Sustainable investment is an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly harm any environmental or social objective and that the investee companies follow good governance practices.
This is regulatory approved definition - see ESA’s Final report of 22 October 2021 on taxonomy-related product disclosure RTS with regard to the content and presentation of disclosures pursuant to Article 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088 (JC 2021 50, p. 36).
When it comes to legal wording it is necessary to refer to Article 2(17) SFDR, which reads:
'Sustainable investment' as 'an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance'.
It is noteworthy, the definition of sustainable investments in Article 2(17) SFDR includes both environmental and social objectives, while the Taxonomy Regulation is only limited to environmental objectives.
Recital 19 of the Taxonomy Regulation explains that the definition of ‘sustainable investment’ in SFDR includes investments in economic activities that contribute to an environmental objective which, amongst others, should include investments into ‘environmentally sustainable economic activities’ within the meaning of the Taxonomy Regulation - see the definition of environmentally sustainable investment in SFDR. Moreover, SFDR only considers an investment to be a sustainable investment if it does not significantly harm any environmental or social objective as set out in the Taxonomy Regulation.
Hence, the definition of “sustainable investment” in SFDR when compared to the definition of “environmentally sustainable investment” in the Taxonomy Regulation can be considered an overarching definition, encompassing the latter.
As underlined by Transition finance report of the Platform on Sustainable Finance of March 2021, both definitions share some similarities, i.e.:
- focus on investment in qualifying economic activities,
- expect that an activity makes a (substantial) contribution to one or more objectives while avoiding significant harm to other objectives (social and governance objectives are not defined in the Taxonomy Regulation, but the minimum safeguards serve this purpose),
but there are also several differences:
- the SFDR definition of “sustainable investment” is a broad set of principles encompassing the widest possible range of sustainability issues, by contrast, the definition of “environmentally sustainable investment” defines six specific environmental objectives (however, financial products with an environmentally sustainable investment objective (Article 9 products) are required to disclose to what environmental objective(s) as defined in the Taxonomy Regulation the product contributes);
- while the Taxonomy Regulation requires a ‘substantial contribution’ to one or more objectives, the SFDR requires a ‘contribution’ only (this means that under the Taxonomy Regulation activities making incremental or small contributions, which may previously have been described as sustainable, do not meet the regulatory definition, activities with limited or neutral environmental footprint may also not meet the definition);
- the SFDR requires the sustainability contribution of an economic activity to be measured and disclosed using key performance indicators (KPIs) but gives flexibility to the discloser to determine the KPIs, while the taxonomy definition provides precise criteria for assessing when an activity can be considered compliant.
Environmentally sustainable investments may be taxonomy-aligned or not.
The European Commission adopted a set of Q&As on 5 April 2023 to clarify that the SFDR deems products passively tracking Climate Transition Benchmarks and Paris-aligned Benchmarks to have ‘sustainable investments’, as defined in the SFDR, as their objective.
European Commission also published Notice of 13 June 2023 on the interpretation and implementation of certain legal provisions of the EU Taxonomy Regulation and links to the Sustainable Finance Disclosure Regulation (2023/C 211/01), where the Commission clarified that investments in ‘environmentally sustainable economic activities' within the meaning of the EU Taxonomy can be qualified as a ‘sustainable investment' within the meaning of the SFDR - see below.
Commission Notice of 13 June 2023 on the interpretation and implementation of certain legal provisions of the EU Taxonomy Regulation and links to the Sustainable Finance Disclosure Regulation, (2023/C 211/01)
Do Taxonomy-aligned investments qualify as ‘sustainable investment’ under the SFDR?
Recital 19 of the Taxonomy Regulation clarifies that ‘sustainable investments’ under the SFDR include investments into ‘environmentally sustainable economic activities’ within the meaning of the Taxonomy Regulation.
In setting out what is required for an activity to be considered as ‘environmentally sustainable’, Article 18(2) makes a link between the Taxonomy Regulation and the SFDR via one of the required steps of the Taxonomy Regulation: the compliance with minimum safeguards. According to the guidance given under question 1 and 2 above, the social elements of the ‘do no significant harm’ principle are considered to be adhered to at entity level for an undertaking that discloses activities as ‘environmentally sustainable’ under the EU Taxonomy.
Furthermore, according to the guidance provided in questions 1 and 2 above, the SFDR do no significant harm principle and the requirement to ensure that an investee company follows good governance practices are deemed to be fulfilled for investments in Taxonomy-aligned economic activities as these comply with the Taxonomy’s minimum safeguards. The four aspects of good governance referred to in point 17 of Article 2 of the SFDR (namely sound management structures, employee relations, remuneration of staff and tax compliance (15)) can be considered to be satisfied by the provisions referred to in Article 18 of Regulation (EU) 2020/852.
Therefore, such investments in Taxonomy-aligned ‘environmentally sustainable’ economic activities can be automatically qualified as ‘sustainable investments’ in the context of the product level disclosure requirements under the SFDR. This means that investments in specific economic activities can be considered to be sustainable investments.
However, if a financial market participant (FMP) invests in an undertaking with some degree of taxonomy-alignment through a funding instrument that does not specify the use of proceeds, such as a general equity or debt, the FMP would still need to check additional elements under the SFDR in order to consider the whole investment in that undertaking as sustainable investment. This means that the FMP would still need to: (i) check whether the rest of the economic activities of the undertaking comply with the environmental elements of the SFDR DNSH principle; and (ii) assess whether she/he considers the contribution to the environmental objective sufficient.
Interactions with MiFID II
Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021 amending Delegated Regulation (EU) 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms include, among other things, a requirement that EU MiFID II portfolio managers and advisers ask their clients about their “sustainability preferences”, and then comply with such preferences when making decisions or providing advice.
After the amendment the term “sustainability preferences” is defined in Article 2(7) of Delegated Regulation (EU) 2017/565 as a client’s or potential client’s choice as to whether and, if so, to what extent, one or more of the following financial instruments shall be integrated into his or her investment:
(a) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in environmentally sustainable investments (as defined in Article 2(1) of the Taxonomy Regulation);
(b) a financial instrument for which the client or potential client determines that a minimum proportion shall be invested in sustainable investments (as defined in Article 2(17) of SFDR);
(c) a financial instrument that considers principal adverse impacts on sustainability factors, where qualitative or quantitative elements demonstrating that consideration are determined by the client or potential client.