The Future of Sustainable Instruments

Financial markets are still aiming to identify the future design of sustainable financial instruments. New sustainability requirements create unanticipated complexities. What will sustainable instruments in the future look like? What is the current market position?

In December 2022, the European Securities Markets Authority published an empirical analysis illustrating the ripple effects seen in the market:

According to that analysis, immediately after the Sustainable Finance Disclosure Regulation became effective in the EU in 2021, the number of assets managed in funds only promoting environmental or social characteristics whilst not being sustainable investments itself – so called Art. 8 funds – grew significantly. In 2022, the picture turned around: Assets under management in those funds started to decline significantly.

At the same time, assets managed in funds qualifying as sustainable investment – so-called Art. 9 funds – grew steadily through the end of 2022, albeit slowly. By the end of 2022, this too changed. In Q4 2022, several large asset managers reclassified their Art. 9 funds into Art. 8 funds. Assets with a total value of 130 billion EUR thus lost their classification as sustainable investments virtually overnight. Around that time, the European Commission announced that Art. 9 funds need to basically exclusively consist of sustainable investments to qualify for that category – many of the funds previously qualified as Art. 9 did not pass this test. Since then, the number of Art. 9 funds in the market has been extremely small.

Are Art. 8 SFDR products the future?

Art. 8 funds currently comprise a broad range of funds. Funds qualify for Art. 8 if information is directly or indirectly disclosed or the impression is created that the investment sought through the funds somehow takes environmental or social features into account.

Art. 8 funds are thus a catch-all for a wide variety of products: from products with only slightly pronounced sustainability features to products that only just miss the requirements of Art. 9. The associated heterogeneity makes it difficult for investors to make distinctions within the group without studying the details of (pre-contractual) disclosure.

This interpretation of Art. 8 only slowly evolved. Initially, the qualification of a product for Art. 8 was perceived beneficial. Still, many investors aim at investing in Art. 8 products. However, this might turn out not to be as beneficial as expected: compliance with disclosure requirements under Art. 8 might not be trivial. Among other things, it requires the determination of measurable sustainability indicators that can be used to determine in retrospect whether and to what extent the promoted environmental and social characteristics have actually been fulfilled by the product.

There appears to be a certain risk, that some of the low bound Art. 8 products in the market may need to indicate in their reporting that they were not able to factually achieve promoted goals. This might then put investors into a difficult position.

Are there new sustainability risks?

The financial market is still in the process of calibrating its exposure to sustainable investments. The issuance of products qualifying as sustainable investment requires considerable effort. This creates a new form of sustainability risk: the risk that structuring and product costs have such a negative impact on returns that demand collapses and regulatory targets may not be achieved.

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Bernd Geier is a partner focused on finance, regulatory law, and funds. His practice covers the entire spectrum of regulatory issues (compliance), with a focus on the financial sector, including FinTech. He advises clients on financial market regulation, transaction structuring and optimisation, outsourcing law, as well as on new technologies (cryptocurrencies) and sustainability requirements (ESG)…Read more