SFDR: The start of a longer ESG classification journey

"The Sustainable Finance Disclosure Regulation (SFDR), which applies since March 10, requires asset managers to sort their funds into different sustainability categories based on the product's characteristics. Funds are categorised as articles 6, 8 or 9, with 'Article 9' funds requiring 'sustainable investment' as their explicit objective.Indeed, classification is not the endgame but rather the first step of a longer journey. Starting in 2022, funds categorised Article 8 or Article 9 will need to publish highly standardized ESG factsheets that detail the fund’s ESG strategy, characteristics, benchmark and due-diligence policies", as published by Natixis Investment Managers in "The Hub", a publication for institutional investors.SFDR information annexes to fund prospectuses and annual reports, these templates will also include a KPI around alignment with the EU Taxonomy – a system for classifying ‘sustainable economic activities’ aligning with the Paris Agreement objective of carbon neutrality by 2050.Harald Walkate, now ESG Advisor and previously Head of ESG at Natixis Investment Managers, commented on some of the issues around SFDR in the publication quoted above and provided insight into how investors and advisors should read between the lines when assessing what SFDR means for sustainable investing.Harald Walkate (HW): "This system, in theory, is helpful for investors to compare funds. In practice, they need to be cautious of simply choosing funds categorised as Article 6, 8 or 9. The classification element of the regulation creates a hierarchy that could lead to a belief that Article 8 and 9 funds are always ‘better’ products. This is also caused by how Article 6 is drafted: it covers both funds that do ESG integration, without being promoted as ‘ESG Funds’ – which is what a majority of the market is doing – and funds that have no ESG approach at all. What the industry needs to avoid is a system where managers are incentivised to incorrectly label their funds as Article 8 or Article 9 to attract clients. If most or all funds are categorised as Article 8 or 9, the investor is no better off than before the regulation was implemented. In effect, this could actually incentivize the ‘greenwashing’ that SFDR is meant to counter."

"Investors therefore need to be cautious of simply choosing funds that are categorised as Article 6, 8 or 9 and should, as ever, do their homework."

"The Hub" (Natixis)

SFDR is one part of a wider framework to foster transparency, disclosure of information by financial market participants and supporting the goal of moving more private and public capital towards sustainable investments.HW: "It seems there were various drivers at the inception of SFDR, which have sometimes made it difficult to understand its main objectives, and how regulators want us to prioritize them – whether it is mobilizing more capital towards ESG goals, improving risk management, or tackling greenwashing. Yet, without a shared understanding of the problems and objectives, I fear that the proposed solutions are not optimally designed and, in some cases, might be counterproductive.I think the principle underpinning SFDR – there are products out there claiming to ‘do’ ESG and I need to help consumers make sense of them – is fine as far as it goes. However, the way that SFDR has been written and is now being interpreted is actually counterproductive. I would say that as a result consumers are less able to assess the different ESG-labelled products."Harald Walkate was also asked: "What else should investors look for when assessing the sustainability of funds?"HW: "Before answering this, I should point out that asset managers and consumers often have different expectations from developing or buying ESG funds.Broadly, this can be, first, ‘ethical or values-alignment’, whereby the investor does not want exposure to certain companies or industries, and the activities or industries considered to be controversial can vary greatly across regions and even across different consumers.Second, ‘financial’ – the investor expects to better manage risks by taking into account ESG factors, or expects better financial performance, through ESG integration, bestin-class, or thematic strategies.And third, ‘impact’ – or making a better world. Here, an investor expects that his or her way of investing will lead to better realworld outcomes.And of course, you can have a combination of these objectives. Given that, today, there are no clear-cut metrics or accepted standards to determine whether any of these expectations are present in the investment process, I believe there are a couple of things that are key to the development of the market for ESG funds, and to avoid greenwashing.First, to provide clarity to the end-investor regarding the conviction of the investment team – its beliefs on the relevance of ESG to the investment process.Second, a qualitative narrative on how this is implemented – how have you assembled your team, what specific expertise is needed, which data sources do you use? Over time, I would like to see regulations move in this direction by providing a classification along the lines of ethical, financial or impact, as described earlier.This would be awarded based on the conviction and narrative of the asset manager or investment team. I’d also suggest that for each category, the fund should describe clearly what it does and how it intends to achieve the goals.So, for category one, the manager should explain which sectors or companies it is excluding, and which data sources it uses to determine the companies in scope. Also, so as to not mislead consumers, it should describe clearly what this investment approach does and does not accomplish; for example, exclusions or negative screening approaches do not generally contribute as much to financial performance or solving societal problems. Investors need to know what they are buying.Finally, there should be a separate category for strategies that do not wish to market themselves as revolving around ESG objectives, but incorporate ESG considerations in their investment research and decision-making and are active owners.""The Hub", a publication for institutional investors investESG.eu is an independent and neutral platform dedicated to generating debate around ESG investing topics. All opinions expressed are those of the author or contributing source.