But what does this mean, exactly?
The SFDR's main purpose is to reorientate capital towards more sustainable businesses and increase transparency on sustainability among financial institutions and market participants. SFDR requires asset managers and other financial market participants to provide transparency on sustainability and imposes mandatory ESG disclosure obligations.
The EU Taxonomy is focused on defining a minimum criterion for environmentally sustainable economic activities. These activities should contribute substantially to one or more environmental objectives without doing any significant harm to any of the others.
A key part of both regulations is to create more transparency in investment strategies and prevent greenwashing and claims that products are sustainable when, in reality, they are not. There are both entity and product-level disclosure requirements.
Who's in scope for it?
Investment firms, such as asset managers who offer portfolio management services, pension providers, and insurance-based investors, as well as qualifying venture capital and social entrepreneurship activities.
In-scope financial products will include investment and mutual funds, insurance-based investment products, private and occupational pensions, and both insurance and investment advice.
If any of these products make sustainable investments, the manager should disclose how those investments are compliant with the ‘do no significant harm’ principle laid out in the regulation.
Under the new classifications, a strategy will be labelled under either Article 6, 8 or 9 of the SFDR depending on their characteristics and level of sustainability:
- Article 6: Funds without a sustainability scope or ESG risk considerations in the investment process.
- Article 8: Funds that promote environmental or social characteristics while including ESG risks and good governance practices.
- Article 9: Funds that have target specific sustainable goals as their objective.
The information to be disclosed shall include the transparency criteria concerning Information on how those characteristics are met and whether metrics have been defined to ensure those characteristics.
The EU Taxonomy creates a clear understanding of what actually constitutes sustainable activities by defining the minimum criteria for environmentally sustainable economic activities. These activities should contribute substantially to one or more of the following six environmental objectives without doing any significant harm to any of the others and by keeping minimum safeguards with regard to other aspects of governance.
The taxonomy defines activities as aligned, not-aligned or non-eligible to its goals, and then presented as a percentage of the entire portfolio:
How does the EU Taxonomy link to SFDR
The EU Taxonomy is a classification system for environmentally sustainable economic activities and is integrated into the SFDR – specifically into articles 8 or 9.
To satisfy both regulations, a fund needs to disclose information about the proportion of Taxonomy alignment. Alignment should be expressed as a percentage of turnover, capital expenditures and operating expenses per transitional and enabling activities.
What does all this mean?
Large listed companies incorporated in the EU are required to report which part of their revenue and expenditure is in line with the Taxonomy. Investors will have to disclose the percentage of their AUM that align with the Taxonomy. Funds classified as Article 8 or 9 are in scope for disclosures.
In practice, according to a survey by MorningStar, many asset managers have enhanced existing strategies, reclassified funds and launched new products consistent with their interpretation of Article 8 and 9 requirements. In Q1 2022, 47% of new funds were launched as either Article 8 or 9 funds, namely, these represent a significant share of new fund launches during each of the last four consecutive quarters.
At BDO, we believe that the Taxonomy will have a positive impact on the market. It will provide a common language for institutional and retail investors, issuers, policymakers and regulators. This will bring standardization and help overcome greenwashing in sustainable finance. Moreover, the disclosures on the Taxonomy alignment of investments will enhance the reliability of information, comparability and transparency on the level of sustainability claims of an investment.
Written by Sivan Lachman, Tech manager at BDO Israel