SFDR was not to intended to be a classification system. However, it has turned out to be so. There are 3 classifications of funds under SFDR:

This is further summarised below.

Article 6 Products

Article 6 is the default classification for funds and the one most appropriate for those with no ESG focus. This means that the fund does not have sustainable investment objective, nor does it embrace investment in assets with environmental or social benefits.

Sustainability disclosure

For Article 6 funds, incorporation of sustainability risks into investment decision making and the impact of sustainability risks on fund returns must be described in the fund’s prospectus (AIF) or Private Placement Memorandum (PPM). Where a fund manager does not consider sustainability risk in the decision-making process, the disclosure should explain why under the principle comply or explain.

PAI Statement

Article 6 products must publish a Principle Adverse Impact (PAI) statement or explain the choice not to. Financial market participants employing more than 500 staff are required to publish PAI statement. The PAI is a disclosure by the firm on possible harm that investment decisions may have on sustainability factors relating to environmental, social and employee matters, respect for human rights, anti‐ corruption and anti‐ bribery matters.

Article 8 Products

Article 8 can be funds promoted as ESG.

Article 8 products promote investments or projects with positive environment or social characteristics and with good governance principles, alongside other non-ESG characteristics. Such “promotion” could include screening out certain environmental and socially harmful investments or considering ESG ratings when making investment decisions.

While sustainable investment is not an objective of the product, it remains an aspect of the investment process. Article 8 products must calculate and disclose the extent of Sustainable-Investment Exposure.” See below for “calculating sustainable investments.”

Benchmark

If the investment product has a benchmark, the Financial Market Participant must disclose whether the benchmark is consistent with the product’s promoted characteristics.

Article 8 funds must also meet the Article 6 disclosure requirements.

Article 9 Products

Article 9 products are products that have a primary objective to target “sustainable investment.”

A sustainable investment is an economic activity that contributes to an environmental or social objective.

“DNSH”

Article 9 funds must comply with the ‘do no significant harm’ principle which means proving that the product does not in any way significantly harm any of the EU Taxonomy objectives.

Benchmark

Article 9 funds must also choose a benchmark index which aligns with the fund objective. The benchmark will then be used to measure achievement of the fund’s sustainable investment objective.

Article 2(17) of SFDR defines the term sustainable investment as:

– An investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy

Or

– an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration, and labour relations, or an investment in human capital or economically or socially disadvantaged communities

Provided that such investments do not significantly harm any of those objectives,

And

Provided that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff, and tax compliance.

For the purpose of the “Do not significantly harm” (DNSH) test, a list of PAI indicators must be considered.

The definition of “sustainable investment” leaves much room for interpretation, especially when it comes to the “do no significant harm” (DNSH) condition. Further, regulators haven’t specified any thresholds. Accordingly, the determination of what these should be has been left to the discretion of asset managers.

As above, For the purpose of the “Do not significantly harm” (DNSH) test, a list of PAI indicators must be considered.

PAI indicators are intended to show investors what adverse impacts a financial product may have on sustainability factors relating to environmental, social, and employee matters, respect for human rights, anticorruption, and antibribery matters.

There are 64 PAI indicators under SFDR.