The deadline for ‘level 2’ of the Sustainable Finance Disclosure Regulation (SFDR) is fast approaching; however, there continues to be a lack of clarity and harmonisation across the European Union over the interpretation of the directive, according to Shane Coveney, partner at Dillon Eustace LLP.

Speaking to ETF Stream, Coveney (pictured) said SFDR is a “move in the right direction” despite the recent challenges faced by the asset management industry over the reclassification of products.

In the ETF industry specifically, the likes of BlackRock, UBS Asset Management and Amundi have all recently downgraded their ETFs from Article 9 to Article 8 amid concerns the strategies would not meet the ‘dark green’ requirements.

In this wide-ranging interview, Coveney highlighted the success of SFDR is focusing attention on ESG investing, the challenges around the availability of accurate data and why there has been confusion in the market over the different classifications.

How do you view the current success of SFDR?

When we look at the implementation of SFDR, there have been some challenges and issues that are still waiting to be clarified from the ESA. It has had relative success given investors are now looking at sustainable investing and the European market is now transitioning towards a more sustainable investment environment. As a result, it is becoming more front and centre in the discussion.

SFDR is a move in the right direction and the regulation will change how investing is done over the next five to 10 years. As we get further clarifications in relation to the disclosures and requirements that are there and how the data that is available is assessed, there is more likely to be strong adaptation to the documentation and more investor clarity.

What are the current challenges involved?

There are obviously issues at the moment around potential greenwashing, for example, whether a fund is Article 8 or Article 9. Given the distribution in Europe where investors are looking to buy Article 8 or 9 products while Article 6 is lower down the food chain in terms of flows, there is a question around how green is a fund.

Article 6 products do not take into account ESG in the investment process or, if they do consider ESG factors, do not promote ESG characteristics in the product. It may be a part of what they do but it is not front and centre. Article 8 products are ‘light green’ strategies that look at ESG issues but it is not the objective of the fund; these products promote environmental or social characteristics. Article 9 is for ‘dark green’ products where the objective of the fund is to have sustainable investments.

Looking at Article 8 funds, some are based on exclusion policies and have some sustainable investments within the product to promote environmental or social characteristics while Article 9 need to have sustainable investments as their objective which is the key distinction between the two.

There are also issues around Article 9.3 funds that designate as a reference benchmark a Paris Aligned Benchmark because they are Article 9 funds by virtue of SFDR but the investments themselves are in companies that are transitioning towards a better climate, so they most likely suit an Article 8 designation rather than an Article 9 designation. The ESAs have issued a question to the European Commission on this point and we await clarification. Therefore, we are likely to see more reclassifications over the next few months.

There seems to be a lot of confusion in the market. What is causing this?

Part of the issue for asset managers is the reliability of data required to show their product is an Article 8 or 9 fund. Nobody wants to be involved in greenwashing and be accused of it.

As a result, asset managers need to be able to show that what they have in their Article 9 fund is a sustainable investments and there is data to back it up. The regulator has been very clear in what it expects – the Central Bank of Ireland (CBI) came out with guidance last month – and through the whole process, it has been looking for greater information to be provided on applications.

If you run an Article 8 fund, for example, tracking a benchmark, you must have information on how that index is consistent with the ESG characteristics of the fund. The CBI has pushed on this and been very proactive in ensuring this is the case.

What has the reaction been from ETF issuers on SFDR?

Given the index-tracking nature of most ETFs in Europe, there has been reliance on index providers to ensure they have the additional information to guarantee they are providing Article 8 or 9 compliant indexes to the ETF Issuers. Transparency is key to this and there has been a lot of work on in the industry to enhance transparency.

ETF issuers have sought to obtain accurate data to permit them to oversee the sustainability of the components of the index and monitor the constituent construction of the relevant indexes which are being tracked. The annexes are proving difficult for some to populate in the correct manner that we would expect them to be. Primarily it is down to ESG characteristics of the fund and the percentage of minimum investment that you will have in ESG. There have been issues around Principle Adverse Impact (PAI) and how ETF issuers take this into account.

Unfortunately, harmonisation across the European Union on SFDR is still lacking. For Article 8 and 9 products in France, for example, asset managers are required to have a reference to ESG in the investment objective of the fund, otherwise, the product issuer is required to include a disclaimer. This is not a requirement in Ireland or Germany so the implementation across Europe has not been harmonised which we would hope would be the case.

How can Dillon Eustace help ETF issuers?

Having worked on a number of innovative ESG projects, and with years of experience advising in this area, our dedicated interdepartmental team can support our clients in responding to legislative and regulatory change and meeting the challenges and opportunities in doing so.

We engage with our clients to assist with keeping clients up to date with all the different developments and the continually evolving regulatory landscape.

In addition, we offer training to a number of our clients who have been trying to navigate the various different requirements and upskilling their respective teams. Our interdepartmental team assists with bringing together all the guidance that comes from the different bodies such as the ESA, CBI and European Commission and are assisting ETF issuers with the implementation of ‘level 2’ requirements and with the required website disclosures.

This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.