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 in 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:

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 the other categories, no such proportions need to be disclosed.

This requirement is the same for both Article 8 and Article 9 funds. The difference between Article 8 and Article 9 is that Article 8 funds can allocate assets quite freely within all of the listed categories, while Article 9 funds should generally make only investments that classify as sustainable. Article 8 funds don't necessarily need to include any investments that classify as sustainable.

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. Upright net impact ratio is 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. As discussed in the policy options section (pages 100-103) of the SFDR regulatory technical standards, this is an intentional omission.

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.

There are two main options:

1. Consider the amount of harm (e.g. tonnes of hazardous waste) in relation to the size of the company, using e.g. revenue as a proxy for its size.

2. Consider significant harm in relation to the size of the positive impacts of a company. This is aligned with the concept of net impact, meaning that investments with clearly positive net impact are necessarily also in line with the DNSH principle.

Both options have their advantages:

• Option 2 robustly takes into account the scale of multiple impacts in different categories and works well in combination with using net impact ratio as a sustainability indicator.

• Option 1 is easy to apply on specific impact categories (e.g. GHG emissions) or dimensions (e.g. environment).

Since both approaches have their merits, the best option is to use a combination of both. Later on in this document, guidance will be provided on how to do that 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 that the net impact ratio of each investment ought to be non-negative.

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 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). This makes the scope of Article 8 funds very large, meaning that the criteria used for individual investments having E/S should also be flexible.

Applying Upright data

This document uses classic units

This indicative guideline is using Upright's "classic" units, instead of the recently introduced money-based units (i.e. impact cents per dollar).

An updated version using the new money-based units will be made available soon. Both units are available via the Upright Platform and API.

Contact your Upright contact person for more information.

Background

The Upright net impact metrics include indicators for positive and negative impacts within 4 dimensions and 19 impact categories that comprehensively capture the impact of a company on the outside world. Additionally, Upright provides a net impact ratio indicator, which relates the size of positive impacts to the size of the 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.

Hard vs. soft limits within classification criteria

A key choice in defining the criteria for classifying investments is to decide whether to use hard or soft numeric limits. Hard limits are a good choice for asset managers valuing maximum transparency and simplicity, while soft limits leave room for qualitative considerations (e.g. companies' positive transition initiatives).

The indicative criteria provided in this guide are based on soft limits. If using hard limits, Upright recommends conducting especially careful pre-analysis to make sure that the kind of investments that are targeted as part of the strategy are not excluded by the limits, and to make any necessary adjustments.

Use of aggregate-level criteria

This documentation is about classifying investments. 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 the following criteria for positive contribution:

• The sum of positive impact scores within relevant impact categories must be higher than +3.0 and the net impact ratio should be positive, OR

• The investee's taxonomy-aligned revenue, CapEx, or OpEx must be greater than 10%.

If the above criteria is not satisfied, the investee must have a credible plan to create a significant positive contribution to the environment or society in the future.

Info

Upright provides three scores for each impact category, the net score, the negative score, and the positive score. The net score is a sum of the negative and the positive score, such that e.g. for a positive score of +5.0 and a negative score of -3.0, the net score is 2.0.

The criteria refers to the sum of positive scores. Assuming that the positive scores for other impact categories are zero, for example a positive score of +2.0 for GHG emissions and a positive score of +1.5 for waste would satisfy the criteria, as their sum +3.5 is greater than +3.0.

Note that it would also be valid to define the criteria based on net scores, rather than positive scores. Positive scores were chosen for use in this guide due to them being conceptually slightly simpler than net scores.

The impact categories listed in the table below are considered relevant:

EU category	Upright dimension	Upright impact category
Environment	Environment	GHG emissions
Environment	Environment	Non-GHG emissions
Environment	Environment	Scarce natural resources
Environment	Environment	Biodiversity
Environment	Environment	Waste
Social	Society	Societal infrastructure
Social	Society	Societal stability
Social	Society	Equality & human rights
Social	Health	Physical diseases
Social	Health	Mental diseases
Social	Health	Nutrition
Social	Health	Relationships
Social	Health	Meaning & Joy
Social	Knowledge	Knowledge infrastructure
Social	Knowledge	Creating knowledge
Social	Knowledge	Distributing knowledge

The threshold of +3.0 has been determined based on Upright impact scores of taxonomy-aligned products and services within relevant impact categories, such that all taxonomy-aligned products will be considered to have positive contributions (with a few exceptions).

This approach is based on the idea of using the EU taxonomy as a list of example products that are considered to have positive contributions in line with the intentions of the EU regulation. While the EU taxonomy is not a comprehensive list of sustainable products, it can be used to understand the scale that positive contributions ought to have.

Detail

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.

Usage of future scenarios

Especially for PE or VC funds that invest in startups that don't yet have much impact, it may be relevant to consider what the estimated impact of the company would be in the future when it has scaled its operations to a certain size.

In addition to PE/VC funds, usage of future scenarios may also be relevant for funds with investment strategies that focus on improvement rather than companies whose activities are already sustainable.

Suggested criteria for environmental or social characteristics

Upright recommends the following criteria for environmental or social characteristics (E/S):

The sum of positive impact scores within relevant impact categories must be higher than +1.0 and the net impact ratio should be positive.

If all of the above criteria are not satisfied, the investee company must have a credible plan or ongoing initiatives that promote environmental or social characteristics in the future, to classify as having environmental or social characteristics.

The impact categories listed in the table below are considered relevant:

EU category	Upright dimension	Upright impact category
Environment	Environment	GHG emissions
Environment	Environment	Non-GHG emissions
Environment	Environment	Scarce natural resources
Environment	Environment	Biodiversity
Environment	Environment	Waste
Social	Society	Societal infrastructure
Social	Society	Societal stability
Social	Society	Equality & human rights
Social	Health	Physical diseases
Social	Health	Mental diseases
Social	Health	Nutrition
Social	Health	Relationships
Social	Health	Meaning & Joy
Social	Knowledge	Knowledge infrastructure
Social	Knowledge	Creating knowledge
Social	Knowledge	Distributing knowledge

The criteria is a loosened version of the positive criteria for sustainable investments, in line with the fact that environmental or social characteristics are a looser requirement in terms of sustainability than sustainable investment.

Suggested DNSH criteria

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

• The net impact ratio of the investee company should be non-negative, AND

• The negative score for the Environment dimension should not be less than -8.0, AND

• The negative score for the Society dimension should not be less than -2.0

If all of the above criteria are not satisfied, the investee company must have a credible plan to address the issues in the future.

Detail

Upright provides three scores for each dimension, the net score, the negative score, and the positive score. The net score is a sum of the negative and the positive score, such that e.g. for a positive score of +5.0 and a negative score of -3.0, the net score is 2.0.

The criteria refer to the negative scores. For example a negative score of -9.0 for the Environment dimension would fail the criteria, as it is less than -8.0.

It would also be valid to define the criteria based on net scores, rather than negative scores. Negative scores were chosen for use in this guide due to them being conceptually slightly simpler than net scores.

The thresholds have been determined based on Upright impact scores of products and services that meet the positive contribution criteria and are taxonomy-eligible but not taxonomy-aligned.

This approach is based on using the list of non-aligned but eligible products as examples of products that fail the DNSH test in line with the intentions of the EU regulation. While this is not a comprehensive list of products that fail the DNSH test, it is used as an example to determine the scale that harm ought to have to be considered significant.

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 also taken into account.

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