Making the SFDR fit for Cleantech Innovation
June 14, 2022
Cleantech for Europe represents the vibrant ecosystem of EU cleantech innovators and investors who are developing technologies and business models to take the EU to net zero.
Our community includes 20 pioneer cleantech investors from 11 EU member states, with a track record of investing in more than 350 early-stage ventures for decarbonisation and sustainability. The innovative companies in which they invest are high-risk, often capital-intensive and need significant support to scale.
Scaling up the EU’s clean technologies is key to the EU’s future climate and industrial leadership – but needs significant funding to succeed. The Sustainable Finance Disclosure Regulation ("SFDR") has the potential to:
However, the early implementation of SFDR Articles 8 and 9 is showing significant issues. The flexible definition of Article 8 is already being used by a large number of funds with questionable sustainability records, while the stringent and historical-based assessment of ESG key performance indicators of Article 9 risks keeping sustainable front-runners out. The proposed disclosures are also very onerous for small investors.
In the below, we outline why the SFDR is a critical tool for the EU’s climate and industrial leadership and propose changes to ensure it encourages the investments in innovation we need to get to net zero.
The SFDR defines two sustainability categories for investment products:
The idea behind this classification is a potential game-changer for the uptake of cleantech, as it could direct vast sums of money to the development and deployment of the technologies the EU needs to get to net-zero.
Large institutional investors such as pension funds, insurance companies and banks are under increasing pressure from clients and the broader society to align their investments with a sustainable future. Most recently, the Glasgow Financial Alliance for Net Zero, convening leading financial market players, pledged to transform the global financial system to ensure that it can finance the transition to net zero.
While the SFDR was not designed as a labelling scheme, our experience in fundraising over the last year shows that it is already being used as one by market participants. Cleantech venture and growth capital fund managers report that calling a fund Article 9 significantly improves its chances of a successful fundraising.
This trend suggests that the SFDR is becoming a catalyst of sustainable investments across the EU.
But this sudden market demand, at a time when the SFDR is in early stages of implementation, poses serious challenges outlined in the following sections.
Any financial product can be classified as an Article 8 SFDR product provided that it ticks the box of promotion of environmental or social characteristics in its investment policy.
The European Supervisory Authorities acknowledged that "the scope of the products with environmental and social characteristics (Article 8) was intentionally drafted as a catch all category to cover all financial products with different environmental or social ambitions that do not qualify as sustainable investments according to Article 9 SFDR’’.
Data from Morning Star illustrates how Article 8 SFDR has been seized by traditional asset managers. 21.8% of funds available for sale in the EU have been classified as Article 8 funds. However, reports have shown that eight in ten of these funds are invested in fossil fuel companies.
The high demand for Article 8 SFDR products means vast sums of money are being re-allocated to funds investing in fossil fuels, only because they promote general sustainability characteristics. Despite their unsustainability, these funds compete with cleantech funds solely focused on sustainable investing and decarbonisation.
The SFDR defines Article 9 products as products which are "expected to make only sustainable investments".
Under Article 9 (3), there is a specific subcategory of products, which have as an objective the reduction in carbon emissions and must align with the EU Climate Transition Benchmark or an EU Paris-aligned Benchmark. The Paris benchmark requires a company reduces their carbon footprint by 7% annually.
However, in cleantech innovation, the sustainability of investments does not come from the company’s reduction of their own environmental footprint, but from the reduction their products or services can generate when sold to other companies. For instance, an early energy efficiency technology company may increase its environmental footprint as it scales its manufacturing. Nevertheless, the technology being manufactured helps reduce the emissions of its clients by a much greater factor.
The Technical Expert Group on sustainable finance, in its report on Benchmarks, highlighted that the methodology cannot be applied for cleantech indices. In addition, both the EU Climate Transition Benchmark and the EU Paris aligned benchmark focus on historical key performance indicators data, such as GHG intensity, which is not relevant for the early venture technology companies our members are funding. We want these companies to increase their emissions as they scale, to enable the rest of the economy to decarbonise. Key performance indicators should be based on potential for future impact, not historical emissions.
Traditional asset managers invest in large, publicly-traded companies which collect regular data on ESG performance and can have it audited by third parties. Venture and growth investors, on the other hand, invest in private, early-stage companies with few resources to collect the necessary data or to have it verified by third parties.
Our members’ experience suggests that the SFDR obligation to gather data on the ESG impacts of their investee activities is out of proportion as regards to their size. As the first source of information for the data recollection are investee companies ,in many cases these companies due to being in early development stages they cannot provide this information. They either do not track this data or this data is not readily available. This is for instance the case with Scope 3emissions, which small companies do not track, as they are not material to them. Simply put, the time and resources allocated to tracing the required data is time lost for scale-up efforts of breakthrough technologies.
Currently, there is inadequate data available to calculate and indicate principal adverse impact, whereas existing non-financial disclosure requirements are not able to deliver the required data to determine sustainability impacts.
Currently, a small financial player should consider the principal adverse impact of their investment activity and report it considering some key metrics including: GHG emissions; carbon footprint; exposure to companies active in the fossil fuel sector. On top of that, they have to complete an “actions taken” column into the template to be completed for each mandatory indicator “to give greater prominence to the engagement and other actions taken and planned by financial market participants” with respect to principal adverse impacts. Importantly, these metrics focus on quantifying the impact, but not illustrating a product’s real potential toward carbon neutrality. These burdensome requirements can deter innovation funding.
"Innovation funders are struggling to train their staff and put in place internal functions capable of gathering and processing such elaborate data."
Munich Venture Partners
The SFDR prescribes the use of the EU Taxonomy for precontractual and periodic disclosures, by requiring to which screening criteria each investee company fits to, and whether they align. However, as explained in our Taxonomy analysis, a large number of clean technologies are not yet included in the Taxonomy scope of activities (eligibility). Further, the alignment criteria are very onerous for small companies. This situation risks reducing the capital flow towards the scale up of the technologies we need most to get to net zero.
"We performed detailed analysis of the emission reduction potential of all our investments and check that they do no significant harm in any other area. We also only invest in companies with no technology lock in, and yet only 40% of our existing portfolio are covered under the Taxonomy technical criteria."
Partner, World Fund
There is also inconsistency between the SFDR and the Taxonomy in the interpretation of the ‘Do not Significant Harm’ (DNSH) principle. A Taxonomy-aligned investment which does no significant harm is not by default a SFDR sustainable investment. It also has to undergo the SFDR DNSH assessment. While in the Taxonomy Regulation, the principle relates exclusively to environmental considerations, in the SFDR it encompasses both environmental and social aspects. The different definition of the principle puts an additional financial burden on cleantech investors who will have to apply both an SFDR and Taxonomy DNSH assessments. The double consideration of the DNSH principle means that small investors would have to allocate significant resources to calculate and measure for the same product a separate list of indicators.
On top of the extensive reporting requirements, our affiliates report that the supervisory authorities in Member States have adopted different approaches as regards to the implementation of the SFDR. Diverging views on the implementation of the delayed until 2023 draft Regulatory Technical Standards has triggered unaligned approaches in different jurisdictions. For instance, the German markets regulator (BaFIN) is already asking for the classification under the technical screening criteria of all portfolio companies, going further than other regulators.
Lack of a consistent interpretation across Member States changes the competitive landscape for funds, as a fund reporting in Luxembourg or Spain would have much less overhead than a fund reporting in Germany. It also increases operational burden and legal uncertainty for cleantech, making it more difficult for cleantech innovation to scale up and fulfil the EU’s climate leadership promise.
