SFDR Unveiled: New Guidelines End Confusion Over 'Sustainable' and 'Impact' Fund Names
fp Frank Partners
Our vision is to align the interests of business, society and the planet.
23 May 2024
On 14 May 2024, the European Securities and Markets Authority ("ESMA") published the "Final Report - Guidelines on funds’ names using ESG or sustainability-related terms". This recent update on the Sustainable Finance Disclosure Regulation (SFDR) answers a growing demand for transparency and integrity in sustainable investments, while also tackling the issue of greenwashing and ensuring that fund names don’t misrepresent their investment strategies.
The much-needed clarification that ESMA’s report offers is three-fold: firstly, it provides guidelines to investors on the use of specific ESG terms in the naming of funds; second of all, it includes the investment thresholds required for sustainable investment funds; and lastly, it introduces a transition category for investments that are not yet green but are on a positive trajectory towards achieving environmental-sustainability goals.
Previous SFDR directives and technical guidance was insufficiently specific with regard to the naming of funds. As a result, funds were labelled using SFDR Article classifications such as Article 6, Article 8 (or "8+" for those promoting ESG characteristics and allocating a percentage of their investments to sustainable activities) or Article 9, creating distinctions between Light Green (Article 8 and 8+) and Dark Green (Article 9) categories. Despite SFDR primarily serving as a directive for reporting requirements, this practice enabled funds to brand themselves inaccurately as "Sustainable" even if they only endorsed some ESG characteristics on a small portion of their investments, and/or continued to invest in the fossil fuel sector.
According to ESMA’s latest report, funds can now incorporate ESG terms, such as "Environmental", "Impact", and "Sustainability", in their names as long as a minimum of 80% of their investments align with environmental or social characteristics or sustainable objectives. It also establishes exclusion criteria for various terms utilised in fund names.
ESMA's finalised guidelines, following a consultation launched in November 2022, have been refined based on stakeholder feedback. Notably, ESMA has removed the initially proposed 50% threshold for the use of "sustainable" or any sustainability-related term, aiming to balance stringent requirements with practical application, and to address concerns about the clarity of definitions and the ease of implementation.
Key updates:
1. Thresholds for ESG-related terms: Funds incorporating any Environmental, Social, and Governance terms in their names must ensure that at least 80% of their investments align with environmental or social characteristics or sustainable objectives. This is to ensure a sizeable portion of the fund’s assets genuinely reflect its advertised ESG commitments.
2. Introduction of “transition” funds, a new fund category: The guidelines introduce a transition category with terms such as “improving,” “progress,” “evolution,” and “transformation.” This category also mandates an 80% investment threshold, while applying exclusions from the EU’s rules for Climate Transition Benchmarks (CTBs) rather than Paris-Aligned Benchmarks (PABs); this adjustment is designed to enable investment in companies that derive part of their revenues from fossil fuels.
3. Exclusion criteria: The guidelines require the application of exclusion criteria based on different terms used in fund names:
a) For terms like "Environmental", "Impact", and "Sustainability", exclusions are determined by the PABs. These exclusions cover activities related to so-called “controversial” weapons, tobacco production, violations of UN Global Compact principles or OECD Guidelines, and specific revenue sources such as coal, oil, gaseous fuels, and electricity generation with high greenhouse gas (GHG) intensity.
b) For terms like "Transition", "Social", and "Governance", exclusions are based on Climate Transition Benchmarks (CAT). These exclusions include companies involved in controversial weapons, tobacco, or violating UN Global Compact principles or OECD Guidelines.
4. Enhanced reporting requirements: The updates also include more detailed reporting requirements to enhance transparency. Financial entities must now comprehensively disclose how they integrate sustainability risks into their investment processes and how they evaluate the potential impact on financial returns. This reporting is designed to offer greater transparency to investors, enabling them to make more informed decisions.
5. Alignment with EU Taxonomy: The SFDR updates ensure better alignment with the EU Taxonomy Regulation, which provides a framework for determining whether an economic activity is environmentally sustainable. This alignment helps standardise sustainability reporting across different regulatory requirements, making it easier for investors to compare and understand the sustainability performance of different funds.
Main reasons for the updates:
The report will be translated into all EU languages and subsequently made available on ESMA's website, coming into effect three months after this publication. Following this, within a two-month timeframe from their publication in all EU languages, competent authorities subject to these guidelines must inform ESMA of their compliance status: whether they comply, intend to comply, or do not intend to comply. Regarding funds, there will be a transitional period of six months for existing funds after the effective date of the guidelines. However, any new funds created after the effective date are expected to adhere to the guidelines immediately upon their inception.
SFDR in a nutshell
SFDR is a cornerstone of the EU’s sustainable finance agenda, enhancing transparency in financial markets. Its aim is not to compel market participants to consider green criteria when investing. Rather, it establishes rules requiring them to justify the sustainability claims they make about their financial products.
The rules apply to financial market participants managing money on behalf of end investors, such as asset managers, insurance undertakings, occupational and other pension providers, as well as investment firms.
The SFDR obliges these financial actors and advisors to inform investors about how they account for sustainability risks that can impact the value of and return on their investments (“outside-in” effect) and the adverse effects that such investments have on the environment and society (“inside-out” effect). This must be done via their websites, in product pre-contractual documents, and in annual reports.
SFDR complements other frameworks like the EU Taxonomy Regulation and the Corporate Sustainability Reporting Directive (CSRD).
Its main elements are:
a) Article 6: Products not integrating any ESG considerations.
b) Article 8: Products promoting environmental or social characteristics.
c) Article 9: Products with sustainable investment objectives.
How fp Frank Partners can assist:
Frank Partners offers comprehensive support for companies navigating the complexities of SFDR disclosure. With our expertise, we help ensure that your fund names and sustainability claims comply with the latest regulatory standards, thus enhancing credibility and investor trust. Our services include:
a. SFDR Compliance Strategy: Tailored strategies to meet SFDR requirements effectively.
b. SFDR Reporting and Documentation: Assistance with the accurate and transparent reporting of SFDR, ESG and sustainability metrics.
c. Ongoing Support: Continuous guidance to adapt to evolving regulatory landscapes and maintain compliance.
To explore how Frank Partners can improve your SFDR disclosure processes and ensure robust compliance, feel free to contact us for more detailed information and personalised advice
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