SFDR, Taxonomy and the challenges for ETFs

This article was first published in the EFT Insider, February 2022.

The structural trend towards environmental, social and governance (ESG) focused investing has been underway in Europe for some years now. European ESG funds have multiplied year-on-year inflows over the past five years. ETFs have increasingly adapted to this trend and have contributed to some of the most successful ESG fund launches over the past number of years. In parallel to this investor led trend, the EU has adopted measures as part of its EU Action Plan on Sustainable Finance designed to make sustainability considerations an integral part of financial policy to support the European Green Deal and channel private investment towards the transition to a climate neutral economy. Two key measures adopted by the EU which ETF issuers and their managers will have been grappling with over the past two years are the Sustainable Finance Disclosure Regulations (SFDR) and the Taxonomy Regulation (Taxonomy). 

The SFDR is intended to provide harmonised rules on transparency in relation to the provision of sustainability related information for financial products, which include UCITS and therefore European ETFs. The SFDR also introduced additional disclosure requirements which apply to certain types of funds with a specific ESG focus. These are the so called "light green" Article 8 funds that promote environmental or social characteristics and so called "dark green" Article 9 funds which have sustainable investment or reduction in carbon emissions as their objective. ETF issuers will have updated their prospectuses to include the relevant disclosures by the implementation date for the level 1 measures under SFDR of 10 March 2021. The implementation date for more detailed level 2 measures has been delayed until 1 January 2023.

The Taxonomy is intended to provide a unified classification system for environmentally sustainable economic activities and thereby reduce the risk of "green washing". It introduced a common language and clear definition of what is considered to be sustainable. The level 1 requirements under Taxonomy were required to be implemented by 1 January 2022 and again issuers of ETFs would have updated their prospectuses to include the relevant Taxonomy related disclosures.

The introduction of the SFDR classification system has driven significant inflows towards funds classified as Article 8 or Article 9 with ESG ETFs, in particular, experiencing significant growth in 2020 with around 200 new ESG ETFs established during that period. In addition to new ESG ETFs, many European asset managers have undergone significant repurposing exercises to upgrade existing ETFs and, in most cases, the indices being tracked by those ETFs to introduce ESG screens or characteristics to be classified under Article 8 or 9. While the inflows to ESG products and the arrival of a harmonized classification regime may be good news from an asset raising prospective, there are a number of challenges which the managers of Article 8 and 9 ETFs are facing in meeting these new obligations.

In particular, the Taxonomy requires that Article 8 and 9 products, where applicable, disclose how and to what extent their underlying investments are in economic activities that qualify as environmentally sustainable under the Taxonomy. Providing this quantitative disclosure is reliant on data available from investee companies. As the sub-set of investee companies in scope of the relevant Taxonomy reporting requirements are not required to provide this information until 1 January 2023 at the earliest, there will be insufficient data available to Article 8 and 9 ETFs to provide this level of quantitative disclosure. This has resulted in most managers of Article 8 or 9 ETFs, where applicable, either explaining why they could not provide a quantitative disclosure or, for now, disclosing 0% alignment of their investments with Taxonomy. Subject to any clarification from EU regulators over the intervening period, this will continue to be a challenge for ESG ETFs over the coming year.

For more information on this please contact Stephen Carson, Partner or any member of our Asset Management and Investment Funds team.

Date published: 1 March 2022