With the EU’s Sustainable Finance Disclosure Regulation now established, the signs are that investors are showing greater interest in Article 8 and Article 9 funds at the expense of those that make limited claims about their ESG credentials. Yet although the rush to green investing is welcome, advisers say there are risks associated with treating SFDR classification as a labelling regime.

SFDR introduced a new array of disclosure obligations for fund managers that depend on how a fund is classified. Article 9 funds, which commit to invest exclusively in sustainable investments, are subject to the most onerous obligations, while Article 6 funds, which make no such claims, face far fewer requirements. In between sit Article 8 funds, whose products might either promote environmental and social characteristics or commit to making at least some sustainable investments.

The decision on how to categorise a fund requires a balancing act between the upside of benefiting from investor appetite for strong ESG credentials, and the downside of the practical difficulties and costs associated with compliance.

Different disclosures required

Simon Witney, a senior consultant at law firm Travers Smith, says: “SFDR introduces different disclosure requirements that are determined by the claims a manager makes when promoting a fund to investors. If, for example, you say that your fund will only invest, or will partially invest, in sustainable investments, then you will have to make certain prescribed disclosures, using a rigid template, to allow investors to see whether you have done that.”

Witney says the regime is not, on the face of it, about product regulation because – at least for Article 8 funds – it does not stipulate that you can only do X, Y or Z. “Broadly speaking, Article 8 of the SFDR does not prescribe what a fund can and cannot do, which is what you might expect from a labelling regime,” he says. “It does provide some additional disclosure, but investors don’t only want disclosure; they want assurance that a fund is behaving in a certain way on ESG. They will not get that from SFDR – they will get that from the fund’s investment policy, which remains crucial.

“All that investing in an Article 8 fund really guarantees you is a certain amount of disclosure, and most investors in private markets are already getting that. I’m concerned investors are placing too much emphasis on this as a label, when it was never designed to be a label.”

According to Morningstar, by the end of September – six months after the introduction of SFDR – almost 37 percent of the assets under management in the EU were in Article 8 or Article 9 funds, with that figure expected to rise rapidly in response to investor appetite.

Paula Langton, a partner who leads the sustainability practice at placement agent Campbell Lutyens, says: “At the moment this is relatively new and we are seeing an array of responses from investors. There are a number of impact funds of funds that are Article 9 themselves and are restricted from investing in a fund that isn’t Article 9, or Article 8 or 9. And certainly some investors are saying they will only invest in sustainability products, so they cannot do Article 6.”

However, she says the landscape is currently more nuanced: “Some investors are saying that at this moment in time they can’t limit their programme based on this, and there aren’t enough opportunities in Articles 8 and 9. Others are saying this is a helpful guideline and gives a good indication of what a manager is thinking, but we are not confining our investing to Articles 8 and 9. Over time I suspect that may develop.”

“SFDR is not product regulation. It’s a disclosure regime”
Patricia Volhard
Debevoise & Plimpton

The problem is a risk of poor decision-making based on SFDR classification alone. Investors might rule out a highly ESG-motivated venture capital fund if it is classified as Article 6 because it cannot meet the costly disclosure requirements of anything more as it is taking minority stakes in small, early-stage companies and feels ill-equipped to meet data requirements. Conversely, an Article 8 fund committed to promoting a social objective may look more attractive but is not necessarily prohibited from investing in businesses heavily reliant on fossil fuels or in environmentally damaging industrial plants, so long as that is allowed by the fund’s investment policy and it makes the necessary disclosures.

Witney says: “I know firms that have made a decision to adopt an Article 6 classification based on their approach to ESG as a tool to reduce risk or enhance returns, only for some investors to come back and say they want the fund to be Article 8. The firm might go along with that but the new classification may not necessitate any change to its investment approach, just a change to its marketing and reporting – which the firm might feel is not adding anything useful to the reporting it already does.

“In private markets, dominated by sophisticated institutional investors doing full due diligence, that may not matter much. But, as the EU regulator has acknowledged, if investors begin to rely on the classification for more than additional disclosure, and don’t fully understand the investment policy of the fund, there’s clearly a risk that investors will make ill-informed decisions – you might even call it regulator-facilitated greenwashing.”

Patricia Volhard, a partner in the investment funds practice at law firm Debevoise & Plimpton, says: “SFDR is not product regulation. It’s a disclosure regime, so an Article 8 fund still has a lot of flexibility. You can set the bar lower or higher when defining your environmental or social targets, and you can still be Article 8 as long as you specifically promote such an environmental or social objective and report on your performance in light of that objective on an ongoing basis. The real question is whether, in defining your objective, you set the bar high enough to meet investor expectations.”

Investor pressure

However, Volhard is already seeing investors putting pressure on managers to classify as Article 8 rather than Article 6: “When SFDR became effective a lot of fund sponsors didn’t want to run the risk of being considered to fall under Article 8. They wanted to talk about their ESG policy but they didn’t want to be considered to be promoting an environmental theme and become subject to that reporting, and face uncertainty as to the scope of that reporting.

“Now, the situation has changed quite substantially. We see more fund sponsors asking how they can qualify for Article 8. There’s a much more positive attitude, and managers want to be within the scope of Article 8 in a manner that they can fulfil. Article 8 has become a standard managers are aiming for, and that must be because investors are asking for it.”

Langton says the direction of travel is clear: “Some of the large law firms have taken quite a conservative stance and advised clients to go very cautiously, because they don’t know how the disclosure obligations will play out. We’ve also seen one or two leading sustainability firms globally that you would think might go for Article 9 hovering instead around Article 8 to keep their options open.

“There has certainly been an increase in investors asking the questions; and if a manager isn’t classified as Article 8, they want to know why. But at the moment, it’s a discussion piece rather than a real money-moving piece. It is an area with nuances. Certainly over time I’m sure we will see a convergence around Article 8.”