Can SFDR live up to promises of greater transparency?
A looming update to the EU regulation has sent fund managers scrambling to downgrade Article 9 funds to Article 8 status.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) is intended to bring clarity to the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants. Article 8 funds are defined as ESG-linked, Article 9 are primarily ESG motivated (such as impact funds), and Article 6 are non-ESG.
With a 1 January 2023 deadline for Level 2 of the regulation’s Regulatory Technical Standards (RTS), requiring greater transparency in disclosure, big names such as BlackRock and HSBC have downgraded Article 9 exchange-traded funds (ETFs) to Article 8 en masse. This has prompted discussion over whether they were ever ESG-backed in the first place and even what the exact function of the SFDR is.
Article 8 is also looking more broad, which raises further potential for greenwashing. With all this in mind, a fundamental question must be how prepared fund managers are for SFDR in the new year.
James Peel is a portfolio manager at Titan Asset Management and is responsible for Titan’s approach to sustainable investing. Of the looming changes and resulting preparations, Peel says: “Given the recent spate of downgrades from Article 9, preparations are actually nearing completion. Funds and fund managers are getting to the right place at just about the right time, although I would say the severity and the speed of the downgrades recently was a little last-minute.”
Last month, data from FE Fundinfo revealed that over 1,500 Article 9 funds are at risk of losing their status, after an analysis of 6,000 products showed that as many as 663 had set a minimum level of investment in sustainable opportunities at 0%.
Not a label maker
Something that has caused a headache for both the SFDR’s creators and fund managers is that what was designed as an exercise in disclosure requirements has transformed, in the words of Chris Fidler, head of global industry standards at educational non-profit organisation the CFA Institute, into “a de facto labelling exercise”.
“When products are more complex, more needs to be disclosed. Within this marketplace, many consumers are looking for an easy button. They want something that functions more like a label, a mark that indicates that a certain level of quality has been met. That's not what SFDR was designed to be,” Fidler says.
For Peel, the fault lies more at the feet of the regulator for, in this initial stage, allowing fund managers to “mark their own homework”. He is sympathetic towards those funds having shifted within the moving space of increased transparency and disclosure.
With concerns abounding over the implementation of Level 2 of the RTS, the European Commission has delayed its introduction to SFDR twice, first last November from 1 January 2022 to 1 July 2022, and then again to 1 January 2023.
The UK has had the advantage of watching how the EU has approached rolling out the SFDR, and the opportunity to learn lessons. The UK equivalent, the Financial Conduct Authority’s Sustainability Disclosure Requirements (SDR), is due to have a one-stage rather than a staggered rollout, and is to come with defined sustainable investment labels.
Jon Collinge, sustainability director at infrastructure investment manager Morrison & Co, says of what SDR can learn from SFDR,: “Delivery timelines should be achievable and therefore less optimistic. The cost of compliance should be considered to avoid fund managers taking the easier or least ambitious option which could be a backward step for the industry. This should be achieved through enhanced engagement with the industry on the requirements.”
Broadening of Article 8
The shift to Article 8 from former Article 9 impact funds has set the category only wider, and a previous criticism that funds that should have been labelled as Article 6 are in the category also. This has created a swathe of funds in this bracket, leading to questions of whether an investor can confidently consider an Article 8 fund an ESG-friendly product.
For Collinge, the answer is simple: “If compliance with the requirements of Article 8 can clearly be demonstrated, an investor should be comfortable with Article 8 as being ESG-friendly.”
However, for Peel, SFDR was never an “overly useful” tool for performing due diligence, and this regard has only deepened with the most recent shifts, meaning he would now argue “no” to an Article 8 fund being by definition ESG-friendly, when he may have argued the opposite six months ago.
Patricia Pina, head of product research at sustainability tech firm Clarity AI, also identifies potential issues within this area of SFDR: “We do understand fears from the market that Article 8 simply becomes a catch-all category as funds steer clear of the less marketable Article 6 category and exercise caution for going for Article 9. The UK’s recent SDR proposal offered one potential solution to this via the usage of regulatory-defined labels with strict qualifying criteria.”
Threat to ESG?
ESG as a concept has faced criticism from many areas in 2022, from a section of the US Republican Party becoming more vociferously opposed to the notion as a betrayal of fiduciary duty, to the NY City Comptroller demanding BlackRock pay greater attention to climate disclosures rather than less.
If SFDR isn’t operating as intended, this may further undermine ESG as a wider notion, due to concerns as to whether such sustainable investments can be clearly defined in the EU, or if SFDR enables what it was supposed to reduce: greenwashing.
According to Collinge, it is “unfortunate” that the SFDR is required due to the extent of greenwashing that has been occurring across the market. He also believes that there is a risk that the compliance burden may increase the number of financial products targeting Article 6, which could have a net negative impact on ESG uptake across the sector.
Florian Berg, research scientist at the MIT Sloan School of Management, sees a further issue within SFDR: “Just because you own a certain footprint in your portfolio, it doesn't mean that you change anything in the real world. For me, the important thing SFDR should be doing is asking questions for both Article 9 and 8 funds; do you want this fund to achieve this real-world impact and, if so, how will it be done?
“Without these two questions, SFDR is the biggest source of greenwashing at the moment.”