4 April, 2023 / Comment
SFDR explained: What qualifies as Article 9, 8 and 6?
By Stuart Forbes, co-founder, Rize ETF
EU regulation is part of a broader push towards sustainable finance
The Sustainable Finance Disclosure Regulation (SFDR) is part of a broader push by the European Commission towards sustainable finance and the transition to a low-carbon, more sustainable economy. SFDR seeks to increase transparency and consistency in sustainability-related disclosures for investment products, providing investors with the information they need to compare the sustainability characteristics of investment products and make informed investment decisions.
Prior to its introduction, investors suffered from a lack of harmonised rules across the EU relating to transparency in sustainability-related disclosures for investment products. Since SFDR’s implementation in March 2021, asset managers must now qualify any ESG or sustainability claims that they make in detailed pre-contractual documents and indicate whether they are disclosing under Article 8 or 9.
SFDR has three main components: transparency requirements, pre-contractual disclosures and periodic reporting.
The transparency requirements oblige financial market participants to disclose how they integrate sustainability risks and other ESG factors into their investment decisions.
The pre-contractual disclosure requires financial market participants to disclose information about the environmental or social characteristics or sustainability objectives of their products to investors before they invest.
The periodic reporting then requires financial market participants to then report back to investors on how those environmental or social characteristics or sustainability objectives were actually met.
The result of SFDR, which was not in fact intended to be a classification system for products, is that investment products can be distinguished into three separate types based on the level of commitment to environmental or social characteristics or objectives of each product: Article 6, Article 8, and Article 9.
Article 6 products make no claim with respect to such characteristics or objectives.
Article 8 investment products are known colloquially as “light green” products. They promote environmental or social characteristics but do not have a specific sustainable investment objective. They invest in companies that meet certain environmental or social criteria, but they do not claim to have a specific environmental or social objective, such as climate change mitigation. Article 8 products may exclude companies involved in controversial activities, such as weapons manufacturing or tobacco production, and/or select companies that meet certain environmental or social standards, such as those related to greenhouse gas emissions or resource use. However, Article 8 products do not have to demonstrate that their investments are contributing to a sustainable objective per se.
To qualify as an Article 8 product, the asset manager must disclose the environmental or social characteristics of the product and explain how they are integrated into the investment process. This disclosure must be made in new pre-contractual documents that are appended to the investment product’s prospectus and then reported against in an annual periodic disclosure.
Article 9 products, on the other hand, are known colloquially as “dark green” products. They have a specific “sustainable” investment objective and are designed to contribute to one or more environmental or social objectives defined by the asset manager (there is no prescribed list of environmental or social objectives, they can be whatever the asset managers defines them to be).
Article 9 products must meet three mandatory dimensions of the definition of “sustainable investment” in SFDR in order to qualify as “sustainable.”
The first dimension is that the product must have a sustainable investment objective and must contribute to either an environmental or social objective. The definition of these objectives is left up to the manufacturer of the investment product. For instance, a solar panel manufacturer would be contributing to the environmental objective of climate change mitigation.
The second dimension is that the investment must not significantly harm any environmental or social objectives. If the product claims to provide exposure to companies involved in renewable energy, it should not invest in companies that harm the climate change mitigation objective or any other environmental or social objective. For example, if the solar panel manufacturer also produces energy from thermal coal or severely mistreats its employees and/or uses forced labour, it would, on the one hand, positively contribute to the climate change mitigation objective and, on the other hand, also harm both the climate change mitigation objective and various social objectives.
The third dimension is that the companies in which the product has invested must follow good governance practices, particularly in sound management structures, employee relations, remuneration of staff, and tax compliance. For example, the solar company mentioned earlier would clearly contravene the first three good governance criteria.
In order to qualify as an Article 9 product, the investment manager must provide clear and concise information about the sustainable investment objective of the product, including how it is measured and monitored. As with Article 8 products, this information disclosure must be disclosed in new pre-contractual documents that are appended to the investment product’s prospectus and then reported against in an annual periodic disclosure.
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