SFDR funds: The power of voluntary assurance

Past years have witnessed an increasing focus on SFDR Art 8 and 9 Funds, both now accounting for almost two-thirds of the European private equity and venture capital funds as per Morningstar, fueled by an increasing investor appetite for sustainable investment strategies combined with the increasing European regulatory pressure. While this can be perceived as a positive development of impact investing, it also constitutes a double-edged sword due to the inherent reputational and financial risk linked to the risk of greenwashing in the absence of adequate independent review. Therefore, as the demand for funds promoting or focusing on sustainable investments rises, so do the requirements of Limited Partners for independent assurance covering the non-financial performance of their investments. 

Introduction

The Sustainable Finance Disclosure Regulation (SFDR) is undoubtedly considered as one of EU’s main tools in the context of its Sustainable Finance Action Plan Goals (and broader EU Green Deal), launched in May 2018 by the European Commission with the following three priorities: reorienting capital flows towards sustainable investments, managing sustainability risks, and fostering transparency. After regulation’s “Level 1” implementation in March 2021 requiring financial market participants to provide disclosure of sustainability risks, investment objectives, and information on the integration of environmental, social, and governance (ESG) factors in investment decisions, the regulation evolved with the application of SFDR Regulatory Technical Standards (Level 2) as of January 2023 with, as principal updates, more detailed disclosure requirements. Following the implementation of the directive, European funds are categorized into three types: SFDR Article 8 funds (also known as "light green"), which promote ESG characteristics; SFDR Article 9 funds (or "dark green"), which aim to achieve sustainable objectives with a positive impact on the environment or society; and SFDR Article 6 funds, which do not integrate sustainability considerations into their investment strategies

This article provides an overview of the growth of SFDR Article 8 and Article 9 funds in response to changing investor preferences. It emphasizes the unique risks and challenges these funds face and explores how voluntary assurance can mitigate these risks effectively.

Investor appetite: from a two-dimensional to a three-dimensional analysis

For the past years and the advent of SFDR regulation, Limited Partners (LPs) have developed and refined their appetite for impact and sustainable investments. Many investors have moved away from a traditional two-dimensional “risk/return analysis” to apply a three-dimensional “risk/return/sustainability analysis”, now also weighting the sustainability component alongside traditional measures of volatility or target return measures such as Total Value to Paid-in capital, Distributions to Paid-in capital and Internal Rate of Return. This trend is reflected by the distribution of funds under the SFDR in Europe at the close of Q1 2024 which, as reported by Morningstar, is led by Article 8 funds, which represent approximately 56% of the market. Article 9 funds account for around 4%, while the remaining 40% consists of Article 6 funds. 

In terms of assets under management (AUM), the Global Impact Investing Network (GIIN) reports, in its “2024 State of the Market”, that the proportion of AUM allocated worldwide by impact-only investors, which allocate 100% of their total AUM to impact investments, increased by a compound annual growth rate (CAGR) of 9% while the percentage allocated by investors who invest in impact alongside impact-agnostic investments increased by a CAGR of 34%.

As an example, the EU’s largest LP, the European Investment Fund, having committed EUR 5,64bn in equity (including private equity, venture capital, private debt and infrastructure) for the year 2023 is mapping all its investments to their Public Policy Goals, aligned with the United Nations’ Sustainable Development Goals.

SFDR Article 8 and Article 9 Funds and the risk of greenlighting or greenwashing 

Due to the absence of strict requirements to target sustainable objectives, SFDR Article 8 funds may end up not making any sustainable investments or just dedicating part of their portfolio to such assets. Morningstar estimates that, as of Q1 2024, one third of SFDR Article 8 funds have currently not a single sustainable investment. This can pose two significant risks for investors:

• Risk of greenwashing

Greenwashing, arising by misleadingly promoting investments as sustainable or responsible without genuine ESG impact, poses a significant risk as it can mislead investors about the sustainability of investments.

• Risk of greenlighting 
  

Considered as a form of greenwashing, the greenlighting consists in shedding the light on one or few sustainable investments in the portfolio while the majority of it is composed of assets without any sustainable angle. 

To partially mitigate those risks, the regulator requires all SFDR Article 8 and Article 9 funds to incorporate the Do Not Significantly Harm (DNSH) principles, meaning that the sustainable objectives of the fund must not badly impact any other sustainable objective. Additionally, those funds must disclose whether they consider Principal Adverse Impacts (PAIs) which are the potential negative impacts related to environmental or social matters that a financial product may have (e.g., GHG Emissions, Biodiversity, Human Rights violation, Gender Equality, etc.). With the growing demand of sustainability information from investors and the MiFID II regulation requiring financial intermediaries to consider client sustainability preferences, the PAIs statement has a critical importance in the disclosure process as evidenced by the 90% of Article 8 and 98% of Article 9 funds considering PAIs, as per Morningstar.

Voluntary assurance against greenwashing 

Voluntary assurance by using the ISAE 3000 limited assurance framework provides a structured method for independent auditors to evaluate non-financial information, such as sustainability claims, ensuring these statements are both credible and aligned with the actual investments. Three main benefits of SFDR voluntary assurance can be highlighted:

• Ensuring reliability

Voluntary assurance requires independent auditors to assess the methods and data supporting SFDR disclosures, ensuring they are verified and conform to established frameworks such as the EU Taxonomy. This thorough evaluation reduces the likelihood of misrepresentation, thereby enhancing the credibility of the reported information and fostering trust among investors looking for dependable and credible ESG data

• Enhancing investor confidence
  

By providing an independent verification of ESG disclosures, voluntary assurance significantly boosts investor confidence in Article 8 and Article 9 Funds. As concerns about greenwashing grow, investors increasingly seek transparency regarding sustainability claims. Third-party audits act as a strong indicator of a fund’s commitment to its ESG objectives, empowering investors to make well-informed decisions. When funds exhibit accountability through independent assurance, they are better positioned to attract and retain LPs, especially those with a focus on sustainable investing. 

• Mitigating the greenwashing risk
  

Voluntary assurance enables fund managers to reduce the reputational risks linked to greenwashing or greenlighting. With regulators and stakeholders increasingly scrutinizing sustainability claims, funds that do not fulfill their stated objectives risk harming their reputation with negative impact on their ongoing or future fundraising. Through a limited assurance engagement, fund managers can proactively identify and rectify potential inconsistencies in their ESG practices.

What’s next?

Since 2018, the EU has continuously refined and expanded its sustainable finance framework, and it is fair to assume that this trend will persist in the future, driven by the increasing urgency of addressing climate change, environmental degradation, and social inequalities. 

Another expected development lies with the future adoption of the International Standard on Sustainability Assurance 5000 (ISSA 5000), a newly proposed framework by the International Auditing and Assurance Standards Board (IAASB). The ISSA 5000 is expecting to provide clear guidance on sustainability assurance engagements as compared to the currently used ISAE 3000 framework covering all types of assurance engagements. Currently under review, the final version of ISSA 5000 should be issued by the end of the year 2024. 

As far as SFDR is concerned, past years have witnessed the emergence of the “SFRD Article 8+ funds” terminology, created by financial market participants, to distinguish between SFDR Article 8 funds that have made sustainable investments and those that have not. While this terminology is not officially recognized in the regulation it is interesting to note that there is a willingness from the market to differentiate SFDR Article 8 funds.

In this rapidly evolving regulatory environment, voluntary assurance on SFDR funds will undoubtedly play an important role and may end up being a game changer for many investment funds.