Transition finance is widely regarded as an essential part of the march to net zero, though its omission from the EU’s SFDR has left Article 9 funds investing in transition companies vulnerable to attack.
Asset management giant abrdn is among managers that offer funds that seek to participate in companies’ climate transition, while at the same time carrying the Article 9 status under the EU’s Sustainable Finance Disclosure Regulation framework.
Under the SFDR, Article 9 funds must be made up entirely of sustainable investments, with the exception of cash and hedging instruments.
Sustainable investments are, however, defined differently under the SFDR and the EU taxonomy, making the concept “sometimes difficult for investors to understand”, says Aquila Capital chief sustainability officer Angela Wiebeck, who manages the Aquila European Renewables Fund.
To add to this confusion, experts are divided as to whether Article 9 funds can actually finance the transition of companies that are seeking to become more sustainable, while maintaining this label.
“Fundamentally, this concept of transition finance has been missed out of SFDR,” says law firm Ashurst partner Lorraine Johnston, arguing that in practice, Article 9 funds can only invest in existing sustainable investments, which will make up a high proportion of their portfolios.
“That doesn’t include a portfolio company or an asset that’s going from brown to green,” she says.
The EU’s legal framework does not have a formal definition for transition finance, an Ashurst note observes. The European Commission has, however, expressed a desire to support transition finance.
In June, when announcing measures intended to strengthen the EU’s sustainable finance framework, the European Commission said that it wanted to “ensure that the EU sustainable finance framework continues to support companies and the financial sector, while encouraging the private funding of transition projects and technologies”.
A consultation on the SFDR will take place in the autumn, which will consider the framework’s shortcomings. Transition finance will feature in the consultation.
“Financing transition stocks is a huge task which presents difficulties with codifying in taxonomy and regulation,” says EY financial services sustainable finance leader Gill Lofts, who does maintain that Article 9 status is compatible with transition activities.
Stricter rules
In the summer, the European Commission and the European Supervisory Authorities said asset managers have flexibility in how they define and measure what constitutes a sustainable investment.
The original guidance, which suggested stricter rules for sustainable holdings within Article 9 funds, has not been reflected in the proportion of sustainable investments they currently hold.
Only 14 per cent of Article 9 funds claim that they are 100 per cent sustainable, according to Jefferies, whose analysts observe in a note that “this is surprisingly low in light of the original recommendation from ESA”. It is unclear, however, whether asset managers are including the permitted cash and hedging instruments within this reporting.
Despite the requirement that Article 9 funds invest almost entirely in sustainable assets, some of these funds still invest in high-emitting companies.
“Although we have ‘transition’ in the name, the word transition for us looks more broadly at transitioning the economy from where we are today to a net zero economy, or a net zero world,” says abrdn investment director Thomas Leys, who oversees the Climate Transition Bond Fund, an Article 9 fund.
The fund uses capital expenditure to quantify companies’ contributions to sustainable goals. “We think that capex is the appropriate metric to look at for transitioning companies, because they’re spending money on supporting that environmental objective.” The fund excludes oil and gas companies from its portfolio.
“We’ve got companies in here that are transitioning themselves,” Leys continues, which are “high-emitting companies that we think have got ambitious, incredible decarbonisation targets”.
“We’ve got ‘enabling’ companies as well,” he adds. “Those are the companies that have got maybe a high carbon footprint, maybe a low carbon footprint, but they would be the ones whose product and services help others decarbonise.” Renewables operators and insulation materials providers fit into this category.
Leys describes the expectation that Article 9 funds invest entirely in sustainable activities, minus cash and derivatives, as “quite unrealistic”. The fund has a 75 per cent sustainable investment threshold.
“People were coming out and saying, ‘Well, how can you be 75 per cent minimum sustainable investment, it surely has to be over 90 per cent or 100 per cent?’. But unless you’re only buying pure-play companies, that doesn’t seem possible to us.”
The Ostrum Global Sustainable Transition Bonds fund sets its minimum proportion of sustainable investments at 80 per cent, and is entirely invested in sustainable bonds.
It too has Article 9 status while financing companies that are exposed to fossil fuels. The fund can invest in, for example, a utility company that is reducing its exposure to fossil fuels and has defined a net zero target, says Nathalie Beauvir-Rodes, senior impact bond analyst at Ostrum Asset Management.
“We want to make sure that when we invest into a green bond, we invest into a green bond issued by a company that has defined a credible transition pathway, and if not we engage with the issuer”, she says.
No significant harm
Some experts say they are unconvinced, however, that transition activities are easily compatible with Article 9 status.
Evgenia Molotova, Pictet Asset Management senior investment manager who co-manages the Pictet Positive Change Fund, says the fund was classed as an Article 8 fund instead of Article 9, as in Pictet’s view the latter’s requirements prevent transitioning companies from being added to the portfolio.
She points to the “do no significant harm” principle that Article 9 funds must assess their portfolios against.
“We are working with companies which potentially do some harm along with good things,” she says. Observing that regulators had an early focus on “best-in-class companies”, she adds that “companies in need [of] change and investment are not best-in-class companies”.
Earlier this year, the French markets regulator proposed that a proportion of Article 9 funds could include transition assets. The Autorité des Marchés Financiers suggested that market participants could rely on the transition plans published by companies — with companies needing to demonstrate the effectiveness of their transitions — or that the EU taxonomy could be expanded to define transition assets.
It acknowledged that adopting these approaches “will require several years of legislative design”.
Ashurst’s Johnston says the “SFDR is not a particularly well-drafted piece of regulation.”
“The whole purpose behind SFDR was this idea that it was going to reorientate capital towards a net zero carbon economy,” she says. “Arguably, transition activities [are] key to that, and that’s not what Article 9 permits.”
The article was amended after publication to explain that Angela Wiebeck manages the Aquila European Renewables Fund.