Generally, the EC’s responses are flexible and not overly prescriptive, and are reflective of the original intention behind SFDR as a disclosure regime. The fact that the ESAs had raised these queries, which reflected industry concerns around certain key concepts, had generated considerable uncertainty, and so the publication of these responses is welcome.


Definition of “Sustainable Investment”

Under SFDR, a ‘sustainable investment’ is defined as an investment in an economic activity that contributes to an environmental objective or a social objective, provided that such investment does not significantly harm any of those objectives and that the investee company follows good governance practices.

In its response to initial queries raised by the ESAs on the implementation of SFDR, the EC confirmed in July 2021 that an Article 9 fund, which is a fund that has sustainable investment as its objective, must only invest in sustainable investments, except for ancillary investments held for specific purposes such as hedging or liquidity. In response, the ESAs issued a number of follow-up queries to the EC in September 2022, requesting further clarity on how the definition of ‘sustainable investment’ should be applied in a number of scenarios.

The EC has now clarified that SFDR does not prescribe any specific approach to determine the contribution of an investment to an environmental or social objective. SFDR requires financial market participants (“FMPs”) to disclose the methodology they have applied, including how they have determined the contribution of their investments to environmental or social objectives, how investments do not cause significant harm to any environmental or social investment objective and how investee companies meet the good governance practices requirement. Since Article 9 is neutral in terms of product design, the product documentation must include information on how the investments comply with the sustainable investment objective of the financial product, in order to comply with the principle of ‘do no significant harm’.

The EC noted that SFDR does not set out minimum requirements that determine concepts such as ‘contribution’, ‘do no significant harm’, or ‘good governance’. Instead, FMPs must carry out their own assessment for each investment and disclose their underlying assumptions about how they meet the sustainable investment criteria. Investments that are ‘sustainable investments’ must not significantly harm any of the objectives. Therefore, referring to a transition plan aiming to achieve that a whole investment does not significantly harm any environmental and social objectives in the future would not, of itself, be sufficient.

In addition, the EC clarified that reference to ‘economic activities’ in SFDR may refer to investment in a specific project or activity, or to a company engaged in one single type of activity. FMPs can also invest in funding instruments that do not specify the use of proceeds and the EC has confirmed that the notion of sustainable investment can therefore also be measured at the level of an investee company and not only at the level of a specific economic activity.

The EC also amended its initial July 2021 response to the ESAs’ questions to explain that an Article 9 product may invest in a wide range of underlying assets, provided these underlying assets qualify as sustainable investments, and that SFDR does not prescribe a single methodology to account for sustainable investments.

These responses and clarifications should go some way towards reducing the uncertainty that had prevailed in relation to the definition of a ‘sustainable investment’, which is central to the categorisation of  Article 9 funds and Article 8 funds that make sustainable investments.  The responses do, however, emphasise that the onus is on FMPs to ensure that there is clear disclosure in pre-contractual and other documents on the sustainable investment objectives of a fund, concepts such as ‘do no significant harm’ and related assumptions.


Products Tracking a Paris-aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB)

The ESAs had queried whether products that have an Article 9(3) objective of reduction in carbon emissions can have either a passive or an active investment strategy, and whether products with an active investment strategy were required to meet any specific requirements when designating an index as a reference benchmark.

The EC has responded to reiterate that SFDR is a transparency regulation, it does not prescribe the use of PABs or CTBs, nor the use of any other specific type of index.

The EC has stated that financial products under Article 9(3) can use a passive or active investment strategy.  Where a product does not passively track a PAB/CTB, SFDR requires a detailed explanation of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement. Financial products that passively track a PAB or CTB are not required to include this detailed explanation, as these products are deemed to have sustainable investment as their objective and to make sustainable investments.

Again, this clarification is welcome, as there had been much uncertainty over the ability of PAB/CTB index-tracking funds to be categorised as Article 9 funds. This may, in turn, result in some PAB/CTB index-tracking funds reclassifying as Article 9 funds.


Article 8 Products and the Promotion of Carbon Reduction

Article 8 does not limit the types of characteristics that can be promoted by financial products, and the EC has clarified that an Article 8 fund may promote carbon emissions reductions as part of its investment strategy, provided it does not have sustainable investment as its objective. This must be clearly disclosed to investors and FMPs must ensure that marketing materials do not mislead investors into thinking that the product has a sustainable investment objective in circumstances where the promotion of carbon emissions reductions is only one characteristic of the product’s investment strategy.


Consideration of PAI at Product Level

The ESAs had requested clarification of the meaning of ‘consider’ in the context of product-level PAI disclosures. Where FMPs consider PAI at product level, they are required to disclose ‘whether, and, if so, how a financial product considers principal adverse impacts on sustainability factors’.  The EC has advised that the disclosure related to the consideration of PAI at product level should include both a description of the adverse impacts and the procedures put in place to mitigate those impacts.


Other Clarifications

Since SFDR does not define ‘employee’, the EC has clarified that it must therefore be determined by reference to the definition set out in applicable national law when determining the number of employees for the purposes of the 500 employee entity-level PAI threshold.

The EC has also confirmed that only one annual report is required in relation to SFDR disclosures for individual portfolio management services, i.e. this requirement should be addressed annually, in every fourth quarterly report.

The EC has also made some clarificatory updates to its May 2022 response to queries regarding the application of Article 5 and 6 of the Taxonomy Regulation.


If you would like to discuss the foregoing in the more detail, or require assistance assessing your disclosure requirements, please contact your usual Arthur Cox contact, or any member of our team.