Arjun's Head of ESG, Rhyadd Keaney-Watkins, shares his thoughts on how the FCA's proposal (CP22/20) on Sustainability Disclosure Requirements and investment labels adds important granularity over the EU's SFDR* and opportunities for infrastructure investment
(*but we still need urgent consolidation and alignment of labelling)
EU SFDR
The EU's Sustainable Finance Disclosure Regulation (SFDR) came into force on 10 March 2021 and sets out pre-contractual, periodic and website disclosure requirements, depending on the 'type of sustainability product'. These 'product categories' are:
Article 6 - funds that do not integrate sustainability into the investment process.
Article 8 ("light green") - funds that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics.
Article 9 ("dark green") - funds that have sustainable investment as their objective.
Despite (as the name confirms) SFDR being aimed at disclosure requirements, it has quickly become a de facto product labelling regime and is sometimes used as a product specification.
With investors rightly seeking to align capital with the most sustainability ambitious strategies, the demand for Article 9 products has been increasing. The most recent (Q3 2022) Morningstar SFDR Article 8 and Article 9 Funds Review reports that although Article 8 products registered net outflows, Article 9 products remained resilient and registered EUR 12.6 billion in net inflows. This is more than double the net inflows registered by Article 9 products in Q2 2022, despite the challenges of inflation, interest rates, threat of recession, and the geopolitical risks of the Ukraine war.
What exactly is an Article 9 product?
These are products which hold 100% 'sustainable investments' (other than investments such as cash or derivatives necessary for liquidity and hedging purposes).
But what is a 'sustainable investment'?
Article 2(17) of SFDR provides a definition of 'sustainable investment'. For ease of reading (and to avoid falling down a very deep rabbit hole), a 'sustainable investment' could be an investment which:
has an environmental objective which is taxonomy-aligned; or
has an environmental objective which is not eligible under the EU Taxonomy (the Taxonomy is not an exhaustive list, and rather, focuses on the most highly emitting economic activities. This has resulted in many economic activities which are not listed, but still offer positive environmental outcomes); or
has a social objective (for which there is no Taxonomy).
Why does this matter?
According to Morningstar, during Q3 2022, over 380 products changed SFDR status, of which 41 were downgraded to Article 8 from 9. As market scrutiny and understanding of greenwashing improves, it is possible that further downgrades are coming.
In light of this risk, it could be viewed that the safest investments to make under Article 9 products are those which can be easily and robustly demonstrated as 'taxonomy-aligned'. Simply put, these are assets which are 'environmentally sustainable today'.
However, where does this leave products with a social objective (requiring market participants to interpret guidance and develop their own rationale and justification)?
And what about the critical role of private capital in transitioning assets from non-aligned, to taxonomy-aligned? These assets will remain critical to society and require capital investment. In fact, with the right execution and asset management approach, these assets can present value-creation opportunities. This is where the "heavy-lifting" occurs and it is in this transition from "brown" to "green" that significant impact can be delivered.
Article 9 strategies may not inherently deliver this impact. While there are examples of Article 9 strategies delivering 'additionality', an Article 9 strategy pursuing developed renewable assets may simply be recycling equity into existing capacity and not actually adding any new 'green electrons' to the grid.
How the Financial Conduct Authority proposals may improve this
The FCA's proposal (CP22/20), Sustainability Disclosure Requirements (SDR) and investment labels, effectively split Article 8 and 9 products into three:
Sustainable Focus, which has at least 70% of assets "invested in assets that are sustainable for people and/or planet". This could be demonstrated through the use of a forthcoming UK Green Taxonomy, but may not be as prescriptive;
Sustainable Improvers, which "invests in assets that may not be sustainable now, with an aim to improve their sustainability for people and/or planet over time" (a 'transition' label was originally proposed, but swapped for 'improvers' ); and
Sustainable Impact, which "invests in solutions to problems affecting people or the planet to achieve real-world impact".
Although there will be infrastructure opportunities within Sustainable Focus and Sustainable Impact; of these three labels, Sustainable Improvers may be of particular importance for infrastructure. This label would be reserved for products "with an objective to deliver measurable improvements in the sustainability profile of assets over time. These products are invested in assets that, while not currently environmentally or socially sustainable, are selected for their potential to become more environmentally and/or socially sustainable over time, including in response to the stewardship influence of the firm".
Infrastructure assets are long-lived assets (25+ years), capital intensive with long capex cycles. Transitioning these assets requires expertise, planning and commitment.
For managers such as Arjun Infrastructure Partners, our investors are looking for sustainable investment opportunities, which deliver positive outcomes over the long-term. Our institutional investors have relatively long-term investment horizons which - when coupled with active asset management - can provide the confidence and capital planning needed to transition assets.
Final thoughts: horses for courses (but all horses are equal)
There are many investors looking for sustainable investment opportunities. But, this can mean different things for different investors, and the appropriateness of investment opportunities may differ from one investor to another.
For strategies which are highly-selective and pursuing assets which are objectively-viewed as sustainable, 'sustainable focus' investments may be more appropriate, where the goal is to "maintain a high standard of sustainability".
For active asset management strategies, with long-term holding periods and a focus on core(+) risk profile assets, there may be a broad range of assets opportunities within 'sustainable improver' products.
For investors seeking highly-selective and actively-engaged investment opportunities, 'sustainable impact' investments - which "invests in assets that provide solutions to environmental or social problems, often in underserved markets or to address observed market failures" - may provide suitable opportunities. It is also expected that this label will include thematic infrastructure opportunities, such as strategies focussing on the transition to net zero.
While this presents a potential step-improvement over the current EU SFDR, this will introduce potential ‘alignment challenges’ across both regimes. This may be particularly problematic as UK and EU regulations are extra-territorial in their application. That may mean that an EU-domiciled product must comply with EU SFDR, but when marketed to UK-domiciled investors, must also meet the FCA proposals. The need for alignment and consolidation of approaches, across sustainable investment practices generally, is urgently needed.
The finalisation of the FCA proposals, and the interpretation of the investment labels by the market, remains to be seen. The consultation closes on 25 January 2023, with final rules due to be published in H1 2023, and come into force no earlier than 30 June 2024. The consultation papers state "there is no hierarchy between the proposed categories", and I would consider it a missed opportunity if the market were to later 'rank' labels in terms of 'greenness' or 'sustainability'.
Each of these three labels should be viewed equally, with each playing an important role in directing capital towards sustainable investments. Whether that is providing continued support to sustainable assets, helping transition assets from brown to green, or seeking opportunities to deliver solutions to the sustainability challenges ahead.