SFDR: Will it mobilize more capital towards significant impact?

SFDR: Will it mobilize more capital towards significant impact?

By Lara Viada, Partner at Creas, originally published by FundsPeople

European regulation in the sustainability field is an important step towards standardization and, therefore, towards the growth of investments that seek to drive impact solutions. However, it is not demanding and clear in defining what sustainable investments aim to achieve, while being excessively rigorous in reporting requirements to demonstrate that they do not generate significant harm.

In 2019, the European Union published the first draft of the Sustainable Finance Disclosure Regulation (Regulation 2019/2088 or SFDR). This regulation accompanies many others that have been promoted since then, such as the Non-Financial Reporting Directive (NFDR), the environmental taxonomy, or the recent amendment of the MiFID II regulation regarding sustainability.

They all share two essential objectives: to mobilize more capital towards sectors and activities that reduce environmental footprint and to bring more clarity to the growing field of sustainable investment, combating greenwashing. Today, almost three years after the publication of the Regulation, we believe that the regulation is having positive effects, although there is still a long way to go.

According to the regulation, new funds created after March 2021 must self-classify according to their sustainability objectives: those that do not take sustainability into account are Article 6; those that consider it as part of their investment process are Article 8; and strategies that include sustainable investments as part of their investment process are Article 9.

Each of these classifications has different information and reporting requirements, with the most relevant being for Article 8 and 9 funds, which must demonstrate that they do not cause significant harm and comply with minimum social safeguards. Additionally, Article 9 vehicles must prove that they contribute to generating solutions.

The EU initiative promoting regulation to encourage transparency and capital mobilization was welcomed by Creas, and the impact sector in general, as an important step towards standardization and, therefore, the growth of investments that seek to drive impact solutions.

Good initiative, but...

However, from the perspective of an impact investor, the regulation is not demanding and clear in defining what sustainable investments aim to achieve, while being excessively rigorous in reporting requirements to demonstrate that investments do not cause significant harm.

Regarding the definition of sustainable investments, the regulation provides for three types: investments with an environmental objective aligned with the taxonomy; investments with an environmental objective not aligned with the taxonomy; or investments with a social objective.

The lack of rigor in defining what substantial positive impact means is a risk for funds that seek to support companies that generate profound and scalable impact.

Most of the SMEs in our country are neither obliged nor have the means to calculate their carbon footprint.

The first type refers to investments made in sectors that have already been mapped and, in addition, meet the technical selection criteria defined to consider an activity as substantially contributing to one of the European Union's six objectives (mitigating and adapting to climate change, sustainable use of resources, transition to a circular economy, pollution prevention, and biodiversity recovery).

This first point is clear and detailed. However, as not all environmental objectives have been mapped yet, nor has a social taxonomy been created (and perhaps not all scenarios can be mapped), the regulation allows for the other two additional types of investments mentioned, of which surprisingly, there is almost no detail.

There is very little description of how the contribution to solutions of non-aligned investments will be analyzed. There is no clear definition of what kind of impact measurement methodology should be used or categorization of how it is defined that a company truly contributes to solutions.

This is particularly surprising considering that there are already international projects that describe this in detail and provide valuable frameworks, such as the Impact Management Project. This lack of rigor in defining what substantial positive impact means is a risk for impact funds that seek to support truly transformative companies with profound and scalable impact.

Regarding the definition of not causing significant harm, the regulation is much more detailed. It proposes very specific indicators that every investor (and therefore every invested company) must report. These are known as Principal Adverse Impacts (PAIs) and consist of 14 mandatory indicators (and up to 33 additional voluntary ones). PAIs include indicators such as Scope 1, 2 (and in the future, 3) greenhouse gas emissions or carbon footprint.

SMEs are at a disadvantage

It would be ideal if all companies could measure these data and have plans to reduce their environmental footprint year after year. However, the reality is that calculating these indicators is even more complex and requires the support of expert consultants or technology to obtain the data. There is no doubt that funds or companies with more financial, human, and technological resources and more experience (NFDR regulations) have a clear advantage over small managers and funds, especially those focused on small SMEs and startups.

Most SMEs in our country are neither obliged by regulation nor have the human and financial resources to calculate their carbon footprint. As Article 8 or 9 fund managers, imposing reporting requirements for many of these indicators would impose excessive bureaucratic burdens on these companies, especially those pursuing social impact and where environmental harm is not material. Although the regulation provides for proportionality in the application of the rules, it is not yet clear how materiality will be understood and what private equity investors, such as Creas, who invest in smaller companies, will have to report.

After the implementation of the regulation in 2021 and 2022, we saw many funds classified as Article 8 and 9, accounting for almost 50% of Spanish products. However, in recent months, we have seen that some investors face numerous challenges in meeting regulatory standards. Proof of this is that some strategies that were initially categorized as Article 9 funds have recently chosen to reclassify themselves as Article 8, as was the case with asset managers such as Amundi, DWS, or MSIM.

It remains to be seen whether the regulation will truly succeed in mobilizing more capital towards companies that are innovating and making the profound transformations we need to curb the climate change curve and reduce growing social inequality. Hopefully, in a few years, we will see the fruits of these efforts.