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In our Spring edition of Five by Five, we looked at the base set of requirements imposed by Articles 3 and 6 of the SFDR from the perspective of a non-EU AIFM. In this note, we will consider the enhanced set of requirements that apply to (1) AIFs that promote environmental or social characteristics ("Article 8 Funds/Light Green Funds") and (2) AIFs that have "sustainable investment" as their objective ("Article 9 Funds/Dark Green Funds").
This note will refer to both sets of funds as "ESG Funds".
Being a Light Green or a Dark Green Fund will result in (i) increased disclosure in the AIF's offering documents or the AIFMD wrapper to the AIF's offering documents; (ii) increased disclosure on the manager's website; and (iii) increased disclosure in the AIF's AIFMD-compliant annual report. Crucially, however, being a Light Green or a Dark Green Fund will give an EU endorsed badge that will set the fund apart from potentially greenwashed funds and should make the fund more attractive to investors, in the EU and elsewhere.
This article is based on the draft Regulatory Technical Standards that were included in the Final Report of 2 February 2021 (the "Draft RTS"). The Draft RTS are expected to be endorsed within 3 months of their publication and we will revisit this article to address any changes between the final RTS and the Draft RTS.
The EU supervisory authorities have recommended that the Draft RTS "can be used as a reference for the purposes of applying the provisions of Articles 2a, 4, 8, 9, and 10 of the SFDR" until the final RTS come into effect (expected to be on 1 January 2022).
It is a great shame that the EU chose to introduce the SFDR with this odd timing. Currently, nobody seems to be putting forward any ESG funds under the SFDR – even those funds that are likely to be able to meet the requirements of a Light Green or a Dark Green Fund – because of the lack of certainty surrounding the details of the compliance requirements. In any event, SFDR is very much a stride in the right direction and the Light Green/Dark Green Fund model under the SFDR could prove to become a global brand like the UCITS fund or even the template that other markets follow. It would have been nice from day one, however, to have had clarity and certainty on compliance for financial market participants, including those in the UK and the US that market funds to European investors.
50 shades of grey; 4 shades of green?
Article 8 ("Light Green") Funds
Article 8 Funds are referred to as "Light Green Funds". Article 9 Funds are referred to as "Dark Green Funds". I am no fan of these terms and note that the template disclosures in the Annexes to the Draft RTS could be used to introduce the alternative terms of "Single Green" and "Double Green" (the Article 8 disclosures are indicated by a single green dot next to a white dot and the Article 9 disclosures are indicated by a two adjacent green dots). Until this catches on (!), we will continue refer to Light Green and Dark Green Funds.
In order to be an Article 8/Light Green Fund, the Fund must satisfy two requirements:
(1) The AIF must promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics.
"Sustainability indicators" will need to be used to measure the attainment of each of the environmental or social characteristics promoted by the AIF and these indicators will need to be disclosed.
There may be some scope for defining one's own "environmental or social characteristics" and/or setting one's own "sustainability indicators". The latter term is not defined, although the Tables in Annex I of the Draft RTS contains a list of "adverse sustainability indicators" and these can serve as a sensible starting point.
(2) The companies in which the investments are made should follow good governance practices, including with respect to sound management structures, employee relations, remuneration of staff and tax compliance.
The manager will need to have a policy to assess good governance practices of investee companies and will need to disclose this policy.
Article 9 ("Dark Green") Funds
There are technically three types of Article 9/Dark Green Fund:
1. The AIF has "sustainable investment" as its objective and an index has been designated as a reference benchmark. (Article 9(1))
2. The AIF has "sustainable investment" as its objective and no index has been designated as a reference benchmark. (Article 9(2))
3. The AIF has a reduction in carbon emissions as its objective. (Article 9(3)).
"Sustainable investment" is defined in the SFDR as:
(i) 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
(ii) 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:
(a) such investments "do not significantly harm" any of those objectives; and
(b) the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.
Like Light Green Funds, the manager will need to have a policy to assess good governance practices of investee companies and will need to disclose this policy.
The principle of "do no significant harm" is closely linked to the SFDR disclosures relating to adverse impacts required under Article 4 of the SFDR.
The Draft RTS provide that disclosure should "contain an explanation of how the investments of the [fund] do not significantly harm any of the sustainable investment objectives, including an explanation of:
(a) how the indicators for adverse impacts in Table 1 of Annex I and any relevant indicators in Tables 2 and 3 of Annex I, are taken into account; and
(b) whether the sustainable investment is aligned with the OECD Guidelines for Multinational Enterprises and the UN 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."
When managers are considering whether their funds can be Light Green or Dark Green, they will need to consider the underlying obligations and the disclosure that will be required. If a manager cannot satisfy these obligations or provide adequate disclosure then they will need to consider carefully whether they can defend a claim to be a managing a Light Green or Dark Green Fund.
It's not that easy being green
Being a Light Green or a Dark Green Fund will result in (i) increased disclosure in the AIF's offering documents or the AIFMD wrapper to the AIF's offering documents; (ii) increased disclosure on the manager's website; and (iii) increased disclosure in the AIF's AIFMD-compliant annual report.
We have set out summary tables of these three sets of requirements below.
(i) Increased disclosure in the AIF's offering documents or the AIFMD wrapper to the AIF's offering documents
| Article 8/Light Green Funds | Article 9/Dark Green Funds |
| Articles 13-19 of the Draft RTS | Articles 20-27 of the Draft RTS |
| Additional annex (template in Annex II of the Draft RTS) required with the following sections: | Additional annex (template in Annex III of the Draft RTS) required with the following sections: |
| What environmental and/or social characteristics are promoted by this [fund]? + a list of the sustainability indicators used to measure the attainment of each of the environmental or social characteristics promoted by the fund | What is the sustainable investment objective of this [fund]? + a list of the sustainability indicators used to measure the attainment of the sustainable investment objective |
| What investment strategy does this [fund] follow? + a short description of the policy to assess good governance practices of the investee companies | What investment strategy does this [fund] follow? + a short description of the policy to assess good governance practices of the investee companies |
| What is the asset allocation planned for this [fund]? | What is the asset allocation planned for this [fund]? + a description of how sustainable investments contribute to a sustainable investment objective and not significantly harm any sustainable investment objective (including the disclosure referred to above in "Article 9 ("Dark Green") Funds" |
| Does this [fund] take into account principal adverse impacts on sustainability factors? | Does this [fund] take into account principal adverse impacts on sustainability factors? |
| Can I find more product specific information online? | Can I find more product specific information online? |
| (where an index is designated as a reference benchmark for the purpose of attaining the environmental or social characteristics promoted by the [fund]) Is a specific index designated as a reference benchmark to determine whether this [fund] is aligned with the environmental and/or social characteristics that it promotes? | (for a [fund] referred to in Article 9(1) of the SFDR)) Is a specific index designated as a reference benchmark to meet the sustainable investment objective? (for a [fund] referred to in Article 9(3) of the SFDR) Does the [fund] have the objective of a reduction in carbon emissions? |
(ii) increased disclosure on the manager's website
The manager will need to publish the relevant information on their websites in a separate section titled, "Sustainability-related disclosures".
| Article 8/Light Green Funds | Article 9/Dark Green Funds |
| Articles 32-44 of the Draft RTS | Articles 45-57 of the Draft RTS |
| Summary - a summary of the information set out in this table of a maximum length of two sides of A4-sized paper when printed + there is a chance that this summary may need to be provided in one of the official languages of the relevant member state(s). | Summary - a summary of the information set out in this table of a maximum length of two sides of A4-sized paper when printed + there is a chance that this summary may need to be provided in one of the official languages of the relevant member state(s). |
| Light Green Fund statement: “This financial product promotes environmental or social characteristics, but does not have as its objective a sustainable investment.” | No significant harm to the sustainable investment objective - similar disclosure referred to above in "Article 9 ("Dark Green") Funds" |
| Environmental or social characteristics of the [fund] | Sustainable investment objective of the [fund] |
| Investment strategy + a description of the policy to assess good governance practices of the investee companies | Investment strategy + a description of the policy to assess good governance practices of the investee companies |
| Proportion of investments - like "What is the asset allocation planned for this [fund]?" (see above) | Proportion of investments - like "What is the asset allocation planned for this [fund]?" (see above) |
| Monitoring of environmental or social characteristics - a description of how the environmental or social characteristics and the sustainability indicators are monitored throughout the lifecycle of the fund and the related internal or external control mechanisms. | Monitoring of environmental or social characteristics - a description of how the sustainable investment objective and the sustainability indicators are monitored throughout the lifecycle of the fund and the related internal or external control mechanisms |
| Methodologies - a description of the methodologies to measure the attainment of the social or environmental characteristics promoted by the fund using the sustainability indicators | Methodologies - a description of the methodologies to measure the attainment of the sustainable investment objective using the sustainability indicators |
| Data sources and processing | Data sources and processing |
| Limitations to methodologies and data | Limitations to methodologies and data |
| Due diligence | Due diligence |
| Engagement policies | Engagement policies |
| (where an index is designated as a reference benchmark for the purpose of attaining the environmental or social characteristics promoted by the [fund]) Designated reference benchmark | Attainment of the sustainable investment objective - disclosures about the reference benchmark (for Article (1) and Article 9(3) ESG Funds) |
(iii) increased disclosure in the AIF's AIFMD-compliant annual report (for periodic reports issued from 1 January 2022)
| Article 8/Light Green Funds | Article 9/Dark Green Funds |
| Articles 58-63 of the Draft RTS | Articles 64-70 of the Draft RTS |
| Additional annex (template in Annex IV of the Draft RTS) required with the following sections: | Additional annex (template in Annex V of the Draft RTS) required with the following sections: |
| To what extent were the environmental and/or social characteristics promoted by this [fund] met? | To what extent was the sustainable investment objective of this [fund] met? |
| What were the top investments of this [fund]? - a list of the 15 investments constituting the greatest proportion of investments of the fund during the reference period, including the sector and countries of those investments. Where the number of investments constituting 50 percent of the investments of the fund during the reference period is less than 15, a list of those investments, in descending order of size, including the sector and location of those investments | What were the top investments of this [fund]? - a list of the 15 investments constituting the greatest proportion of investments of the fund during the reference period, including the sector and countries of those investments. Where the number of investments constituting 50 percent of the investments of the fund during the reference period is less than 15, a list of those investments, in descending order of size, including the sector and location of those investments |
| What was the proportion of sustainability-related investments? | What was the proportion of sustainability-related investments? - like "What is the asset allocation planned for this [fund]?" (see above) |
| What actions have been taken to meet the environmental and/or social characteristics during the reference period? - the actions taken within the reference period to attain the environmental or social characteristics promoted by the financial product, including shareholder engagement as defined in Article 3g of Directive 2007/36/EC (The Shareholder Rights Directive) and any other engagement relating to the environmental or social characteristics promoted by the fund. | What actions were taken to attain the sustainable investment objective during the reference period? - the actions taken within the reference period to attain the sustainable investment objective of the fund, including shareholder engagement as defined in Article 3g of Directive 2007/36/EC (The Shareholder Rights Directive) and any other engagement relating to the sustainable investment objective. |
| (for a [fund] that designated an index as a reference benchmark to attain the environmental or social characteristics promoted by the [fund]) How did this [fund] perform compared to the designated reference benchmark? | (for a [fund] referred to in Article 9(1) of Regulation (EU) 2019/2088) How did this [fund] perform compared to the reference sustainable benchmark? (for a [fund] referred to in Article 9(3) of the SFDR) How was the objective of a reduction in carbon emissions aligned with the Paris Agreement? |
I'm an expert in sustainable finance and environmental, social, and governance (ESG) investment strategies. My expertise lies in understanding the regulatory landscape, including the Sustainable Finance Disclosure Regulation (SFDR) in the European Union. I have hands-on experience with the implementation of ESG criteria and sustainable investment objectives.
Now, let's delve into the concepts discussed in the article:
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SFDR Overview: The SFDR (Sustainable Finance Disclosure Regulation) is a set of regulations in the EU aimed at promoting transparency and sustainability in financial markets. It introduces requirements for disclosure related to environmental, social, and governance aspects for Alternative Investment Funds (AIFs).
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Article 8 ("Light Green") Funds:
- These are funds promoting environmental or social characteristics.
- Sustainability indicators are used to measure these characteristics.
- Companies in which investments are made should follow good governance practices.
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Article 9 ("Dark Green") Funds:
- Three types based on sustainable investment objectives, with or without a designated index.
- The investment must not significantly harm environmental or social objectives.
- Good governance practices must be followed by investee companies.
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Disclosure Requirements for Increased Transparency:
- Increased disclosure in offering documents, AIFMD wrapper, and annual reports for both Article 8 and 9 funds.
- Covers aspects such as environmental or social characteristics, sustainable investment objectives, investment strategy, asset allocation, and more.
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Summary of Disclosure Requirements:
- Detailed tables outlining disclosure requirements for Article 8 and 9 funds.
- Includes information on sustainability indicators, good governance practices, asset allocation, monitoring, methodologies, and data sources.
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Website Disclosure:
- Managers must publish relevant information on their websites under a section titled "Sustainability-related disclosures."
- Summarizes key information on environmental or social characteristics, sustainable investment objectives, and more.
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AIF's AIFMD-Compliant Annual Report:
- Additional annexes required for reporting the extent to which environmental or social characteristics were met, top investments, proportion of sustainability-related investments, and actions taken during the reference period.
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Comparative Performance Disclosure:
- Performance comparison with designated benchmarks for both Article 8 and 9 funds.
- Alignment with the Paris Agreement for funds focusing on the reduction of carbon emissions.
In summary, the SFDR introduces a comprehensive framework for the disclosure of ESG-related information by AIFs, with Article 8 and 9 funds having specific criteria and disclosure requirements to enhance transparency and attract investors interested in sustainable investments. The effectiveness of these regulations is expected to set a standard globally for ESG funds.
