ESG Disclosure Regulation: a closer look at Article 8 and Article 9
Diana Ribeiro Duarte and Margarida Torres Gama of Morais Leitão look at the challenges of classification under articles of the SFDR
March 2021 saw Regulation (EU) 2019/2088 of the European Parliament and of the Council of November 27 2019 on disclosure of information related to environmental, social, and governance (ESG) criteria in the financial sector (SFDR) finally becoming applicable.
This regulation, issued in the context of the EU Commission’s commitment to the Sustainable Development Goals of the UN 2030 Agenda for Sustainable Development, represents a major milestone by introducing unprecedented harmonised requirements on sustainability-related disclosure in financial products to a multitude of financial market actors and advisors.
The reporting obligations in this respect apply to multiple entities, including (i) alternative investment managers, (ii) qualified private equity fund managers, (iii) pension product manufacturers and providers of pan-European individual retirement products, (iv) insurance companies and insurance intermediaries that distribute insurance-based investment products, and (v) investment firms and credit institutions that provide portfolio management and investment advice.
Such entities are classified either as financial market participants or financial advisers, depending on their role in the conception, governance, provision and/or placement of the financial products, such classification then impacting their respective duties in terms of ESG disclosure.
The big question: Article 8 or Article 9?
Among other duties, Article 6 of the SFDR includes obligations on financial market participants and financial advisers to disclose in the pre-contractual information regarding the financial product information on the impacts on sustainability risk in the performance of their activities and on the returns of the products.
The exact elements to be made available under the ESG pre-contractual information of financial products depend however on the category of financial product – in particular whether the product is one that “promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices” (Article 8 of the ESG Disclosure Regulation) or one that “has sustainable investment as its objective and an index has been designated as a reference benchmark” (Article 9 of the ESG Disclosure Regulation).
This distinction is not totally clear in practice in all situations, but the legal market has already been experimenting with it.
Article 8 covers products that promote ‘E’ or ‘S’ features, regardless of whether the investment outcome is actually made in ESG products or the investment objective is specifically to have a positive impact on the environment and society (unlike Article 9). The information to be provided to customers refers fundamentally to how the ‘E’ and ‘S’ factors are taken into account, for instance, in the allocation of the product's invested capital and other decisions in the context of the product management.
A financial product will fall within the scope of Article 9 when its objective is primarily to have an ‘E’, ‘S’ or ‘G’ impact, which will usually translate into the majority of the portfolio of such product being comprised of ESG investments.
In a nutshell, an Article 9 product can be said to generally have to meet the following requirements: be (i) an investment in an economic activity (ii) that contributes to an ESG objective, and (iii) simultaneously does not significantly undermine any of these objectives, with (iv) the target company following good governance practices.
Under Article 9, the fact that the investment also has a financial objective does not remove it from the scope of Article 9, but the fact that a product in fact meets the said ESG objectives but is not obliged or expressly mandated to do so will probably remove it from such scope.
The evolving market
In practical terms, this distinction is expected to only become more tangible after several classifications of the financial products are made by the relevant market players. In any case, the approach to the categorisation under these articles has already been reported as not always being consistent among entities and across jurisdictions, which, if not dealt with, may entail risks to the credibility the system.
This issue is not minor, especially taking into account that, in the first month of application of the ESG Disclosure Regulation, investments in funds classified under Articles 8 and 9 are said to have reached 25% of all European assets.
The market is changing rapidly, and financial market operators are seeking to achieve a better ESG rating by investing massively in financial products rated under Articles 8 and 9 of the SFDR.
Increasing regulation will undoubtedly tend to encourage them to adopt ESG aspects in their investment processes, leading to an inevitable connection between profitable and sustainable investment, but attention should be drawn to the densification of some criteria in order to mitigate risks of it being seen as somehow enabling ‘greenwashing’ (in particular, under Article 8).
Diana Ribeiro Duarte
Senior lawyer, Morais Leitão
Margarida Torres Gama
Senior lawyer, Morais Leitão