SECTION 4 : ESG REGULATION
What are SFDR ’ s level 2 requirements ?
SFDR ’ s level 1 regulatory technical standard ( RTS ) has been applied since March 2021 and requires financial institutions to report on the ESG-related activity of the sectors and companies they invest in .
The proposed level 2 RTS has been designed to supplement the level 1 text , giving more detail on what asset managers will have to disclose and how it should be presented with a focus on sustainability risks , sustainability factors and technical disclosures . Additionally , asset managers will also be required to report on 18 mandatory principle adverse impact statements ( PAIS ), assessing the sustainable impact of their investments , effective 30 January .
Investors will also have to prove their alignment to one of six environmental objectives via the Taxonomy Regulation . These comprise of climate change mitigation ; climate change adaptation ; the sustainable use and protection of water and marine resources ; the transition to a circular economy ; pollution prevention and control and the protection and restoration of biodiversity and ecosystems .
How will the changes impact ETFs ?
The biggest impact facing ETFs will be the potential downgrade of products that do not meet the more stringent and thorough sustainability criteria demanded by level 2 .
The number of downgrades could be substantial , particularly given the level of fund upgrades over the past year , as a result of asset managers marking their own homework in a bid to capture growing investor demand for Article 8 or 9 ETFs .
For example , in Q2 alone , 700 products switched their SFDR status with the majority upgrading from Article 6 to Article 8 , according to Morningstar . No funds were downgraded from Article 8 or 9 to Article 6 while just 16 were downgraded from Article 9 to Article 8 .
In the ETF space , many have upgraded from Article 8 to 9 , as seen by the JPMorgan Carbon Transition Global Equities UCITS ETF ( JCPT ) after its index became a designated climate transition
“ GIVEN THE ALPHABET SOUP OF THE REGULATORY LANDSCAPE , INVESTORS NEED TO KNOW HOW TO SLICE THROUGH THE UNCERTAINTY AND WHETHER ASSET MANAGERS INTERPRET THE REGULATION AS THEY DO ”
benchmark , investing at least 80 % of its assets in sustainable investments .
Hortense Bioy , global director of sustainability research at Morningstar , said : “ Passives are underrepresented in Article 8 and overrepresented in Article 9 . Overall , passives account for 23 % of all funds in the Article 9 category due to the very sizable number of ETFs that track Parisaligned benchmarks .”
According to Bioy , there is currently a debate as to whether these funds have a place in the Article 9 category at all .
Highlighting the scale of downgrades we could see , Morningstar recently found that 23 % of funds labelled Article 8 do not meet their criteria as an ESG fund .
What do ETF investors need to know ?
Given the alphabet soup of the regulatory landscape , investors need to know how to slice through the uncertainty and whether asset managers interpret the regulation as they and their clients do .
Downgrading an ETF , and upgrading in some cases , could cause issues with the end client who has stated how they would like to be invested from an ESG perspective .
In this regard , it is important to understand how the ETFs they are invested in interpret SFDR and how they are aligned with the taxonomy . “ Currently , not all asset managers are reporting their SFDR considerations ,” Bioy said . “ Roughly 90 % of Article 8 and Article 9 funds report on their SFDR considerations , however , less than half report on the minimum percentage of sustainable investment and just a quarter report on their sustainable taxonomy alignment .”
Part of the problem asset managers are trying to grapple with , according to Gavin Haran , head of policy for asset management at Macfarlanes , is there is currently no minimum level defined for Article 8 funds . For example , asset managers can prove they are aligned with one of the six objectives defined by the taxonomy while disclosing they have 0 % of sustainable investments .
This is likely to be even more important given MiFID II ’ s suitability requirements which must consider their client ’ s sustainable preferences while also considering their other investment objectives .
Bioy said : “ Financial intermediaries will be required to ask their clients what their sustainability preferences are , and if a client says it wants sustainability in its portfolio , the investment manager will have to find a portfolio that has this exposure .”
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