In this article we explore the application of some key elements of the EU Sustainable Finance Disclosure Regulation (SFDR) and its expected impact on the transition to a more sustainable economy.

In recent years, we’ve already evidenced the impact of changing legal definitions about what constitutes ESG characteristics for the investment management industry. This has led to a wave of reclassifications and re-labelling of a large number of funds, based on the extent to which they consider environmental, social and governance (ESG) risks and factors.

While investors and issuers supporting the transition to a sustainable economy do benefit from the guidance which such laws and regulations around ESG provide, some more questions need to be answered: One of the topics under debate is whether investments into climate and environmental transition activity can be considered “sustainable investment” under the EU SFDR. Those who deal with sustainable finance laws and regulations know that an answer to what may look like a simple “let’s-apply-common-sense” question may not be simple at all.

SFDR Article 2(17) defines sustainable investment as “an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy; or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance”.

A number of questions arise from this legal definition. Some of these include: is sustainable investment (“SI”) restricted to economic activities only, or can it apply at an entity-level? How does the definition of SI apply to investments in instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company? Is environmentally sustainable investment under SFDR the same as environmentally sustainable investment under the EU Taxonomy? How can investors define and measure their contribution to an environmental or social objective? How can investors ensure that investments do no significant harm to other objectives? What precisely constitutes good governance practices?

Following the adoption of the SFDR back in 2019, detailed technical standards have been published and became effective in January 2023. The European Commission also released several sets of Q&As, now handily consolidated in one document, aiming to deliver more clarity around the interpretation of various terms and provisions. Among others, the Commission confirmed that EU Taxonomy-aligned investments would be compatible with the definition of “sustainable investments” although it would not be restricted solely to these activities, and it would not be further prescribing the definition of “sustainable investment”. Furthermore, the Commission said that financial market participants must conduct their own assessment for each investment and disclose underlying assumptions for the definitions. This flexibility gives investors an opportunity to contextualise their application of the definition of SI within specific facts and circumstances, such as different types of portfolio investments (e.g. non-financial, financial companies and sovereign, supranational and agency entities), markets (e.g. developed, emerging and developing) and regional specificities. However, this approach may lead to confusion in the market and most likely to increased scrutiny on investors’ assumptions and disclosures.

The concept of climate and environmental transition, a key focus area for companies and investors, adds another layer of complexity to the application of SFDR. Discussions continue to be held surrounding the debate whether the financing of climate transition can be considered SI under SFDR (Article 9 product) or whether it should be seen as promoting environmental (and social) characteristics (Article 8 product).

There are a few considerations that may help determine product designation after all: the Commission’s Q&A confirmed that the sustainable investment definition is agnostic with regard to the financing instruments, and hence it can apply to instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company. Furthermore, investment products applying passive investment strategies which track a Paris-aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB) (meeting the requirements of the EU Low Carbon Benchmark Regulation) are deemed to be sustainable investments. It appears the same logic can be applied to active investment strategies. To this end, the Commission declared that the vendors of financial products with an active investment strategy focused on carbon emissions reduction, and which apply the same requirements (selection criteria etc) as those applied by PAB and CTB, must explain why they consider such products to have sustainable investment as their objective.

The Commission was also asked explicitly whether an economic activity can contribute to the general environmental objective of climate change mitigation if it is only covered by a transition plan (for instance a plan aiming to reach climate-neutrality based on the ACT methodology). The response did not quite provide a direct answer but stressed the importance of meeting the “do no significant harm” (DNSH) criteria. Specifically, the Commission confirmed that “referring to a transition plan aiming to achieve that the whole investment does not significantly harm any environmental and social objectives in the future could for instance not be considered as sufficient”. In other words, if an investment is causing significant harm to the environment and/or society whilst having a climate transition plan in place, then it might be a stretch to be considered an SI. To this end, investments into companies whose climate targets are aligned with SBTi (or equivalent methodology) may not, solely by virtue of being SBTi aligned, have sufficient ground to qualify as sustainable investment.

It does not seem impossible, however, for transition investments to be deemed “sustainable” under SFDR, subject to financial market participants being able to explain how they meet the key requirements of the SFDR’s definition (positive contribution to environmental and/or social objectives, DNSH principle and good governance). With regard to DNSH, the following points need to be considered: SFDR requires that financial products with sustainable investment as their objective must, as part of the DNSH-related disclosures, also consider principal adverse impact indicators (PAIs) as well as minimum social safeguards under the EU Taxonomy Regulation. Furthermore, the minimum requirements for a climate transition benchmark (CTB) include certain mandatory exclusions which mostly (but not wholly!) overlap with the SFDR’s PAIs and EU Taxonomy and which can also be taken into account.

Finally, some questions also remain around what constitutes “good governance”. A single definition doesn’t exit, but there are many resources that can assist in formulating the respective policies. Meanwhile, the practice is evolving with asset managers and institutional investors having started to publish their SFDR disclosures.

The complexity of the EU Sustainable Finance frameworks, as briefly illustrated above, has led some financial market participants to err on the side of caution, concluding that their financial products investing in climate and environmental transition are more suitable to be described and marketed as investment promoting environmental (and social) characteristics (Article 8).

Going forward, it is very unlikely that there will ever be one approach to classifying financial products supporting climate transition as sustainable investment (Article 9) or products promoting environmental and social characteristics (Article 8). As companies continue to enhance their sustainability reporting and disclosure practice, especially on transition planning, we may see a wider spectrum of financial instruments (including fixed income) – in addition to the more commonly seen use-of-proceeds structures – being used to finance the transition. These financial instruments could well be classified as either Article 9 or Article 8. For example, the recently published recommendation by the European Commission on facilitating finance for the transition to a sustainable economy encourages issuers to consider issuing bonds that demonstrate the use of proceeds for transition purposes. The recommendation also notes that sustainability-linked bonds can be used to raise capital for improving the company’s sustainability performance, both at company and activity level. Importantly, the improvements should be linked to sound sustainability performance targets (including, but not limited to, EU Taxonomy performance indicators) and a timeframe that is aligned with the transition. Finally, as the quality and reliability of sustainability reporting and transition planning continues to improve, we should see greater differentiation of conventional debt between companies with differing sustainability profiles.

It is important to remember that laws and regulations are not static. On 27th July, the Commission announced that a public consultation will be launched in September this year on the revision of SFDR – recognising that the rulebook has not been working as intended. The revision process itself will not happen quickly, but the consultation opens up a formal avenue to provide feedback on what has and has not been working with the regulation as well as to consider how it should evolve to best support climate and environmental transition.

This is a positive step, but it clearly indicates that the development of sustainable finance laws and regulations will continue to be a dynamic process and that sustainable finance markets will have to adapt – to some degree – to ongoing legal and regulatory uncertainty. In the meantime, market standards, such as the ICMA Transition Finance Handbook and the CBI Frameworks to Access Transition can provide a helpful reference point to issuers and investors around defining transition finance.