The Commission has clarified requirements for financial product classifications and the definition of “sustainable investment” under the SFDR.

In April 2023, the European Commission (Commission) published a series of answers to questions that the European Supervisory Agencies (ESAs) had raised in September 2022 on the legal interpretation of certain aspects of the Sustainable Finance Disclosure Regulation (SFDR). The answers seek to clarify outstanding questions from stakeholders, including in relation to the definition of “sustainable investment” under the SFDR. Previous uncertainty with respect to this definition contributed to considerable market movement in the form of product re-classifications in the latter half of 2022.

Background to the SFDR

The SFDR is a key pillar of the EU’s action plan on financing sustainable growth. The Regulation aims to help investors distinguish and compare between the many investment strategies marketed with ESG/sustainability aspects that are available (and are likely to become more prominent) in the EU.

The SFDR introduces comprehensive sustainability disclosure requirements covering a broad range of metrics at both the entity and product level for in-scope firms. At a product level, the SFDR imposes three distinct sets of requirements for financial products, depending on how firms aim to market those products:

• Article 9 funds: Products that have sustainable investment as their objective.
• Article 8 funds: Products that promote environmental or social characteristics.
• Article 6 funds: Products that do not qualify as Article 8 or Article 9

While the SFDR was not intended to be a labelling system, in practice many market participants have treated these categorisations as product labels. Firms are therefore incentivised to market their funds as being “green” in order to promote their products’ sustainability benefits.

The Commission has gradually rolled out disclosure requirements under the SFDR. Core disclosures requirements came into force in March 2021, while enhanced disclosure requirements, underpinned by specific Regulatory Technical Standards (RTS), took effect on 1 January 2023.

Market Uncertainty Regarding Product Classifications

In addition to the underlying SFDR and RTS, the EU issued guidance on the SFDR on several occasions. However, a number of financial product providers still found aspects of the SFDR requirements to be unclear, particularly in relation to those that distinguish an Article 8 product from an Article 9 product.

As a result, certain financial product providers became wary of the risk that products they had marketed as Article 9 could be challenged as “not sustainable enough” and lead to associated allegations of greenwashing. These providers therefore decided to “downgrade” certain products from Article 9 to Article 8. Research by Morningstar found that more than 300 funds classified as Article 9 were downgraded in Q4 2022, representing €175 billion in assets, or 40% of the Article 9 category.

In their questions, the ESAs reinforced the fact that significant market uncertainty remained regarding the definition of “sustainable investment” in Article 2, point (17) SFDR and how this terminology should be applied in practice. Ensuring compliance with the “sustainable investment” definition is central to the Article 9 classification, as well as for Article 8 products that commit to a minimum proportion of sustainable investments. The ESAs and financial product providers were therefore concerned that if the Commission answered the questions with a narrow interpretation of these requirements, particular products might be disadvantaged in benefitting from these classifications.

The lack of clarity over aspects of the SFDR, including in relation to the application of the “sustainable investment” definition, meant that, in 2022, certain financial products providers were wary of the risk that products they had marketed as Article 9 could be challenged as “not sustainable enough” and lead to associated allegations of greenwashing. These providers therefore decided (as referenced above) to “downgrade” certain products from Article 9 to Article 8. Research by Morningstar found that more than 300 funds classified as Article 9 were downgraded in Q4 2022, representing €175 billion in assets or 40% of the Article 9 category.

Clarifications for Financial Market Participants

The Commission, contrary to stakeholders’ concerns, largely took a broad and permissive approach in its responses to the questions on product classifications, confirming the following:

• Determining ESG contributions: The definition of “sustainable investment” set out in Article 2, point (17), SFDR does not prescribe any specific approach to determine the contribution of an investment to environmental or social objectives.
• Assessing sustainable investments: SFDR does not set out minimum requirements for the key parameters of a sustainable investment, i.e., concepts such as contribution, do no significant harm, or good governance. Financial market participants must carry out their own assessment for each investment and disclose their underlying assumptions. The Commission emphasises that this policy choice gives financial market participants an increased responsibility towards the investment community. Participants should therefore exercise caution when measuring the key parameters of a sustainable investment.
• Disclosing assessment methodologies: Financial market participants must disclose the methodology they have applied to assess sustainable investments, including:
  • how they have determined the contribution of the investments to environmental or social objectives;
  • how investments do not cause significant harm to any environmental or social investment objective; and
  • how investee companies meet the “good governance practices” requirement.
• Choosing compatible instruments: Financial market participants in scope of the SFDR can invest in funding instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company. As an example, financial products referred to in Article 2, point (12) SFDR, such as undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIFs), can invest in the general equity or debt of an investee company. The notion of sustainable investment can therefore be measured at the level of a company and not only at the level of a specific activity.

Outlook

The Commission’s additional guidance is a welcome development for market participants. However, risks associated with greenwashing remain a key area for EU and global market participants, with increased regulatory developments across jurisdictions. Furthermore, the ESAs are consulting on the SFDR RTS to consider, amongst other things, the approach to the sustainable investment test under Article 2, point (17), SFDR.[1]

Latham & Watkins will continue to monitor developments in this area.

Endnotes

[1] https://www.esma.europa.eu/sites/default/files/2023-04/JC_2023_09_Joint_consultation_paper_on_review_of_SFDR_Delegated_Regulation.pdf.