After more than two years of work, the Taskforce on Nature-related Financial Disclosures (TNFD) has issued its framework of recommendations for companies and financial firms to identify, assess, manage and disclose nature-related issues. The framework has been devised to become a metrics standard and provides guidance on nature-related assessment and disclosure.

The TNFD recommendations set a road map to guide companies in integrating nature into their governance, strategy, risk and impact management, and metrics and targets. Under four pillars, there are 14 recommended disclosures (Figure 1) covering nature-related topics that echo those in the Task Force on Climate-related Financial Disclosures (TCFD).

“Nature is no longer a corporate social responsibility issue, but a core and strategic risk management issue alongside climate change. Corporate and investor stewardship of, and investment in, nature is a transformational opportunity for companies who innovate and financial institutions who finance the solutions needed at scale. The TNFD recommendations help organisations meet this challenge.” 

TNFD – Executive summary of recommendations, Sept. 18, 2023.

Figure 1: TNFD’s recommended disclosures

_{Source: TNFD.}

Importantly, the framework also supports financial institutions in portfolio construction and investment product development. It follows a broad “AR3T” action sequence (Avoid, Reduce, Restore, Regenerate, Transform) that prioritizes companies that avoid or minimize negative impacts on nature over the pursuit of restoration efforts or reconstructive measures. 

TNFD’s “AR3T” recommended action sequence

• Avoid: Prevent negative impacts from happening in the first place; eliminate them entirely
• Reduce: Minimize negative impacts that cannot be fully eliminated
• Restore: Initiate or accelerate the recovery of an ecosystem with respect to its health, integrity and sustainability
• Regenerate: Take actions within existing nature uses, such as agricultural practices, to increase the health, integrity, function and productivity of an ecosystem
• Transformative Action: Consider ways in which organizations can contribute to needed systemic change inside and outside their value chains.

This sequence is correlated to a high degree with the four-step index construction process at the core of the ISS STOXX^® Biodiversity indices framework, introduced in April 2023 (Figure 2). The indices allow investors to take a comprehensive approach to biodiversity challenges, and integrate sophisticated data from ISS that assess companies’ nature-related footprint. 

Figure 2: ISS STOXX Biodiversity Indices four-step framework

Source: STOXX ^[2]

Both STOXX and TNFD frameworks contemplate similar steps addressing the different degrees and types of biodiversity action (Figure 3).   

Figure 3: Correspondence between the STOXX and TNFD action sequences

Source: STOXX ^[3]

While the STOXX Biodiversity framework sets a defined target to reduce a portfolio’s carbon emission, the TNFD recommendations clearly identify greenhouse gas emissions as a cause of indirect negative impact on biodiversity, making it imperative to reduce them in the fight for nature.

For a detailed explanation of the ISS STOXX Biodiversity framework, please see our article: “New ISS STOXX indices use comprehensive framework to help investors address biodiversity challenges.”

Looking ahead

The TNFD recommendations also include a set of core global disclosure metrics that provide an overview of a company’s position in the context of biodiversity (Figure 4). 

Figure 4: TNFD core global disclosure metrics for nature-related risks and opportunities

_{Source: TNFD.}

The ISS STOXX Biodiversity indices already address those metrics where available. Examples are the exclusion of companies that fail to pass norms-based and ESG controversies filters (C7.2), and the integration of the UN Sustainable Development Goals (SDGs) (C7.4). 

The ISS STOXX biodiversity framework can be expanded, deepened and enhanced if and when information on companies’ assets, liabilities, revenue and expenses that are vulnerable to nature-related risks (C7.0 and C7.1), as well as on the amount of capital and investment deployed towards nature-related opportunities (C7.3) becomes available. 

It is to be hoped that, through the new requirements of the CSRD (Corporate Sustainability Reporting Directive) and through stewardship actions, we will obtain more disclosure from companies.

* Antonio Celeste is Director for Sustainability Product Management at STOXX.

^[1] The TNFD is composed of executives from businesses, financial institutions and market intermediaries from across 180 countries with asset management responsibilities over USD 20 trillion (source: TNFD).

^[2] The Potentially Disappeared Fraction of species (PDF) is a metric used to quantify the impact of corporates on biodiversity. PDF represents the potential decline in species richness in an area over a period due to unfavourable conditions associated with environmental pressures. 100% PDF means full destruction of biodiversity in a given area, 0% means total preservation from human activities.

^[3] The PDF considers a company’s set of environmental pressures on species and habitats, its entire value chain and geographical location, hence it addresses the Transformative Action step as well. 

In a midyear review report, ISS ESG, a leading provider of ESG data, analytics and insights, and a partner with STOXX in indexing solutions, recounts what’s happened this year in terms of ESG reporting regulation and what may unfold in the second half. According to the report’s authors, the general trend as signaled so far by policy proposals, updates and guidance is one of greater and more granular reporting obligations, whether for companies or investors. 

While the policy agenda is keeping in line with forecasts at the start of 2023, “policymakers are also taking the opportunity to assess implementation challenges and reporting burdens, with a focus on ‘right-sizing’ regulation,” Anna Warberg, Head of Stewardship & Engagement at ISS ESG; and Karina Karakulova, Director of Regulatory Affairs and Public Policy at parent company ISS, wrote.

From TNFD to EU Taxonomy

In May, the Taskforce on Nature-related Financial Disclosure (TNFD) released a final draft of its proposed framework, whose final version is now planned for September this year. The TNFD follows on the example of the Taskforce on Climate-related Financial Disclosure (TCFD) and aims to develop risk management and disclosure guidelines to report and act on evolving nature-related risks.

The standard-setting International Sustainability Standards Board (ISSB), which in May started a consultation on its next projects and priorities, is likely to rely on the TNFD’s framework, according to Warberg and Karakulova. 

The ISSB in June launched its first sustainability-related reporting standards, which the UK’s Financial Services Authority has said will help bring “complete, consistent, comparable and reliable corporate sustainability disclosures” across jurisdictions.

While the ISS ESG report covers global developments, the leading steps in ESG disclosure action continues to be in Europe. In June, the European Commission (EC) approved in principle a new set of EU Taxonomy Technical Screening Criteria for the four remaining environmental objectives of the six in the EU Taxonomy:

• Sustainable use and protection of water and marine resources
• Transition to a circular economy
• Pollution prevention and control
• Protection and restoration of biodiversity and ecosystems

The criteria identify which economic activities contribute to one of the objectives and, at the same time, cause no significant harm to any other. The Council of the European Union and the European Parliament (EP) have four months to object to the Technical Screening Criteria before the package becomes EU law. The EU’s executive arm also proposed new rules to strengthen the transparency, governance and independence of ESG ratings.

Separately, the EP in June adopted a position on the Corporate Sustainability Due Diligence Directive (CSDDD), launching discussions on the package between the EP, the EC and the Council of the EU. The CSDDD requires companies to explain their due diligence processes with regards to sustainability matters. It also sets out the conditions under which companies can be held accountable for adverse impacts to the environment and human rights, among other things. The tri-party negotiations will continue in 2023 and are likely to extend into 2024, Warberg and Karakulova wrote. 

In July, the EC adopted new European Sustainability Reporting Standards (ESRS), which provide more details on the Corporate Sustainability Reporting Directive (CSRD) from last year. ESRS requires companies to report on the “double materiality” environmental impact of their operations and value chain, and relieves them — for now — of mandatory disclosures on climate mitigation, biodiversity and water.^[1]  

“Considering both ISSB’s potential for global reach and the companies covered under the CSRD, an expanding universe of reported metrics and information is likely to materialize soon for reporting periods beginning on or after Jan. 1, 2024,” the ISS ESG report read.  

What else to expect in the second half 

The European Securities and Markets Authority (ESMA), the EU’s financial markets regulator and supervisor, in July responded to an EC request by providing an assessment on the Shareholder Rights Directive (SRD). 

Another key topic for investors in coming months is a review of the Sustainable Finance Disclosure Regulation (SFDR). The European Supervisory Authorities in April proposed to expand and clarify the indicators that relate to principal adverse impacts (PAIs), and to amend the disclosure for product issuers. SFDR is one of the landmark frameworks steering sustainable investments, and Qontigo this year published a methodology guide for reporting the sustainable investments (SI) percentage of STOXX and DAX indices.

Elsewhere, ESMA is expected to issue in the third quarter final guidelines on funds’ names using ESG or sustainability-related terms.

“Change usually happens slowly in the regulatory world, but recent regulation related to ESG investing is accelerating the pace of change, even as regulators simultaneously advance new requirements and, in some cases, revisit existing regulation,” the ISS authors wrote.

ESG regulation is one of ten chapters that make up ISS ESG’s midyear report. Other topics include the journey to Net Zero, ESG investing in times of an economic slowdown, and the food industry’s impact on climate and biodiversity. 

Nature-related risks

Regulation is also increasingly focusing on the topics of biodiversity and human rights, following years when most of the attention was placed upon climate change. STOXX, in partnership with ISS ESG, this year unveiled the ISS STOXX^® Biodiversity indices. The new suite aims to provide investors with a broad and holistic framework under which to consider the impact of portfolios on our ecosystems.

“Biodiversity is not only a risk but also an opportunity for companies and investors,” said Antonio Celeste, Director for Sustainability Product Management at STOXX. “At STOXX, we continuously monitor market developments in terms of sustainability data disclosure, and steady progress in this field is enabling solutions that can be integrated into investment portfolios.”

ESG rule-making continues to move at a fast pace in Europe and beyond, and the above list of legislative packages is not exhaustive. With more clarity and increased guidance on regulation, and improved data, the possibilities to integrate sustainability parameters in investment portfolios will grow, while “greenwashing” risks should decrease. The remainder of 2023, and indeed the next couple of years, promise to deliver much more on the ESG regulatory front.    

For questions and comments on the ISS ESG report, please write to sales@iss-esg.com. To enquire about STOXX’s sustainability solutions, please reach out to marketing@qontigo.com.

^[1] For more on this, see Edie, “More than 50,000 companies to be impacted by new EU sustainability reporting rules.”

During the same period, SFDR Art. 8 funds, however, registered net outflows of EUR 3.3 billion, mostly due to sales of bond funds, the data show. One year after the introduction of the European legislation, the two categories combined increased their share of total European fund assets to 45.6%, from 42.4% at the end of 2021, the data show. Initial SFDR requirements applied from March 10, 2021.

The SFDR is one of three regulatory pillars in the EU’s Action Plan on sustainable finance, which aims to reorient capital towards more sustainable businesses and has been a driving force in reshaping financial market behavior across the globe. 

Art. 9 products are those that specifically seek to achieve an environmental (E) or social (S) objective while doing no significant harm to any other E or S objective and ensuring that investee companies follow good governance practices. Art. 8 funds more generally “promote” E or S characteristics — to use the European Commission’s definition. Because Art. 9 products are more ambitious in their sustainability imprint, they carry more demanding disclosure requirements.

Overall, Art. 8 and 9 funds grew their assets by 8.5% in the quarter to EUR 4.2 trillion, the report showed. There were 6,862 funds classified as Art. 8 and 898 as Art. 9 as of the end of March.

Flows into the most sustainability-focused funds also materialized despite strong outperformance from energy stocks, an industry that may be under-represented in many ‘green’ funds. The STOXX^® Europe 600 Energy climbed 13% in the first quarter amid a rally in crude prices, compared with a 7.9% slump for the benchmark STOXX_^® Europe 600.

Long-term trend

“The move to sustainability-focused strategies is a structural trend among asset managers that will continue independent of the market and cycle backgrounds,” said Markus Zellmann, Senior Director for Legal at Qontigo. “This is true of new investments but also of existing funds that are implementing new responsible policies. In the EU, this trend has gained additional strong momentum through the integration of the clients’ sustainability preferences into the MiFID suitability assessment.” 

The suitability assessment within the MiFID framework is a requirement for providers of investment advice and portfolio management to offer suitable personal recommendations to their clients or make appropriate investment decisions on their behalf. The obligation scope was widened by the EU’s Action Plan, which requires those same firms to ask questions to identify clients’ individual sustainability preferences and to be able to recommend products accordingly.  

Many European asset managers have switched the strategy of established funds to make them compliant with Arts. 8 and 9 and meet the rising demand for responsible investment strategies. Amundi and Lyxor have replaced the underlying index of two broad-market pan-European ETFs with the STOXX^® Europe 600 ESG Broad Market, which removes laggard companies in terms of ESG criteria. 

Since SFDR kicked in, assets in Art. 8 and 9 funds have increased as a share of all European fund assets (Figure 1). The remaining funds are aligned with SFDR Art. 6, a regulatory baseline that doesn’t require ESG integration. Art. 6 fund assets have shrunk in relative terms since April 2021.   

Figure 1: Monthly assets breakdown by SFDR classification in percentage terms

_{Source: Morningstar Direct. Data as of March 31, 2022. Based on SFDR data collected from prospectuses on 96% of funds available for sale in the EU, excluding money market funds, funds of funds and feeder funds.}

¹ Morningstar, ‘SFDR Article 8 and Article 9 Funds: Q1 2022 in Review,’ May 5, 2022. 

This year’s Summit, which we have called ‘Together in ’22,’ will take place in London on May 5 and in New York on May 19. The two events will offer insights on some of the most important topics from industry thought leaders as well as Qontigo experts. 

Last September we celebrated the second anniversary of Qontigo, launched in 2019 to bring together the analytics and indexing capabilities of Axioma, DAX and STOXX. These annual summits are an opportunity to present and discuss the latest developments in both fields, and to hear from practitioners, academics and industry partners on trends across the financial-services and technology spaces. The conference has become a key date for asset managers, asset owners, hedge-fund managers, ETF issuers and structured products participants, and for the team at Qontigo. We are particularly excited to be back together in person this year to connect ‘with you.’

Sustainability and climate risk

This year we will be covering a truly rich and wide menu of topics — from ESG to factor and thematic strategies. Key among them will be the subject of responsible investing, as few issues continue to dominate investors’ agendas as strongly these days. 

Two panels will examine climate stress-testing. In one of them, we’ll hear from Sarah Hopkins and David Nelson from Willis Towers Watson (WTW) on the firm’s unique Climate Transition Value at Risk (CTVaR) methodology, which helps investors run a forward-looking, bottom-up evaluation of asset repricing risks in a decarbonization pathway. CTVaR lies at the center of the STOXX Willis Towers Watson Climate Transition Indices (CTIs), which are specifically designed to help investors manage climate-transition risks.

Next up, Bert Kramer of Ortec Finance will walk us through ways to model the impact of climate change on a portfolio. Founded by leading experts in the fields of econometrics and technology, Ortec Finance’s ESG and Climate solutions combine research-backed knowledge, advanced financial models and innovative technology. 

ESG data and responsible investing

We’ll also hear from a panel of leading sustainability data providers on the challenges and opportunities of building sustainable portfolios. Panelists from Clarity AI, ISS ESG, RepRisk, SDI AOP and Sustainalytics will share current challenges and best practices for integrating ESG data into the portfolio construction process.

The London Summit will also feature Ronald van Dijk, Managing Director and Deputy Chief Investment Officer at APG of the Netherlands, to discuss the role and benefits of custom ESG indices. APG last year partnered with Qontigo to launch the iSTOXX APG World Responsible Investment (RI) Indices, a suite that incrementally layers in ESG, carbon and Sustainable Development Investments (SDI) ambitions.

In New York, Professor Roberto Rigobon from the MIT Sloan School of Management, one of the researchers leading MIT’s Aggregate Confusion Project, will deliver a keynote address on ‘The ESG Zoo and What to Do.’

Our own Melissa Brown and Rob Stubbs will dissect the expanding world of Sustainability ETFs to explore whether fund naming conventions actually mean anything for investors.

Finally, Andrew Ang, Head of Factors, Sustainable and Solutions for BlackRock Systematic, will close the day by sharing his unparalleled expertise in quantitative investing and dive deep into the topic of Sustainable Alpha.

Thematic and factor investing

The London summit will host a dedicated panel on thematic investing. We will give the floor to Rob Powell, Head of Thematic & Sector Product Strategy at BlackRock, and Qontigo’s Christoph Schon to hear how a changing world and market background in 2022 will affect an investment segment that’s boomed in recent years. 

Nick Baltas, R&D, Portfolio Construction and Cross-Asset One-Delta Strategies at Goldman Sachs, will also take the London stage to share his thoughts on a topic that is top-of-mind with investors this year: inflation. In particular, Nick will discuss how systematic investing can provide solutions in the current inflationary regime.

In other presentations, Qontigo’s Applied Research team will lead the audience through interesting conversations around factor investing and a proprietary model to gauge investor sentiment. 

Technology in focus 

We are also pleased to have two very knowledgeable speakers that will bring into focus the technology side of our business. Andy Brown, CEO of Sand Hill East and CTO of Fintech Innovation Lab, will join us with a presentation promisingly entitled ‘Change.’ Andy and the team at Sand Hill East work with startup technology companies to help them develop their businesses — from idea to go to market.

Neal Pawar, COO at Qontigo, will also cover the future of FinTech by unpacking how ‘buy vs. build’ has evolved over time, the factors influencing this evolution, and how firms can best prepare for the changes ahead.

Reserve your seat

These are just some of the highlights we have prepared for the two days, and there will be more, including wellness breaks and a cocktail hour that will be a great opportunity to meet up with colleagues and make new acquaintances.

You can register for the event, and view the full agenda, here. 

We hope that you will join us!


* Molly McGregor is Chief Marketing Officer for Qontigo.

A recent Qontigo whitepaper¹ examined the criteria used in the 12 most important frameworks setting standards for SI products in Europe, to highlight the discrepancies among the various labels and inform interested stakeholders about the intricacies of the current situation. The study provides a like-for-like comparison of exclusionary criteria and portfolio-construction techniques as applied in each individual label. 

On February 24, Qontigo and Responsible Investor hosted a webinar to discuss the state of play in Europe’s ESG labeling landscape. A panel of experts discussed the aims of the labels, their intersection with broader European regulation, and what it all means for the ultimate goal of achieving a more sustainable economy. 

Anna Georgieva, Qontigo’s Associate Principal for Sustainable Investment and co-author of the recent whitepaper, moderated the panel. Fund design has great implications for the growth of sustainable investing, she said, and asked the speakers whether the current assortment of labels may hinder the development of investment products.

“In the current landscape, frameworks proliferate and cover a wide range of objectives,” said Georgieva. “Even a simple look at the labels’ names — SRI, ESG, sustainability, green, climate — reveals this diversity. Ironically, alignment with European Union (EU) rules is itself a source of divergence. The interpretation of sustainability or investor preferences is not yet uniform across EU legislation.”

Markus Zellmann, Legal Counsel at Deutsche Boerse Group, first tackled the overarching problem of misalignment within EU sustainability legislation. The EU Taxonomy, he said, was conceived as a Europe-wide classification of environmentally sustainable economic activities. However, a delay in the introduction of the Taxonomy vis-a-vis other initiatives that were meant to fall under its scope, such as the EU’s Low Carbon Benchmarks Regulation (BMR) and the Sustainable Finance Disclosure Regulation (SFDR), has left investors facing overlapping yet divergent rules, and differing definitions of what sustainable is.  

“This makes it very complex to handle,” Zellmann said. “By way of an example, if you are a benchmark administrator and you create a sustainable benchmark under BMR, like a CTB/PAB² index, it is not said that those fit the definitions of what’s sustainable under the SFDR or the Taxonomy.” 

“Currently we have a high number of labels defining what is sustainable, and have some regulation, but the coherence of those regulatory standards is low,” Zellmann said. He added that the introduction and expansion of the EU Taxonomy could change this.  

Figure 1 – Major EU sustainability regulations 

_{Source: Deutsche Boerse Group, Black arrows mean the starting rules framework references the end regulation. Green arrows denote that none of the regulations reference the Taxonomy’s definition of what is sustainable. This is somewhat surprising since the Taxonomy was created to allow a respective common definition, according to Deutsche Boerse’s Zellmann. Of course, the scope of the Taxonomy is limited to environmental aspects and does not cover all economic activities. Hence, it makes sense that the SFDR uses a sustainability definition that is wider than that of the Taxonomy. Still, the SFDR and the BMR could have been expected to at least reference the Taxonomy’s definition as far as possible — which neither the SFDR nor the BMR currently does.}

The influence of green labels in Europe is not to be underestimated. Novethic, which researches and audits sustainable investments, has counted more than 2,100 funds, with a total of EUR 1.3 trillion, that have been awarded European labels (Figure 2). Over 300 funds have at least two labels, and some have up to four, an indication of the differing goals and scope of the various frameworks. 

“No one size fits all,” said Nicolas Redon, Green Finance Expert at Novethic. “There are different types of labels. If you are both investing in green, but conducting ambitious engagement as well, your green label will not necessarily reward the fact that you’re conducting engagement. If you do a lot in your strategy and want to see that rewarded, you can take different labels. And then there are also national regulatory requirements in place.” For example, Redon explained, French law requires at least one labeled fund “in the offer of each multi-fund life insurance policy in the country — so there is a need for asset managers to get those labels in order to be distributed by unit-linked products in these life insurance policies.”

Figure 2 – European labeled funds

_{Source: Novethic.}

Tom Van den Berghe, Managing Director at Belgium’s CLA, which governs the country’s Towards Sustainability (TS) label, gave the perspective of a labeling agency. He explained that TS seeks to evolve alongside emerging regulation, client preferences and scientific research, as well as establish equivalences with other labels in Europe. Three-year-old TS has been intentionally positioned as a broad ESG label, he said. 

TS “is not the strictest dark green label, but that was never the intention,” said Van den Berghe, who is also Director for Sustainable Finance at Febelfin, Belgium’s financial sector federation. “The challenges we have are so broad that we need the involvement of all players to reach sufficient impact. We cannot limit ourselves to niche initiatives. We don’t want to have a label that is only suitable to the more convinced green investors — we also want to have a sustainable offer for more conservative investor profiles.”

“We’ve chosen to create a set of minimum standards for an SRI (Socially Responsible Investing) product, the minimum level of sustainability a product needs to obtain to be credible as being sustainable,” he said. “It is a minimum standard but nonetheless it is quite ambitious. It is a pre-requisite, and then you can go beyond the label and formulate your own criteria or expectations on sustainability.” 

Challenges

Van den Berghe also said that a functional label should strike a balance between sustainability approaches, for example exclusions vs. engagement, and find an equilibrium between financial returns and sustainability objectives. Novethic’s Redon, whose firm audits France’s Greenfin label, added that it is currently very difficult for issuers and investors to accommodate the many exclusions found across different labels, with the fossil-fuel sector being a prime example of this challenge. 

Another topic that was touched upon during the debate was the multiplication of SFDR Article 8 and Article 9 stamps, which are disclosure standards rather than labels. 

“In the vast area of products which are Article 8-compliant, you need more explanation of how your product is sustainable,” said Zellmann of Deutsche Boerse. “That’s not really anything that is comparable or tangible for an investor. Just because the product is Article 8, it means nothing; you need a label or other measures like a taxonomy-based assessment, to understand whether it is green or sustainable at all.” 

What effect the EU Taxonomy will have on this landscape remains to be seen, according to Zellmann. The European classification could make some labels obsolete, as the reporting of Taxonomy-aligned revenues in a transparent way would enable investors to choose what best fits their profile. At the same time, some labels could remain relevant to cater to specific investor needs.

“In the future, the legislative approach will be more coherent and will focus more on the Taxonomy,” Zellmann added. “The Taxonomy’s scope will be wider, and that will have an impact on requirements for labels.” 

Impact investing

To finish, the panel was asked if impact investing is well served by current labels.

Van den Berghe said labels are frequently used as engagement tools, but also act as a more direct lever for corporate change: he mentioned that the Belgian labeling agency has received calls from companies seeking information to align processes with the label’s guidelines. 

Conclusion

As the discussion showed, country labels have become deeply embedded in the distribution of investment funds within the many national markets. Qontigo’s Sustainable Investment Team has argued that labels have the potential to influence the success of the sustainability transition, but currently form a highly divergent and fragmented field. Investors, intermediaries and fund issuers navigating this landscape will only see their due-diligence tasks increase as new EU rules frameworks become established.

Overall, the webinar provided an enlightening exchange of ideas around a topic that will only gain precedence in coming months. 

¹ Georgieva, A., Mehrotra, S., ‘Sustainable investment fund labeling frameworks: An apples-to-apples comparison,’ February 2022.
² The European Union Climate-transition Benchmarks (CTBs) and Paris-Aligned Benchmarks (PABs) follow EU rules establishing Climate Benchmarks standards that came into application in 2020. 

The European Union’s push to embed sustainability criteria in financial markets is leading to a surge in ESG uptake both inside and outside the bloc, and rules became tighter with the introduction of the Sustainable Finance Disclosure Regulation (SFDR) almost one year ago. 

SFDR is one of three regulatory pillars in the EU’s sustainable finance action plan from 2018, which aims to reorient capital towards more sustainable businesses and has been a driving force in reshaping financial market behavior across the globe. The action plan is completed by the regulation on climate benchmarks and sustainability-related disclosures for benchmarks, and the EU Taxonomy Regulation. Initial SFDR requirements started to apply on March 10, 2021.¹ 

In summary, SFDR outlines entity-level disclosure rules relating to sustainability risks, the consideration of principle adverse impacts (PAIs)² of investment decisions on sustainability factors, as well as, on a product level, the publication of sustainability-related information where a sustainability objective is targeted. It covers financial market participants³ and financial advisers by imposing pre-contractual, website and periodic reporting obligations. The rules apply to investment vehicles including mutual funds, ETFs and derivatives. 

At the center of SFDR, three articles define respective reporting obligations:

• Art. 6: The regulatory baseline. It applies to all financial market participants and advisors, regardless of product strategy. Product manufacturers and advisers need to inform users and clients whether and how they integrate sustainability risks into their products and advice (a practice commonly known in the market as ‘ESG integration’).  
• Art. 8: Products that seek to promote environmental (E) or social (S) characteristics.
• Art. 9: Products that seek to contribute to the achievement of an E or S objective while doing no significant harm to another E or S objective.⁴

Market participants need to categorize their product universes into baseline-only, Art. 8 or Art. 9. Because Art. 9 products are more ambitious in their E/S imprint, they carry more demanding disclosure requirements. 

So where does all this leave market participants?

Given its scope and ambition, SFDR is not without questions and doubts around responsibilities and implementation.⁵ On top of the work involved in complying with the requirements, there have been complaints from industry members about a lack of harmonization between new and existing sustainable finance legislations, and on the misalignment between SFDR definitions and market practitioners’ own terminology. Such definitions include the concepts of double materiality, sustainable investment and PAIs on sustainability factors.

Investment firms could therefore be forgiven for feeling anxious in the face of a regulatory burden that already seems daunting before confusion is added to the mix. 

Some important points may help lessen those initial concerns.

First off, SFDR is not a product label but a framework that aims to provide harmonized disclosure requirements to strengthen investor protections against greenwashing.

This is a shared journey for everyone – the spirit of the regulation is important to bear in mind when navigating the sometimes-unclear wording in it. Firms that are genuine about facilitating the transition to a low-carbon and more equitable world should use that as a guiding principle when revising existing fund methodologies and developing new ones.

A perfectly aligned and smooth introduction of the rules would have taken years in preparation. Luckily, policymakers realize that, when dealing with sustainability, we no longer have the luxury of time.

Initial SFDR disclosure obligations (‘Level 1’) started on March 10, 2021 and must be applied by regulated entities following a principles-based approach. ‘Level 2’ technical standards requirements are scheduled to come into effect on January 1, 2023 (postponed by one year last November).

Few products are currently seen as aligned with Art. 9 and its more stringent do-no-significant-harm criteria. According to Morningstar research, as of September 30, 2021, Art. 9 funds represented 4% of EU fund assets, while Art. 8 funds accounted for 33%, with both having a growing share of total fund inflows.⁶

The role of Qontigo

SFDR and other EU initiatives have resulted in a reassessment of our index solutions at Qontigo, which we have taken on in following the spirit of the interventions. This comes at a time when we have extensively grown our ESG, Sustainability and climate offerings. One of the main developments in the near future will be the roll-out of impact-oriented strategies. 

To facilitate the reporting obligations of clients and index end users, Qontigo has worked to determine where and how our indices align with the essence of the regulation. We are also working on a solution with Clarity AI to support disclosures on topics such as Taxonomy alignment and PAIs on sustainability factors.

We partner with Clarity AI, the global, leading sustainability technology platform, which leverages big data and machine learning to provide impact and sustainability analysis, and reporting capabilities. Through its EU Regulatory Solutions, which include over 40,000 organizations, Clarity AI can help you comply with EU Taxonomy and SFDR disclosure requirements.

Indices, and the precise description of their approach and methodology, play a key role in the disclosure obligations for products that use them as a reference benchmark. The regulation requires that market participants explain how an index is consistent with either the promotion of, or objective of, contributing to the improvement of environmental or social characteristics.

A few methodological proxies are currently necessary to assess the likely alignment of indices with the SFDR classifications:

• Using an index designed around an overarching ESG score, business activity or carbon intensity exclusions, can be aligned with the concept of ‘promoting environmental and/or social characteristics.’
• To align with Art. 9 requirements, a product methodology needs to strive to increasingly contribute to the E/S objective over time. For example, the decarbonization path and decreasing weight of companies with no carbon targets in the Qontigo Paris-Aligned Benchmarks satisfy that obligation. 
• Good governance is loosely defined around four pillars within the regulation: sound management structure, employee relations, staff remuneration and tax compliance. As of today, the absence of violation of global societal norms such as the U.N. Global Compact, the OECD Guidelines for Multinational Enterprises or the U.N. Guiding Principles on Business and Human Rights may meet that requirement; but this may change over time. Here, we’ll also be watching the European Commission’s initiative on sustainable corporate governance, which may be adopted later this year. 
• ‘Do no significant harm’ (DNSH) is a key SFDR mandate. The absence of ESG controversies may be a good proxy, although as with other criteria, this may change and become more detailed over time. Qontigo’s Paris-Aligned Benchmarks are future-proofed in this sense by having gone above and beyond the letter of the climate benchmarks regulation and included an indicator for ‘lack of significant obstruction’ of Sustainable Development Goal No.13 — Climate Action.

For questions regarding the implementation of SFDR, please contact us.

No pain, no gain

SFDR seems like a burden for market participants. The incorporation of such a detailed set of rules can feel arduous at first. Yet, as the regulation is interpreted, clarified and harmonized, practice cultivated and confusion eliminated, complying with it should become a more practical and pragmatic task with time. The end goal is worth all the work.

*Anna Georgieva is Senior Sustainable Investment Specialist at Qontigo.

This article is purely informative and does not constitute any legal advice. 

¹ The European Supervisory Authorities (ESAs) in early February 2021 published a final report on draft Regulatory Technical Standards (RTS) with regards to the content, methodologies and presentation of sustainability-related disclosures under empowerments in the SFDR. While the requirements in the SFDR on Level 1 apply since March 10, 2021, the ESAs suggest that the RTS will not apply until January 1, 2023 (postponed from January 1, 2022), following a letter from the EC in November 2021. Moreover, in October 2021 the ESAs published a final report on draft rules for how investors should disclose their products’ EU Taxonomy-alignment under the SFDR, improving on previous templates with the aim to establish a single rulebook and comparable format for sustainable disclosures under the SFDR and the EU Sustainability Taxonomy. Research for this blog was underpinned by ECOFACT’s regulatory database.
² PAI disclosures are focused on a set of indicators for both climate and environment-related adverse impacts and adverse impacts in the field of social and employees matters, respect for human rights, anti-corruption and anti-bribery matters. See: ESMA, ‘Final Report on draft Regulatory Technical Standards,’ February 2021.   
³ Financial market participants include pensions and asset managers, insurance providers, and corporate and investment banks.
⁴ Both Arts. 8 and 9 products require that investee companies follow good governance practices. 
⁵ As an illustration, the ESAs, in charge of policing implementation of SFDR, wrote a letter to the EC in January 2021, requesting clarification on ‘several important areas of uncertainty in the interpretation of SFDR.’ In response, the EC published a Q&A in July 2021, providing guidelines for interpreting the meaning of ‘promotion’ under Art. 8 and explaining the scope of both entity- and product-level SFDR requirements (Art. 9). In November 2021, the EU Commission corrected the Q&A. Although helpful, this Q&A did not fully alleviate industry concerns, with Arts. 8 and 9 still largely seen as too broad.
⁶ Morningstar, ‘SFDR Article 8 and Article 9 Funds: Q3 2021 in Review,’ November 3, 2021.

The list of sustainable investment (SI) frameworks guiding portfolio design is long and continues to proliferate. Many countries now have their own ESG labels to ensure a certain quality of SI for the growing pool of funds targeting sustainability goals. But with each one having different stated aims, scope and criteria, how should fund issuers navigate this complicated landscape?

A new whitepaper¹ by Anna Georgieva and Saumya Mehrotra of Qontigo’s Sustainable Investment team examines the criteria used in the 12 most important European frameworks setting standards for SI products, including Belgium’s Towards Sustainability label, the German-speaking countries’ FNG Label, and France’s SRI and Greenfin labels. They provide a like-for-like comparison of exclusionary criteria and portfolio-construction techniques as applied in each individual label. The authors’ motivation is to highlight the discrepancies among the various labels and inform interested stakeholders about the intricacies of the current situation.

The authors present a detailed analysis of the various frameworks, after narrowing down the common set of criteria under the labels as they relate to:

• which companies are excluded from portfolios (negative screening), and 
• how portfolios are constructed above and beyond these exclusions.

The analysis seeks to answer some key questions for the asset-management industry, including: 

• What are the existing labels’ aims? Which criteria are aligned with each other and where do they diverge?
• Is it actually feasible to design a financial product that aligns with all labels? What are the implications for the scalability of SI products?
• What are the effects of attempting to limit the number of labels to the bare minimum through standardization, as opposed to encouraging divergence on the grounds that there is no one-size-fits-all solution when it comes to SI?
• What does this all mean for the ultimate goal of transitioning to a more sustainable economy?

Trends in ESG labels

ESG labels have gained significant preeminence in recent years as tools to provide transparency and drive capital towards sustainability goals. The entry into force of the Sustainable Finance Disclosure Regulation (SFDR) in 2021 — a much-followed, de-facto label — is already prompting many fund companies to adjust their offerings. Labels have the potential to influence the success of the sustainability transition, the whitepaper’s authors note, helping avoid misallocation of funds and greenwashing, and guaranteeing a certain normative quality for end investors. 

However, as they also make clear, the labels currently form a highly divergent and fragmented landscape (Figure 1). Ironically, alignment with European Union rules is often in itself a source of divergence since SI is not interpreted uniformly in the different pieces of EU legislation. The EU Taxonomy, when finalized, could change this.

Figure 1 – Overview of the analysis

_{Source: Qontigo, ‘Sustainable investment fund labeling frameworks: An apples-to-apples comparison.’}

The study first identified three major categories in terms of the labels’ key focus: 

• broad sustainability 
• broad environmental 
• specific environmental focus on climate.

Second, the authors manually interpreted and classified the labels into three product design buckets: 

• exclusions only 
• minimum performance only 
• a combination of both.

Analyzing each label’s criteria is key to recognize trends and help guide investors in the path forward in portfolio design. Some take-aways from the analysis show that norms-based exclusions are now a must, and weapons and energy dominate product-involvement screens. However, the thresholds applied differ vastly. Interestingly, the authors note that while exclusions based on environmental criteria are common, social and governance criteria are less so but growing in importance. Another emerging trend, they write, will be the use of exclusion indicators that progress and become more stringent through time, to incentivize companies to transition.

With respect to portfolio construction, the authors observe that ESG integration is necessary but not always seen as sufficient to classify as an SI strategy anymore, not least because it is now a regulatory baseline for all funds under the SFDR. Best-in-class is currently the most common strategy, with thematic and impact gaining more relevance. Engagement approaches are increasingly recognized as a powerful lever to drive real-world impact.

The ‘impossible’ pan-European ESG-labelled fund

In an illustration of the challenges faced by fund issuers, the authors analyze what thresholds a product would need to meet if it was designed to be widely distributed across European markets. 

What would such a product based purely on common exclusions look like? Would it even be feasible from a portfolio construction and sales perspectives? Readers can find the answer in the study, but two warnings emerge from this exercise. Firstly, given the lack of harmonization, fund issuers may fail to achieve scalability, slowing down the mainstreaming of sustainable investing. Secondly, the application of the highest common denominator for each criterion among the various labels can lead to highly restrictive criteria that could exclude systemically important companies in the sustainable transition. 

“There is very little common ground between labels as to what constitutes a sustainable investment product,” the authors write. “Consequently, it can be argued that failure to establish basic common ground would result in major drawbacks for both investors and the SI agenda at large.” 

Recommendations for fund issuers

In the face of these challenges, there are key takeaways for fund issuers, the authors write. In particular, they recommend staying abreast of relevant developments in order to play an informed and active role in policy engagement and regulatory consultations. To future-proof products, it is also important to adhere to standards that are both science-based and that incorporate elements incentivizing the real economy towards the sustainable transition, they add.

“Labeling, to the extent it is deployed as a tick-box exercise, is frequently less impactful for achieving this goal than a spectrum of other actions such as supporting sustainability R&D and participating in collaborative engagement investor initiatives,” they write. “Such actions could have a more positive impact on differentiation and serve the overall industry.”

The whitepaper will prove to be a useful source for fund issuers, investors and intermediaries to understand a topic that will only grow in importance day after day. We invite you to download the report and get in touch with comments and questions. 

¹ Georgieva, A., Mehrotra, S., ‘Sustainable investment fund labeling frameworks: An apples-to-apples comparison,’ Qontigo, January 2022. 

“I am pleased to welcome Mohan to our team. Since the launch of Qontigo almost two years ago, we have seen steadily strengthening demand for our solutions, created by leveraging Qontigo’s advanced indexing and analytics capabilities. Those unique capabilities, combined with Mohan’s proven ability to deliver innovation, value and growth, will help us to accelerate the fulfillment of our vision and value proposition by meeting—and exceeding—the enterprise-level needs of our highly demanding strategic accounts.”

Brian Rosenberg, Chief Revenue Officer of Qontigo

Prior to his most recent roles as Global Head of Partnerships and Head of Services and Solutions, he led Analytics Client Coverage in the Americas for MSCI and RiskMetrics Group.

“I am delighted to welcome Neal Pawar to Qontigo. Neal was a client and we enthusiastically collaborated for many years. We share a common vision that modern technology—the cloud, open architectures and platforms—is the pathway to revolutionizing this business. And I am confident that Neal’s broad industry experience, not to mention his track record as a pioneer and transformative innovator, will accelerate our efforts to deliver unprecedented value and competitive advantage to clients, by enabling them to leverage an entire spectrum of superior indices, analytics, data, tools and solutions across a fully integrated common platform.”

Sebastian Ceria, Chief Executive Officer of Qontigo

“Over the course of my career, I’ve seen the commoditization of many parts of the financial technology stack. Axioma, STOXX and DAX—and now Qontigo—have played an important part in that evolution by building sophisticated analytics and indexing products leveraged by firms across the financial spectrum. As a computer scientist, I’m excited that the next chapter in my career has brought me to Qontigo—a data and technology pioneer where we will continue to innovate and deliver for an expanding range of clients.”

Neal Pawar

Over the course of his career, Pawar has worked for a diverse set of leading firms in multiple segments of the finance industry, consistent with Qontigo’s expanding footprint in the marketplace today. Before joining Deutsche Bank in September 2019, Pawar spent five years at AQR, where he led the modernization of infrastructures that helped to propel the transformation and scaling of AQR to become one of the world’s most successful hedge funds. AQR was an early client of Axioma, which was founded by Ceria and then acquired by Deutsche Börse and merged with the STOXX and DAX index businesses to create Qontigo in 2019.

Earlier, Pawar spent three years in Zurich with UBS Wealth Management as Chief Information Officer, where his experience developing that firm’s wealth platform will be applied to Qontigo’s plans to expand into the wealth space. Before UBS, he was a partner at the D.E. Shaw Group for 11 years, where he held a number of positions, including Global Head of Back-Office Technology (later spun off as Arcesium), experience that will also be leveraged at Qontigo to drive improvements in operational excellence.

Pawar graduated from Brown University with a degree in computer science in 1994.