Indicative guidelines for classifying investments in line with SFDR

This document provides information on using Upright data to classify investments in line with the EU Sustainable Finance Disclosure Regulation (SFDR).

No legal advice

Upright is an impact data provider. The contents of this document do not constitute legal advice, are not intended to be a substitute for legal advice, and should not be relied upon as such. You should seek legal advice or other professional advice in relation to any particular matters you or your organisation may have.

Background

The need for classifying investments

The EU Sustainable Finance Disclosure Regulation requires classifying funds into three categories:

• Article 6 ("grey")

• Article 8 ("light green")

• Article 9 ("dark green")

Conceptually, the difference in these three classes of funds is related to the sustainability promise they provide. Article 9 funds have sustainable investment as objective, while Article 8 funds merely have sustainable or environmental characteristics. Article 6 funds don't make any sustainability-related promise, while still possibly taking sustainability risks into account as part of normal risk management.

In addition to the fund's classification, Article 8 and Article 9 funds must disclose how (they plan to) allocate assets in terms of the sustainability of their investments. According to the regulation, the asset allocation must be stated using the categories summarized in the following table:

For Article 9 funds, pre-contractual disclosures must state the minimum proportion of investments within categories A, B, and C, and periodic reporting must disclose the actual proportion of investments within the same categories. For Article 8 funds, pre-contractual disclosures and periodic disclosures additionally need to disclose the proportion of investments within category D. Article 9 funds should generally make only investments that classify as sustainable, while Article 8 funds don't necessarily need to include any investments that classify as sustainable. Article 8 funds are required to make investments that promote sustainable characteristics.

Detail

Article 9 funds combine categories D and E into a single category called Not sustainable or Other.

The planned asset allocation must be stated in pre-contractual disclosures. Later on, the actual asset allocation must be reported as part of the fund's periodic reporting.

Other than for the categories related to the EU taxonomy, the EU regulations or their technical standards do not provide specific criteria for determining how investments should be sorted into the listed categories. Thus the criteria are left for the market to determine.

In this document, guidelines are provided for using Upright data to classify investments as sustainable or having environmental or social characteristics in line with the EU SFDR regulation. The guidelines are indicative and are not in any way binding for Upright's customers.

Definition of sustainable investments in the EU regulations

The EU defines sustainable investment as investments that contribute (significantly) to an environmental or social objective, while not doing significant harm to either of those objectives.

The definition of sustainable investment is provided in Regulation (EU) 2019/2088, Article 2, point 17 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 that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance

What is a positive contribution in the context of the EU regulations?

While the EU taxonomy lists some specific types of sustainable activities, the EU regulations do not provide a comprehensive rulebook for determining which activities, companies or investments can be considered sustainable.

The definition of sustainable investment mentions resource efficiency indicators as means for determining the sustainability of investments. The Upright net impact framework is essentially a resource efficiency indicator, as it captures both the resources a company uses and the value it creates with those resources.

The definition of sustainable investment requires that positive contributions must be either to the environment or society. While the EU taxonomy regulation lists some further environmental objectives, there are no exhaustive lists of types of environmental or societal contributions that should be considered.

What is significant harm in the context of the EU regulations?

While the EU taxonomy regulation provides some activity-specific rules for determining significant harm, none of the EU regulations or their regulatory technical standards provide a general rulebook or thresholds for determining what would constitute significant harm. Thus, what exactly constitutes significant harm is left for market participants to determine.

It is obvious that "significant" must be considered in some relative sense. For example, a significant amount of hazardous waste must be different for a small IT consulting company than for a large battery manufacturer. The amount of harm (e.g. tonnes of hazardous waste) can be considered in relation to the size of the company, using e.g. revenue as a proxy for its size.

Later on in this document, guidance will be provided on how to consider significant harm with Upright data.

What are environmental or social characteristics in the context of the EU regulations?

The concept of environmental or social characteristics (in short, E/S) is defined only vaguely in the texts of the EU SFDR regulation. It is a looser requirement than sustainable investment: all sustainable investments also have E/S characteristics, but not all investments with E/S characteristics are sustainable.

E/S investments that don't classify as sustainable are relevant for Article 8 funds. While they are not required to disclose what proportion of investments is E/S, they are required to disclose the binding elements of the investment strategy that ensure that the fund attains the promoted environmental or social characteristics.

What are binding elements?

In the context of the EU SFDR regulation, binding elements are rules for selecting investments that have been designed to ensure that the E/S characteristics (or in Article 9 funds, the sustainable investment objective) is attained. Each fund defines its own binding elements: an example of a binding element would be to require exceeding at least one set threshold for the positive score within one impact category.

While there has been little direct guidance on what kind of investments classify as having E/S, the available guidance on what kind of funds classify as Article 8 implies that the concept of E/S is highly flexible. The question of what kinds of funds classify as Article 8 was discussed in a European Commission guidance on 14th July 2021 as follows:

"Article 8 means that where a financial product complies with certain environmental, social or sustainability requirements or restrictions laid down by law, including international conventions, or voluntary codes, and these characteristics are “promoted” in the investment policy the financial product is subject to Article 8 of Regulation (EU) 2019/2088.

The term ‘promotion’ within the meaning of Article 8 of Regulation (EU) 2019/2088 encompasses, by way of example, direct or indirect claims, information, reporting, disclosures as well as an impression that investments pursued by the given financial product also consider environmental or social characteristics in terms of investment policies, goals, targets or objectives or a general ambition in, but not limited to, pre-contractual and periodic documents or marketing communications, advertisements, product categorisation, description of investment strategies or asset allocation, information on the adherence to sustainability-related financial product standards and labels, use of product names or designations, memoranda or issuing documents, factsheets, specifications about conditions for automatic enrolment or compliance with sectoral exclusions or statutory requirements regardless of the form used, such as on paper, durable media, by means of websites, or electronic data rooms."

In short, if the fund is marketed with even indirect ESG/Impact/Sustainability related promises, it should be at least Article 8 (if not Article 9). ESMA's report from the 14th of May 2024 further noted that any fund using ESG or Sustainability terms in their naming needs to be classified as Article 8 or Article 9. The report sets specific asset allocation thresholds depending on the terms used in the fund names. Funds using ESG terms need 80% of assets promoting sustainable characteristics, while funds using sustainability-related terms need at least 80% of assets allocated towards sustainable investments.

Applying Upright data

Background

The Upright net impact metrics include indicators for positive and negative impacts within four dimensions (environment, society, health, and knowledge) and under those 19 impact categories that comprehensively capture the impact of a company on the outside world. Additionally, Upright provides the net impact sum, which expresses the sum of positive and negative impacts.

The relative scores that Upright provides for impact dimensions and impact categories are relative to the size of the company, using revenue as a proxy for size.

Use of aggregate-level criteria

This documentation is about classifying investments in a fund. Article 8/9 funds may also choose to define investment criteria based on fund-level aggregate results, which can be effective in ensuring that overall objectives are met.

Suggested criteria for positive contribution

Upright recommends one of the following types of impact datasets for positive contribution: monetized impact or sustainable revenues. Passing one of the two criteria described below would qualify the company to have a positive contribution:

1. Monetized impact: Exceeding a positive impact score threshold in a specific impact category within the net impact framework OR,

2. Sustainable revenues: Exceeding an aggregate UN SDG revenue alignment of 50%

The specific recommended thresholds for each criterion are outlined below.

1) Monetized impact as positive contribution criteria

Positive contribution based on monetized impact uses net impact data as the metric for the criterion. For a company to pass this positive contribution criterion, it needs to exceed at least one of the thresholds for net impact scores listed in the table below. The unit for the net impact score thresholds is “impact cents per dollar of revenue.” More details on the monetary units of net impact can be found here.

EU category	Upright dimension	Upright impact category	Threshold
Social	Society	Societal infrastructure	6.8
Social	Society	Societal stability	5.4
Social	Society	Equality & human rights	2.5
Social	Health	Physical diseases	7
Social	Health	Mental diseases	3.3
Social	Health	Nutrition	15
Social	Health	Relationships	9.4
Social	Knowledge	Knowledge infrastructure	3.8
Social	Knowledge	Creating knowledge	4.4
Social	Knowledge	Distributing knowledge	10.8
Social	Social	Group of select social impacts*	13.5
Environment	Environment	Group of all environmental impacts**	3.6

Group thresholds

*For social impacts, there is a group threshold covering select impacts in addition to the individual category thresholds. The threshold is set for the sum of the impacts within the select categories. This additional social impact criterion captures sustainable companies that contribute simultaneously to multiple of the relevant social impact categories, but don't exceed an individual impact category threshold. The group threshold includes the following eight (8) impact categories: Societal infrastructure, Societal stability, Equality and human rights, Knowledge infrastructure, Creating knowledge, Distributing knowledge, Physical diseases, and Mental diseases.

**For Environmental impacts, the threshold of 3.6 is a group threshold for the sum of all environmental impacts in the Upright framework. The Environmental impacts are grouped due to environmental improvements typically occurring across multiple impact categories simultaneously (e.g., removing pollutants can result in improvements in water quality and biodiversity). Assessing positive environmental impacts as a whole usually leads to more meaningful results than assessing each environmental category separately. The environmental impact categories include the following five (5) impact categories: GHG emissions, non-GHG emissions, Scarce Natural Resources, Biodiversity, and Waste.

The absolute difference between the thresholds listed in the table above is due to the varying monetary size of impacts between the categories. Read more here regarding weighting and monetization of impacts.

To ensure the objectivity of the approach to define the monetized impact thresholds, Upright has benchmarked other relevant sustainable investment definition approaches, ensuring that the suggested thresholds produce a share of sustainable investments of key indices that reflect current market standards. Upright holds a unique position to comprehensively review and set the thresholds, as it has analyzed the impact of 50,000+ companies, enabling testing different thresholds for sustainable investments. The thresholds have been triangulated by ordering a company universe (MSCI ACWI IMI) by net impact scores, evaluating the companies with the largest positive impacts for each impact category, and benchmarking them towards the impacts of all products and services in the Upright model.

The table below lists examples of economic activities passing the monetized impact thresholds within each relevant impact category.

Upright dimension	Upright impact category	Examples of company activities exceeding the threshold
Society	Societal infrastructure	Housing Critical transportation Energy Water and sanitation
Society	Societal stability	Education services and solutions Media (following the principles of journalistic ethics)
Society	Equality & human rights	Increasing racial, economic or gender equality, or enforcing human rights
Health	Physical diseases	Healthcare Pharmaceuticals Medical technology
Health	Mental diseases	Psychiatric healthcare and pharmaceuticals
Health	Nutrition	Production, processing and distribution of nutritious foods
Health	Relationships	Connectivity services Software for forming and nurturing relationships
Knowledge	Knowledge infrastructure	Connectivity equipment Cybersecurity software and equipment
Knowledge	Creating knowledge	Research services Production of academic journals
Knowledge	Distributing knowledge	Education services and solutions Media (following the principles of journalistic ethics)
Social	Group of select social impacts*	Companies with some revenue contributing to different social impact categories at the same time
Environment	Group of all environmental impacts**	Renewable energy and low-carbon infrastructure Environmental remediation Products significantly more environmentally efficient compared to common alternatives Contributors to resource efficiency and circular economy

Exclusion of impacts on jobs and taxes

The Upright net impact model captures impacts in a broad sense, including Jobs & Taxes as part of a company's societal impacts. The EU regulations or their technical standards only provide a very broad definition of sustainable investment, leaving it unclear whether taxes & jobs should be considered. To be on the safe side, these are not included in the list of impact categories considered for significant positive contributions.

2) Sustainable revenues as positive contribution criteria

Positive contribution based on sustainable revenues uses UN SDG alignment as the criterion. For a company to pass this positive contribution criterion, it needs to exceed an aggregate UN SDG revenue alignment of 50% towards any of the SDGs. In Upright's UN SDG revenue alignment data, each company is assessed towards each of the SDGs and corresponding targets, to provide the aggregate metrics of a company's revenue aligned and misaligned to at least one of the SDGs.

The SDG revenue alignment data can be separated between environmental and social objectives, or considered jointly. Read more about the UN SDGs here.

The threshold of 50% UN SDG alignment is based on a combination of typical market practices, analysis of the alignment of the 50,000+ companies already modeled by Upright, and analysis from applying the threshold to key indices such as MSCI ACWI IMI.

Suggested DNSH criteria

Upright recommends the following Do No Significant Harm (DNSH) criteria for sustainable investments:

1. Monetized impact: Not exceeding a negative impact score threshold in a specific impact category within the net impact framework OR,

2. Sustainable revenues: Not exceeding a quantified UN SDG revenue misalignment towards any single goal of 50%

Note that the investor may choose to include both of the above criteria.

1) Monetized impact as DNSH criteria

For a company to pass the DNSH criteria using net impact, it can not exceed any of the thresholds listed in the table below. The unit for the net impact score thresholds are “impact cents per dollar of revenue”, more details on the unit can be found here.

EU category	Upright dimension	Upright impact category	Threshold
Social	Society	Societal stability	14
Social	Society	Equality & human rights	1.3
Social	Health	Physical diseases	10
Social	Health	Mental diseases	12
Social	Health	Meaning & Joy	6
Social	Health	Relationships	5
Social	Knowledge	Distributing knowledge	2
Environment	Environment	GHG emissions	12
Environment	Environment	non-GHG emissions	5
Environment	Environment	Scarce natural resources	4
Environment	Environment	Biodiversity	7
Environment	Environment	Waste	3.5

To ensure the objectivity of the approach to define the monetized impact thresholds, Upright has benchmarked other relevant DNSH definition approaches, ensuring that the suggested thresholds exclude a share of key indices that reflect current market standards. Upright holds a unique position to comprehensively review and set the thresholds, as it has analyzed the impact of 50,000+ companies, enabling testing different thresholds for significant harm within each impact category. The thresholds have been triangulated by ordering a company universe (MSCI ACWI IMI) by net impact scores, evaluating companies within key exclusion lists, evaluating the companies with the largest negative impacts for each impact category, and benchmarking them towards the impacts of all products and services in the Upright model.

2) Sustainable revenues as DNSH criteria

DNSH criteria based on sustainable revenues uses UN SDG alignment as the criterion. For a company to pass this DNSH criterion, it cannot exceed an aggregate UN SDG revenue misalignment of 50% towards any of the SDGs. In Upright's UN SDG revenue alignment data, each company is assessed towards each of the SDGs and corresponding targets, to provide the aggregate metrics of a company's revenue aligned and misaligned to at least one of the SDGs.

To ensure the objectivity of the approach to define the sustainable revenue thresholds, the 50% UN SDG misalignment criterion is based on a combination of typical market practices, analysis of the UN SDG misalignment of companies on key exclusion lists, analysis of the alignment of the 50,000+ companies already modeled by Upright, and analysis from applying the threshold to indices such as MSCI ACWI IMI.

The exclusion of companies based on net impact scores or UN SDG misalignment follows the intention of the DNSH criteria in the EU regulation, by mitigating adverse impacts towards any of the SDGs or any of the impact categories within the net impact framework.

Principal Adverse Impact indicators

In addition to Upright net impact metrics, Upright provides data for the mandatory SFDR Principal Adverse Impact indicators. Upright (or the EU SFDR regulation) does not provide thresholds for these indicators, but the regulation requires that they are taken into account and disclosed.

You may include additional criteria based on specific principal adverse impact indicators.

Suggested criteria for environmental or social characteristics

Upright recommends that similar criteria and thresholds are used for environmental or social characteristics (E/S) as for Do No Significant Harm (DNSH):

1. Monetized impact: Not exceeding a negative impact score threshold in a specific impact category within the net impact framework OR,

2. Sustainable revenues: The quantified UN SDG misalignment towards any single goal must not exceed 50%

Note that the investor may choose to include both of the above criteria.

Upright considers the DNSH criteria-based exclusion of companies with large negative impacts across the 14 net impact categories or the 17 UN SDGs equivalent to the promotion of sustainable characteristics. This approach reflects the typical market practice of Article 8 funds that mainly apply exclusion lists as their criteria. However, this criteria goes further by setting specific quantified impact data-based thresholds rather than using simple company-based exclusion lists. Hence, the criteria suggested for the promotion of E/S characteristics are the same criteria as suggested for the DNSH. As the criteria are the same for sustainable characteristics as for DNSH, the threshold and the basis for the thresholds are also the same. Find the suggested thresholds and their basis in the DNSH chapter above.