In March 2021, financial institutions across Europe started the implementation of the EU's Sustainable Finance Disclosure Regulation (SFDR), taking the first step in a process that has the aim of increasing transparency and shifting capital towards sustainable objectives.
This is a pivotal moment for the financial industry. The SFDR is the EU's regulatory measure to drive investment towards sustainable development.
It supports the European Green Deal, the Paris Climate Agreement, and the EU's goal of being carbon neutral by 2050. SFDR classifies regular funds as Article 6, funds that exhibit some sustainable characteristics as Article 8, and funds that focus specifically on achieving a sustainability goal, and for which sustainability is a binding and mandatory part of the investment process as Article 9.
All Triodos IM's funds were designated as Article 9 products.
Financial institutions met the first of their new compliance obligations in March 2021 by disclosing their investment policies and procedures and describing how sustainability and ESG risks are integrated into the investment decision-making process.
In July 2022, they will have to provide more detailed explanations about their measurement and performance.
Impact, risk, and return
SFDR will undoubtedly increase transparency in the sector and encourage investors to take ESG considerations into account.
As such, it is a huge step forward. Yet, ever since its introduction, it has been criticised for flaws in its design, vague definitions, and concerns about data integrity and reliability.
For instance, SFDR focuses mostly on climate change. And although this is important, a sustainable future requires more than that; the loss of biodiversity is equally pressing, as are rising social inequality and loss of resilience in our economies.
In addition, SFDR takes a risk perspective as its starting point, specifically the risks that could have negative effect on the value of the investment. However, the important distinction with authentic sustainable investors is the intention with which they make their investment decisions, so based on impact-risk-return aspects.
Without considering impact (positive and negative) at the start of the investment process, the old risk-return adage remains. At Triodos IM, we start with positive impact screening, then mitigate possible negative impacts by applying our very strict minimum standards, and then we manage any residual sustainability risks.
This generally means lower risk exposure; no exposure to fossil fuels, for example, means no exposure to possibly sharply rising CO2 prices, or not running the risk of assets becoming stranded.
The risk of greenwashing is also a real concern as it could have an impact on the credibility of the whole industry. There are already many examples of investment products that are designated as Article 8 or Article 9 status but which sometimes still include non-sustainable investments, such as fossil fuels.
It is therefore imperative to have more regulation on the non-sustainable part.
Not only regarding the obligation to classify non-sustainability, but also in terms of expected returns or risks an asset manager can promise to its clients.
In addition, we need forward-looking regulation. Not only based on data reports on what is good or not good, but also making it obligatory that asset managers commit themselves to forward looking ambitions, asking whether portfolios are Paris-aligned, what their path to net-zero looks like and what their goals are concerning circularity and board diversity.
Come July 1, 2022, when all the data, all the sources and all the methodologies being used have been explained and validated, we will be able to see what impact the SFDR has had on the industry.
If the industry only focuses on labelling and categorising existing products, no additional money will flow to sustainable solutions and the much-needed shift of capital will fail to materialise.