companies with clear goals and key performance indicators (KPIs) for progress, and these targets must be shared publicly. The timeframe for expected improvements should also be specified. If companies do not meet their goals, there may be consequences, such as selling off the investments. Examples include companies that plan to spend more than 10% of their current revenue on projects aligned with the EU Taxonomy, those working towards specific decarbonization goals within a certain period, and companies increasing their revenue from environmentally friendly products or services in line with the SDGs.
3. Engagement Strategies - This strategy is for companies with poor environmental (E) or social (S) performance. The goal is to actively engage with these companies to encourage them to improve over time. FMPs should clearly define what they hope to achieve through this engagement and what constitutes successful improvement. If the companies do not show progress within a set timeframe, they might be sold off. This approach is particularly important for dealing with companies that do not disclose such information, especially in developing countries. It ensures these companies are not immediately excluded from sustainable investment opportunities and encourages them to make positive changes in their environmental and social practices.

Additionally, all investments designated as SI must undergo a Do No Significant Harm (DNSH) test against mandatory Principal Adverse Impact Indicators (PAIs), ensuring that investments contribute positively and do not harm other sustainability objectives.

Potential Risks of SFDR Application:

When applying SFDR principles, Fund Managers should adopt both a regulatory and marketing perspective. This dual view is crucial for understanding the implications of flexible versus strict interpretations of the regulation on market expectations and product ownership. While flexibility in SFDR allows for innovative investment strategies, it also poses risks, such as potential market confusion and the challenge of aligning investment products with client sustainability preferences. We caution against overly prescriptive standards that could stifle ESG fund innovation and emphasize the importance of market-driven transparency in fostering credible and innovative sustainable investment strategies.

Conclusion:

Feel free to reach out to us if you need an ESG advisor or help with ESG data collection to support your existing ESG workflows and compliance efforts. At A Triple C Consulting , we have ESG legal expertise (Magic Circle Law firm based in Luxembourg), ESG data platform (Seneca ESG ), and ESG climate and carbon accounting capabilities. A true end-to-end service offering at your disposal. ?? ?? ??

Best regards,

Albin Axelsson

Founder & CEO 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.