The term 'green finance' is often used interchangeably with the 'sustainable finance' and

define neither of them - which causes confusion (the said regulations provide, however, definitions of how a type of activity can be assessed to be sustainable). Good example is Recital 5 of the Taxonomy Regulation.

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Taxonomy Regulation, Recital 5 

In December 2016, the Commission mandated a High-Level Expert Group to develop an overarching and comprehensive Union strategy on sustainable finance. The report of the High-Level Expert Group published on 31 January 2018 calls for the creation of a technically robust classification system at Union level to establish clarity on which activities qualify as ‘green’ or ‘sustainable’, starting with climate change mitigation.

 

It is also true that the term ‘green finance’ is used in a variety of financial frameworks across the world (like green banks, green bonds, green loans, green mortgages etc.) - which led to ‘greenwashing’ concerns. The proposal for an EU Green Bond Standard (GBS) was intended as the answer to this threat.

 

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If financial product is marketed and/or sold to investors as ‘environmentally sustainable’, then the extent to which it is green (the ‘greenness’) must be disclosed to investors by reference to the taxonomy.

 

It is argued that terms “green” and “sustainable” have different meanings in different frameworks and may not always describe the same finance:

  • green finance is generally understood to be targeting the positive agenda towards climate and the environment and the term is used in the markets for products, instruments and finance purporting to be focussed on, and/or dedicated to, environmental objectives;
  • sustainable finance often has a wider meaning and inference than green, not only because it can cover social as well as economic and financial sustainability and governance, but because it can also mean identifying finance for both the positive agenda and that which is undermining environmental objectives (Transition finance report of March 2021, Platform on Sustainable Finance, p. 29). 

 

Light green - less ambitious 


Investors also differentiate between so-called:

The former are products that promote environmental characteristics (Article 6 of the Taxonomy Regulation and Article 8(4) SFDR) while the latter are the ones that invest in an "economic activity that contributes to an environmental objective" (Article 5 of the Taxonomy Regulation and Article 9(6) SFDR), respectively: Article 8 and Article 9 Funds.

This "green" terminology dominated regulatory debate and sustainable products classifications. Natasha Cazenave, ESMA Executive Director, at the ICI Investment Management Conference on 24 March 2022 (Key priorities for the asset management industry in 2022: sustainable finance and systemic risk, ESMA34-466-282) said:

“One important development we need to recognise is that although SFDR was primarily a transparency regulation, both fund managers and investors are increasingly treating the disclosures categories as product classification. More and more investment funds market themselves as either Article 8 or Article 9 SFDR - meaning products promoting environmental or social characteristics and products with sustainable investment as their objective. Out of a sample of 27,000 EU funds representing EUR 10 trillion assets under management, 30% included in their precontractual documentation an SFDR Article 8 or Article 9 statement. As a consequence, Article 8 products, which are also called “light-green” products in SFDR, have been called out for less ambitious environmental or social characteristics”. 

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FAQs, Commission Technical Expert Group on Sustainable Finance

The taxonomy is first and foremost a tool for investors.
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Regulation introduces disclosure requirements, rather than telling investors in what to invest. There is no obligation to invest only into taxonomy-compliant economic activities. However, if a financial product is marketed and/or sold to investors as ‘environmentally sustainable’, then the extent to which it is green (the ‘greenness’) must be disclosed to investors by reference to the taxonomy. This allows for many different investment strategies to co-exist, while avoiding a straightjacket approach.

 

The above categories of green products are subject to different sets of disclosure rules on the pre-contractual information.

Financial products disclosing under Articles 8 or 9 that make sustainable investments are required to disclose several elements which relate to the sustainability aspect of their investments and explain the basis for assessing their investments as sustainable. These disclosures include, amongst others, the below elements:

  • a description of how the sustainable investments contribute to a sustainable investment objective;
  • explanations on how the SFDR DNSH principle is complied with by showing how the PAI indicators have been taken into account;
  • how the sustainable investments are aligned with the OECD Guidelines for Multinational Enterprises and the Guiding Principles on Business and Human Rights, including the principles and rights set out in the eight fundamental conventions identified in the Declaration of the International Labour Organisation on Fundamental Principles and Rights at Work and the International Bill of Human Rights; and
  • the policy to assess good governance practices of investee companies.

Moreover, financial products disclosing under Article 8 SFDR that promote environmental characteristics and financial products disclosing under Article 9 SFDR that invest in sustainable investments contributing to environmental objectives are required to provide disclosures on those sustainable investments which are taxonomy-aligned, according to Articles 5 and 6 of Taxonomy Regulation.

Explanatory Memorandum to Commission Delegated Regulation supplementing Regulation (EU) 2019/2088 of 6 April 2022 of the European Parliament and of the Council with regard to regulatory technical standards specifying the details of the content and presentation of the information in relation to the principle of ‘do no significant harm’, specifying the content, methodologies and presentation of information in relation to sustainability indicators and adverse sustainability impacts, and the content and presentation of the information in relation to the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports adopted by the European Commission reads:

“Financial products that claim to pursue the objective of ‘sustainable investments’, with no significant harm, as defined in Article 2, point (17), of the Sustainable Finance Disclosures Regulation must be accompanied by the disclosures provided for in Article 9 of that Regulation. Financial products that promote ‘environmental or social characteristics’ – but not necessarily make in part ‘sustainable investments’ with no significant harm – must be accompanied by the disclosures provided for in Article 8 of the Sustainable Finance Disclosures Regulation”. 

 

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Financial products that have sustainable investment as an objective should only make sustainable investments.

SFDR Q&A, European Commission, July 2021

 

Disclosures for green direct and indirect investments in pre-contractual and periodic disclosures have been also explained in ESAs Clarifications of 2 June 2022 on the ESAs’ draft RTS under SFDR (JC 2022 23). According to this document, where a financial product promotes environmental or social characteristics or commits to a sustainable investment objective, the relevant pre-contractual and periodic disclosures should be provided for that financial product. The pre-contractual and periodic disclosures could outline what share of the investments of the financial product is held directly and what share is held indirectly. The proportion of the investments used to attain the environmental and social characteristics promoted by the financial product (in the case of a financial product which promotes environmental or social characteristics) or the proportion of the investments used to attain the sustainable investment objective (in the case of a financial product with a sustainable investment objective) should be disclosed in addition to what the purpose of the remaining proportion of investments is. For the sake of clarity, with regard to this remaining proportion of investments of the financial product, which are investments that do not qualify as sustainable or as contributing to the environmental or social characteristics promoted by the financial product, environmental or social safeguards could be considered. Such safeguards should be described so that end investors receive accurate information on the entirety of the investments made by the financial product. For the avoidance of doubt, as stated by the European Commission in its SFDR Q&A from July 2021, financial products that have sustainable investment as an objective should only make sustainable investments. However, disclosures are still required on the amount and purpose of any remaining assets to demonstrate how those do not prevent the financial product from attaining its sustainable investment objective.

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Sustainable investment

The European Commission and the European Supervisory Authorities provided additional clarifications on the definition of sustainable investment in a series of published Q&As (Consolidated questions and answers on the SFDR and the CDR 2022/1288, Ref.: JC 2023 18, 17 May 2023).

In particular, the Commission explained that the notion of sustainable investment can be measured at the level of a company and not only at the level of a specific activity (Q&A II.1).

The Commission explained that Articles 8 and 9 SFDR are neutral in terms of product design (Q&A V.1).

Furthermore, the Commission clarified (Q&A II.2) that the SFDR does not set out minimum requirements that qualify concepts such as contribution, DNSH, or good governance, i.e. the key parameters of a ‘sustainable investment’. Financial market participants (‘FMPs’) must carry out their own assessment for each investment and disclose their underlying assumptions.

The European Supervisory Authorities, furthermore, explained (Consolidated questions and answers on the SFDR and the CDR 2022/1288, Q&A V.16) that, in line with the Commission’s interpretation about discretion within sustainable investments in SFDR, it is possible for FMPs to define their own contribution criteria for socially sustainable investments and create their own framework for their sustainable investments under SFDR as long as they adhere to the minimum criteria of Article 2(17) SFDR, i.e. contribution, DNSH and good governance. 

FMPs should not, however, interpret Article 2(17) SFDR differently for different financial products that they make available and apply different interpretations of “sustainable investments” to different financial products that they offer.

 

Market data regarding Article 8 and Article 9 funds

 

 

Platform on Sustainable Finance Report of 29 January 2024 on a compendium of market practices refers to a Morningstar study published in October 2023, which mentions funds disclosing under Articles 8 and 9 of the SFDR account for 56% of total EU fund assets. The vast  majority of these funds (53% of total assets) are classified under Article 8 (promoting  environmental or social characteristics), despite significant outflows since 2022. Article  9 funds (with a sustainable investment objective), although smaller in size (accounting  for 3.4% of total fund assets) continue to attract new capital from end investors.  

The said Platform on Sustainable Finance Report of 29 January 2024 observes that most Article 8 funds consider at least seven mandatory PAI indicators, and most Article 9 funds  consider at least 11. Those PAIs tend  to be more focused on ‘involvement-type’ PAIs, which show a company’s exposure to  a given economic activity. For example, 80% of funds considered exposure of companies to the fossil fuel sector and 93% considered exposure to controversial weapons. How exactly these indicators are considered in the investment process is less clear, and  substantial variation in practice is likely, given that the SFDR does not prescribe how this  should be done.

Moreover, Article 8 products are increasingly setting carbon reduction objectives. While in October 2022 only 1% of Article 8 products had done so, by  September 2023 this had increased to 10%.

Assets invested against the Paris-aligned benchmark and climate transition benchmark represent US$120bn in assets, the majority of which are securities issued by European and global large cap corporates.

Most of those assets invested against EU  climate benchmarks (79%) are still classified under Article 8, in spite of the Commission’s clarification in April 2023 that financial products that passively replicate climate  transition and Paris benchmarks can be considered sustainable investments and  therefore be classified under Article 9. 

In 2023 only 28% of Article 9 funds reported a target  of EU Taxonomy-alignment above 0% and less than 10% of Article 8 funds committed to invest a portion of their assets into EU Taxonomy-aligned assets.

 

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