What is SFDR?
In simple terms, SFDR classifies financial products (mainly funds) in the EU market based on their sustainability/ESG attributes into three categories, with different disclosure requirements for each type:
- Article 6: General products that do not actively consider sustainability factors in investments, also known as Article 7.
- Article 8: Products that promote environmental or social characteristics.
- Article 9: Products with sustainable investment as their objective.
For products that consider sustainable investment, SFDR provides specific guidance on disclosing the following three types of information:
- Disclosure of sustainable objectives and how they will be achieved before product issuance.
- Continuous disclosure and updates on sustainable development goals, evaluation methodologies, etc., on the institution's website.
- Periodic disclosure of progress in sustainable aspects during the reporting period (e.g., target achievement level, evaluation indicators).
Where is the Problem?
To simplify understanding, many studies and media reports refer to Article 8 products as "light green" funds and Article 9 products as "dark green" funds. Institutions themselves assess which category their funds fall into based on the regulations. SFDR's current predicament can be summarized as "dark green too dark, light green too light."
On the one hand, there is still no satisfactory answer within the EU to the fundamental question of "What is sustainable investment?" On the other hand, preparing portfolio information disclosure requires disclosure information from invested companies, and currently, the disclosure rate by companies is still inadequate.
How Sustainable Should Article 9 Be?
For Article 9 funds, there is still no clarity on whether they should be 100% used for sustainable investment. According to a report by Responsible Investor, a guidance document from the European Commission "indicates" that assets held by Article 9 funds should be 100% sustainable investments.
In the original guidance issued by the EU in July 2021, one of the questions posed was whether products under SFDR Article 9 must invest entirely in projects that meet SFDR Article 2(17) (i.e., sustainable investments). The response from EU financial regulators was that the "sustainability" of sustainable financial products currently available on the market varies, and theoretically, products that do not meet the goal of "sustainable investment" as described in Article 9 should be classified as Article 8 products. This does not clearly answer whether Article 9 products can only be used for sustainable investment but has been interpreted to mean that Article 9 products should be 100% for sustainable investments.
SFDR's technical standards (also known as Level 2 standards of SFDR) came into effect in January 2023. Due to fears that their funds would not meet the 100% sustainability requirement, towards the end of 2022, Amundi, BlackRock, HSBC AM, and others downgraded their Article 9 products to Article 8. Notably, Amundi announced that "almost all" of its Article 9 funds had been downgraded to Article 8, reducing the total from €45 billion to just €3 billion. Data shows that in the fourth quarter of 2022, 307 Article 9 funds were downgraded to Article 8, with a total size of €175 billion.
Is Article 8 Reliable?
Institutions have been leaving Article 9, but overall the enthusiasm for sustainable funds remains strong, leading to significant growth in the share of light green funds, i.e., Article 8 funds. In the European fund market, the share of Article 8 funds by size was about 38% at the end of 2021, rising sharply to 52% by the end of 2022. This increase was influenced by the issuance of new funds, upgrades from Article 6 to Article 8, downgrades from Article 9 to Article 8, and changes in fund net value.
In contrast to Article 9, the problem with Article 8 is that it is too "light green." Article 8 is described in SFDR as promoting "environmental or social characteristics," for example, a fund investing in a renewable energy company could be recognized as promoting environmental characteristics as long as its other investments do not have significant environmental or social harm. The biggest difference from Article 9, as stated in the EU guidance, is whether the goal is sustainable investment. In this example, the fund's investment in a renewable energy company may be driven by market prospects rather than necessarily to promote sustainable development.
The European Securities and Markets Authority's (ESMA) Securities Market Stakeholder Group (SMSG) recently reported that the scope of environmental and social characteristics is so broad that almost any project can be more or less aligned with these goals.
In comparison, the names of the largest Article 9 funds generally contain keywords such as "climate," "environment," or "sustainable," whereas the largest Article 8 funds are often themed around "income," "growth," or specific sectors.
Is the Data Available in 2023?
Although funds specifically investing in the Chinese market are quite niche in the European fund market, more often being part of a global or Asia-Pacific allocation, after screening we found one Article 9 fund specifically investing in China: BlackRock's "BGF China Impact Fund."
The fund publicly disclosed information only on its top ten holdings and their respective weights. As of February this year, the fund held 34 positions, with the top ten accounting for 41.71% of the total. To facilitate evaluation, the weights of these top ten holdings were proportionally increased to make the total weight 100%, and the performance of these ten companies was individually assessed.
The fund's investments are quite diverse, with its largest holding, China Water Affairs Group, primarily engaged in urban water supply and wastewater treatment. Other notable holdings include CATL (Top 5) and BYD (Top 10), both leaders in the electric vehicle sector, and Sungrow Power (Top 8), involved in renewable energy equipment production. There are also two companies in the construction and building materials sector, namely Honglu Steel Structure (Top 6) and Weixing New Building Materials (Top 7).
In terms of environmental indicators, seven companies disclosed Scope 1 and Scope 2 greenhouse gas emissions data, but only two disclosed the proportion of renewable energy in their energy use, averaging less than 7%. For some key indicators, such as carbon footprint and greenhouse gas emissions intensity, only one company provided data.
Under additional social indicators, it was found that most companies still lacked comprehensive supplier codes of conduct and employee grievance mechanisms. The proportion of the ten companies invested in by the fund that lacked supplier conduct codes was 64.6%, and the proportion lacking employee complaint handling mechanisms was 42.8%.
In Conclusion
On December 9, 2019, SFDR was officially published in the Official Journal of the EU. Despite concerns about data and technical standards being raised at that time, the challenges encountered during implementation have still exceeded expectations, especially with the "big downgrade" of Article 9 in the second half of last year, which has given this regulation an unstable label.
With the unclear definition of sustainable investment and the ambiguous requirement for Article 9 funds to invest 100% in sustainable projects, institutions have rushed to downgrade Article 9 funds to Article 8, raising doubts about whether both Article 9 and Article 8 categories are prone to greenwashing.
The SFDR mechanism allows fund companies to assess whether their fund products meet and which classification requirements according to EU regulations, rather than submitting an application for review by an official EU body.
Furthermore, there is no definitive incentive for sustainable fund products or a clear threshold for investing in sustainable projects, which, in some cases, restricts the investment scope of funds with a sustainable label. The key driver for institutions to launch sustainable funds is the strong market demand for them. Because this factor is certain, the issues faced during SFDR's implementation are unlikely to deter institutions from launching related products and classifying them according to SFDR. In the fourth quarter of 2022 alone, about 165 Article 8 funds and 49 Article 9 funds were issued.
As a recent comment on ESG stated: "To some extent, it is precisely the success of ESG that hinders ESG. Before people fully understand ESG, it has already become mainstream." At least, ESG has not been denied as a success.