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Given the challenges of climate change, the reduction of greenhouse gas emissions and, more generally, our negative or positive impact on the environment and society are issues that concern all sectors of our economy.
However, one of the foundations of any economic activity is its financing. By reinvigorating the financial system and encouraging investors to focus on sectors that contribute to the ecological transition and a sustainable growth model, the European authorities hope to have a broad impact, while at the same time making the financial sector and those who contribute to it more accountable.
It was with this in mind that the SFDR was set up.
The SFDR regulation: what is it?
The SFDR, which stands for Sustainable Finance Disclosure Regulation, is a European regulation designed to promote investment in so-called sustainable financial assets and increase the transparency of these financial products in terms of their contribution (or otherwise) to sustainable development, the reduction of greenhouse gas emissions and the consideration of social factors.
In particular, this regulation obliges financial players to be more transparent about the funds they manage or invest in, by informing investors not only about the "sustainability" of the investment products they sell, but also about the impact of climate and social change on their potential profitability. This is the application of a double materiality system.
To this end, the SFDR classifies investment funds into different categories according to their social and environmental impact.
Article 6, 8 and 9 funds
Funds are thus classified into 3 distinct categories, "article 6", "article 8" and "article 9" funds, enabling investors to make informed decisions about the sustainability of the financial product in which they are investing.
Article 6 funds: these are funds with no explicit sustainable investment objectives. They are labelled as "non-sustainable funds". They are not required to integrate an ESG dimension into their investment processes, but must still disclose basic information on sustainability risks.
Article 8 funds: these are funds with sustainability objectives but no particularly stringent rules. They are also known as "‘environmental and socially promoting funds’". They are designed to promote environmental or social characteristics in their investments. These funds integrate ESG factors into their investment process and define specific sustainability objectives in their investment policy.
Article 9 funds: these are the most advanced funds in terms of sustainability, also known as "super green" or "dark green" funds. They must make a substantial contribution to EU sustainability objectives, such as the Paris Climate Agreement. These funds are required to significantly integrate ESG factors into their investment decisions. They must have independent verification mechanisms to assess their impact on sustainability.
Why do we talk about green finance?
The SFDR is one of the tools put in place to contribute to the development of what is commonly referred to as "green finance" or "sustainable finance". The aim is to redirect investments towards activities that have a positive impact on the environment and society, and in particular to promote those that are committed to decarbonization projects. These tools also include instruments such as green bonds and the European taxonomy.
The stated aim is to better allocate financial resources, taking into account not only short-term financial performance and profitability criteria, but also sustainability criteria.
The double materiality analysis of financial products introduced by the SFDR and the notion of DNHS (Do Not Significantly Harm) enables us to take better account of this new balance by giving priority to a long-term vision. Investing in a product solely on the basis of profitability can become risky if it is likely to be affected by the consequences of climate change. So it's better to invest in products that are less risky in the medium and long term, and that promote "sustainable" activities.
What are the main objectives of the SFDR regulation?
The European regulation has four main objectives:
Improving transparency: The SFDR aims to increase the transparency of financial products by requiring management companies, investors and financial advisors to disclose information on the sustainability of their products and activities using a dual-materiality analysis. This should enable investors to make more informed decisions by taking sustainability factors into account.
Encouraging sustainable investment: By requiring financial sector players to disclose sustainability information, the SFDR aims to encourage investment in projects and companies that have a positive impact on the environment and society. Ultimately, this should encourage the transition to a more sustainable economy.
Aligning investments with the EU's sustainability objectives: SFDR helps to align investments with the European Union's sustainability objectives, such as the Paris Climate Agreement and the United Nations Sustainable Development Goals. It encourages investment in projects and companies that contribute to achieving these goals.
Preventing greenwashing: The SFDR aims to avoid the practice of "greenwashing", whereby a financial product is misrepresented as being more sustainable than it really is. By imposing strict disclosure standards for ESG-related risks and opportunities, the regulation aims to ensure that the information provided to investors is accurate and reliable.
Which companies and products are affected by this regulation?
SFDR applies to two types of profile:
- financial market players (asset managers, insurance companies, credit institutions, etc.)
- financial advisors, which include players from the first category when they provide investment advice services
They are legally obliged to provide information on the sustainability of the financial products they advise, and to classify them according to the sustainability criteria set out in the aforementioned regulations (articles 6, 8 and 9). Fund managers must also provide information justifying their investment decision-making process.
History of the SFDR regulation
The SFDR is a component of the European Green Deal, which aims to achieve climate neutrality by 2050, and to reduce greenhouse gas emissions in the European Union by 55% by 2030, compared with 1990 emission levels.
This Green Deal was set up within the European Union to meet the targets set by the Paris Climate Agreement, ratified in 2015.
SFDR is a European regulation dated November 27, 2019, effective since March 10, 2021. It was enhanced in April 2022 with the adoption of the RTS (Regulatory Technical Standards), effective since January 1, 2023.
The RTS are reporting standards to which financial market players must adhere in order to provide information on the potential impact of financial products on sustainability, as well as pre-contractual information models and periodic information models that must be transmitted to investors.
Finally, since September 2023, the European Commission has launched a double consultation aimed in the first part at gathering testimonies on the perception that different players have of the requirements of the regulation and the associated reporting rules.
The second part of the consultation, carried out with a more restricted audience, aims to assess the relevance of the regulations and the classification of funds under categories 6, 8 and 9, by proposing alternatives.
SFDR regulation and European taxonomy: what you need to know
The SFDR is to be compared with the European taxonomy, known as the green taxonomy.
As mentioned above, green taxonomy is also one of the tools introduced by the European Union as part of the Green Deal.
The European Green Taxonomy focuses on classifying sustainable economic activities, while the SFDR concentrates on providing specific information on sustainability in the financial sector.
Both initiatives aim to promote sustainability in the financial sector, but with different objectives and approaches.
The European taxonomy is a classification of economic activities that make an effective contribution to the EU's environmental sustainability objectives. It defines precise criteria for determining which economic activities are considered sustainable.
The green taxonomy covers six environmental sustainability objectives:
- climate change mitigation
- adapting to climate change
- sustainable use and protection of aquatic and maritime resources,
- the transition to a circular economy
- pollution prevention and control
- protecting and restoring biodiversity and ecosystems.
It is primarily intended to be used by companies and investors to identify and promote green investments in line with the European Union's sustainability objectives.
The two initiatives are complementary in that the Green Taxonomy can help financial players identify investments in line with sustainability objectives, while the SFDR ensures transparency on how these investments are managed and communicated to investors.
Some limitations
Finally, what is a sustainable investment?
Since the introduction of the SFDR regulation, there seems to be a blurring of the distinction between what can be considered an Article 8 fund and an Article 9 fund.
The difficulty lies in defining what constitutes a sustainable investment.
In particular, the SFDR specifies that Article 9 funds must integrate the notion of DNSH (Do no Significant Harm), i.e. their purpose must not be detrimental to any of the environmental or social objectives supported by the green taxonomy.
This definition remains relatively vague. Each financial player may have its own interpretation.
At the end of 2022, the entry into force of the RTS led to a massive downgrading of article 9 funds to article 8.
The European Commission has been asked to clarify the sustainability criteria for defining an Article 9 fund. However, in a letter dated April 14, 2023, the Commission indicated that it would not provide an answer to this question, leaving it up to the financial sector to choose what it considers to be a sustainable asset.
A review of super green funds
Article 9 funds, or Dark Green, are the focus of attention.
In 2022, a consortium of journalists including Follow the Money and Le Monde published an investigation entitled. "The great green investment investigation" in which they studied 838 super green funds out of the 1141 in existence at the time of their analysis. These 838 funds represented a total investment of 619 billion euros.
They were able to note that, although considered as Article 9, almost half of them were investing in the aviation and fossil fuel sectors, undermining the classification criteria established by the SFDR.
Similarly, in a study published in March 2023, entitled "How Green is Dark Green?", University of Zurich finance researchers Marc Chesney and Adrien-Paul Lambillon took a close look at funds labeled "Article 9", as well as the companies that benefit from them. They note that, although these Article 9 funds are considered more sustainable in theory, many of the assets included in this category are not actually so.
Their findings highlight the fact that investment fund managers seem to favor large multinationals, which are able to mobilize significant resources to improve their "green score" (Net Zero strategy, ESG ratings) without any significant impact on this score from violations of key principles of the UN Global Compact or OECD guidelines.
Conversely, smaller, more environmentally and socially responsible companies see their positive impact reduced, and are therefore less in demand.
Conclusion
In conclusion, by introducing the SFDR, the European Union has sent a clear signal of its determination to develop an innovative sustainable finance system. The SFDR is a key instrument for redirecting investments towards activities with a positive impact on the environment and society, and accelerating their development. It supports tools such as the green taxonomy and the CSRD in Europe's transition to a sustainable economy.
While certain limitations have been pointed out, the European Commission seems to have realized this by launching a new consultation, 2 years after its implementation, to take a critical approach to this regulation and to study alternatives to the classification of the different funds, which is to date the main point of contention.
Sources :
- "SFDR : Soon the end of article 8 and 9 funds ?", Novethic Essentiel, 15/09/2023
- "Sustainable finance: greenwashing risks for SFDR", Youmatter, 10/07/2023
- "SFDR (Sustainable Finance Disclosure Regulation): definition, explanations, issues..."Youmatter, 16/05/2023
- "European Commission decision on the answers to be provided to questions requiring the interpretation of Union law submitted on 9 September 2022 by the ESAs SFDR", ESMA (European Securities and Market Authority), 05/04/2023
- "How Green is 'Dark Green'? An Analysis of SFDR Article 9 Funds", SSRN, 28/02/2023
- "The great green investment investigation", Follow the Money, 29/11/2022
- "Sustainable finance: understand the Taxonomy and the SFDR regulation to express your preferences"Autorité des Marchés Financiers, 06/10/2022
- "An important step for sustainable finance in Europe: the transparency obligations created by the entry into force of the SFDR regulation", Autorité de contrôle prudentiel et de résolution (Banque de France), 01/04/2021
- "Sustainability-related disclosure in the financial services sector", European Commission
