Q&A: The EU’s SFDR sustainability rules

The SFDR rules – which started to come into effect in 2021 – give asset managers like AXA IM a template for reporting how environmental, social and governance (ESG) factors are handled at firm level and product level. That should give clients a simpler way to compare how asset managers are approaching major sustainability issues like climate change.

Under the rules, asset managers are expected to  provide greater transparency on the degree of sustainability of financial products. This includes:

• Consideration of sustainability risks, including the risk of depreciation in the value of underlying assets due to environmental or social events
• Consideration of principal adverse impacts (PAI) on sustainability factors; these are the negative effects on environmental, social and employee matters as well as respect for human rights, anti-corruption and anti-bribery resulting from an investment decision
• Sustainable investments in economic activities that contribute to environmental or social objectives. They include investments in EU-taxonomy-eligible economic activities

Read more about AXA IM’s approach to sustainable investment here.

There are three distinct categories, known by the name of the part of the SFDR regulation that applies in each case:

• Article 6 products are those which only assess and address sustainability risks
• Article 8 products are deemed to be those that promote environmental and social characteristics, taking ESG criteria into account as part of the investment process
• Article 9 products have a sustainable objective and therefore target specific sustainability outcomes – either environmental or social – alongside targets for financial returns. They aim to reduce, as far as possible, any negative effects in respect of environmental, social and employee matters, as well as embedding respect for human rights, anti-corruption and anti-bribery into investment decision making

The regulation introduces precise templates to be used to describe the characteristics of the product on an ex-ante (“pre-contractual disclosures”) and on an ex-post basis (“periodic reporting”), for Article 8 and Article 9 products.

The SFDR has also had to be aligned with the EU Taxonomy, a separate but related piece of regulation that effectively lists the business activities that companies and investors can legitimately claim are 'climate-friendly'. It also introduces the principle of ‘Do No Significant Harm’ that has had to be addressed as part of SFDR requirements.

Although the final regulatory technical standards have been adopted since April 2022, we have found that opinion still differs about what could be considered as a “sustainable investment” under SFDR. However, the advent of SFDR Level II still prompted us to refine our methodology, reclassify some Article 9 products as Article 8.

We have also disclosed the methodology used by AXA IM Core on traditional assets to qualify an issuer as sustainable under SFDR for Article 9 financial products that invest 100% of eligible assets in sustainable investments¹ , and for Article 8 financial products that can invest partially in sustainable investments. Appropriate product documentation aligned with the regulatory standards has also been released or is due to be released shortly.

We continue to support the long-term objective of the EU to enhance transparency in the area of sustainable investing and are actively involved in industry groups aiming to positively influence investors and ultimately to channel flows into sustainable assets to support the transition to a Paris-aligned world.

In our view, data availability and comparability will be the main enablers to build a consistent and transparent ESG framework for investors. More efforts are required on that front and AXA IM will continue to advocate and contribute to this ongoing effort.

We continue to monitor market practices and regulatory/supervisory guidance, and as such our interpretation of SFDR Levels 1 and 2 may evolve over time to reflect regulatory guidance and/or market views.

For products considered to fall under Article 8 or Article 9, there are more detailed requirements, and new appendices being added to the pre-contractual and periodic reporting documentations. Asset managers must publish, as examples:

• How the investment strategy takes into account the ESG characteristics or the sustainable objective, including with regard to planned asset allocation.
• Details of ESG objectives and a breakdown of the different categories of investment.
• Details of how negative impacts are quantified and addressed and how holdings that might cause harm to the sustainability objectives are screened out.
• A list of applicable sustainability indicators.
• Information on how the use of derivatives is consistent with the ESG aims of the product.

Pre-contractual documentation aligned with the regulatory technical standards were released ahead of implementation date of 1 January 2023, and periodic reporting at fund level, published from the beginning of 2023, now includes the SFDR appendix for Article 8 and Article 9 products.

In addition, PAI statements at entity level are to be published by 30 June 2023, which will comprise quantitative and qualitative information pertaining to the asset managers’ strategy to measure and address PAIs.

Again, the new rules set consistent and common templates for all affected firms to follow, including a list of 18 mandatory Principle Adverse Impact indicators. Those indicators are not yet necessarily reported by investee companies, which results in some implementation challenges.

That means that it is now possible to quantify and compare ESG outcomes far more effectively than it was before. The advent of the SFDR rules reflects this encouraging development, but it also reflects the rise of sustainability as a priority at government level. SFDR is part of a wider EU effort to reorient capital allocation towards more sustainable business models. More generally, this comes as part of a global trend which includes commitments such as those entered into as part of the Paris Agreement on climate change.