How Sustainable is your investment?

According to the European Union’s Sustainable Finance Disclosure Regulation, or SFDR, an investment must satisfy three criteria to qualify as “sustainable”:

1. The economic activity of the investment must provide a positive contribution to an environmental or a social objective.
2. The investment does not significantly harm any other environmental or social objective.
3. The investee company must follow good governance practices.

Since the introduction of SFDR in 2021, there has been uncertainty across the investment industry, particularly about the interpretation of the notion of “sustainable investments”. Divergent interpretations have appeared in the market, which can be clustered into two main approaches:

1. Activity-based: the percentage share of a company’s revenue from positively contributing activities is considered its sustainable investment share, provided the “Do No Significant Harm” principle and good governance criteria are satisfied. For example, ABC Energy Company, with a split of 30% revenues from renewable power generation and 70% from non-renewable power generation, would have a 30% sustainable investment share.¹
2. Company-level: here the sustainable investment assessment is binary – yes or no – and is determined by an investment manager’s in-house methodologies and assumptions. Typical methodologies consider one or more of the following elements: a minimum percentage sustainable revenue share, a net-zero commitment, a top ESG² score performance or a specific key performance indicator. Using the same example, an investment in ABC Energy Company might be classified as a “sustainable investment” because at least 20% of its revenue is from renewable power generation.

The European Commission confirmed in its SFDR Q&A that the definition of ”sustainable investments” is non-prescriptive, and that investment firms must carry out their own assessments and disclose their underlying assumptions.