Just before Brussels closed down for the summer break, members of the European Parliament reached an impasse on the Sustainable Finance Disclosure Regulation (SFDR).
The Committee on Economic and Monetary Affairs was supposed to agree a negotiating position in July, which would then be voted on by colleagues in the wider parliament, but it couldn’t come to a consensus.
“That’s largely due to differences of opinion when it came to how the Transition category should operate,” explains Leo Donnachie, a senior policy specialist at the Institutional Investor Group on Climate Change (IIGCC), referring to the European Commission’s plan to introduce a dedicated SFDR category for investment products that support the climate transition.
Using ‘Article 7’ to capture transition
“A lot of time is being spent discussing the extent to which the concepts of transition and transition finance should be captured this time around,” continues Donnachie.
“But it’s also proving to be the biggest sticking point.”
Leonard Ng, head of UK/EU financial services regulation at law firm Sidley, says that while the topic is a source of headache for lawmakers, the new ‘Article 7’ label will almost certainly remain part of the final SFDR 2.0.
“I don’t think the Commission would have introduced the Transition label unless they felt there was broad support for it, so the current negotiations are really about tweaking what qualifies as a transition investment, rather than reviewing whether the category should exist,” he tells IPE.
For asset owners, he adds, “the Article 7 category makes a lot of sense, because under SFDR 1.0, ‘transition’ products were being squeezed into Article 8” – the label for funds that aren’t ‘sustainable’ but do incorporate the concepts to some extent.
“But that’s not what Article 8 is for.”
European Council
The European Council, meanwhile, has already finalised its negotiating position.
In keeping with other sustainability legislation, it is keen for SFDR to be less strict than the Commission’s proposal.
“I don’t think the Commission would have introduced the Transition label unless they felt there was broad support for it”
Leonard Ng at Sidley
“The Council wants to soften some of the transition criteria,” explains Ng. “For example, they want to add more flexibility around the inclusion of sovereign debt in Article 7 funds.”
One of the pension industry’s biggest gripes with the Commission’s proposal is that sovereign bonds are largely deemed ineligible as ‘transition’ assets, but the Council wants them to be accepted for a small portion (15%) of a portfolio.
“They also want to allow some fossil fuel-related activities, which is usually a no-go,” Ng notes, referring to a plan to raise the fossil-fuel exclusion threshold from 1% to 20% if a company’s capital expenditures and plans demonstrate it’s investing in becoming greener.
Membership bodies
“If done well, the transition category has the greatest potential to drive real-world change within the sustainable finance regime,” says Donnachie.
Perhaps surprisingly, responsible investment groups like IIGCC and the Principles for Responsible Investment (PRI) are more closely aligned with the Council than the Commission when it comes to defining elements of transition finance.
The PRI recently published a paper calling for coal to be a permissible revenue stream under Article 7, to allow investors to support companies making the shift away from the fuel.
At the heart of the debate sits the question of what SFDR is intended to do.
The Commission has increasingly positioned the framework as a way of tackling greenwashing in retail investment, which is why the proposed screens are so strict.
“But if there’s too much focus on SFDR as a greenwashing regime, you risk ending up in a situation where all the exclusions leave you with a tiny investable universe,” argues Donnachie, noting that “SFDR is [also] intended to encourage the creation of products that will channel capital into the real-world”.
For that latter objective, he continues, what matters is whether companies have credible strategies to align with a low-carbon economy – not what their legacy revenues are.
“It would help investors if there was more clarity on some of the definitions underpinning the transition category,” he believes, including what makes a credible engagement strategy and transition plan.
“Some clarity on what the exclusion criteria will mean for an investment universe is also important.”
Asset managers’ role
Valentin Pernet isn’t banking on EU legislators taking a “clear position” on what counts as a credible transition investment.
“And that makes sense, because it’s a Pandora’s box,” says the global head of sustainable investment at ODDO BHF.
“They expect the market to regulate itself by applying credible methodologies and disclosing them.”
The expectations mirror the Commission’s approach to the original SFDR, where investors were given the controversial task of deciding their own definition of ‘sustainable investment’ when they made claims – leading to panic about whether they would fall foul of supervisors’ expectations, and driving wildly differing levels of ambition between products using the same regulatory labels.
Some of the same challenges may arise this time around, Pernet points out.
For example, ODDO BHF has a relatively strict definition of a ‘transition’ investment, so just one of its 15 relevant funds would pass the proposed 70% threshold for assets aligned with its in-house methodology — the rest could only be marketed as Article 8.
Other asset managers may take a less stringent approach to qualify for Article 7.
“[It] encourages asset managers to develop their own approach to propose Article 7 products,” says Pernet.
“But they will have to ensure their methodologies are credible and robust.”
