A primer on Article 9 - learnings and reflections from the field
October 10, 2024
Hadron collider or ‘core of things’. World’s largest and highest-energy particle collider.
Introduction
Why are we at Climentum Capital an Article 9 fund?
Article 9 funds are required to document sustainability and impact delivery with a high level of rigor. Therefore, data around Article 9 funds will serve as the most suitable proxy for understanding the state of sustainable & impact investing: whether it’s in line with the requirements of the European Green Deal and effectively addressing climate change.
Or, to put it in plain terms, data around Article 9 funds will show us whether money is flowing to where it’s needed to achieve an economy with net-zero greenhouse gas emissions by 2050.
In this series, we’ll demystify what being an Article 9 fund means. We’ll explain quickly and accessibly why they matter and why they are the most suited instrument to effectively address climate change while generating exceptional returns, transforming our industries, and achieving an economy with net-zero greenhouse gas emissions by 2050.
“The main consequence of the SFDR is that all investment funds must disclose to what extent they consider ESG factors in their investments.”
In 2021, the EU introduced its Sustainable Finance Disclosure Regulation (better known as the SFDR). The EU describes the new regulations as a transparency framework designed to enable investors and consumers to make more informed investment decisions and contribute to the sustainable transition.
The main consequence of the SFDR is that all investment funds must disclose to what extent they consider environmental, social and governance (ESG) factors in their investments. As a result, all European funds self-categorize as either an Article 6, 8 or 9 fund depending on their level of sustainability & impact orientation.
This move by the EU is a move towards making the financial sector more focused on sustainable and impactful investments. Specifically, it is an attempt to combat greenwashing by forcing European funds to be more transparent, while increasing flows to impactful investing.
However, confusion around the regulation remains. What do the different categories actually mean? How do funds prove that they qualify? Does it really prevent greenwashing? What does this mean for investors, founders and society as a whole?
This white paper addresses all of these questions. It is a jargon-free guide to everything you need to know about SFDR and Article 9 funds.
The guide is split into three sections.
SFDR simplified. We start by cutting through all the noise about SFDR. We explain the basics of what it is and how an Article 9 fund works.
The impact of the SFDR This section dives into the reasons behind the EU’s new legislation and the impact it has on all players involved.
The future of the SFDR. Here we explore the challenges surrounding the SFDR and, drawing on our own experience as an Article 9 fund, share our thoughts for how it could evolve.
SFDR simplified
What is the SFDR?
The SFDR, or Sustainable Financial Disclosure Regulation, is an initiative introduced by the EU in 2021. It is a transparency framework stipulating how financial market participants must disclose sustainability information, essentially forcing funds in the EU to categorize themselves as more or less sustainability and impact oriented - and to report accordingly.
One immediate purpose of the SFDR is to ensure that funds with self-proclaimed sustainability and/or impact objectives properly assess both the risks and the positive impact delivery. Funds can no longer claim to invest sustainably or deliver impact without proving it to a reasonable extent.
The SFDR’s wider purpose is to combat greenwashing in the financial market and attract more private funding to help Europe make the shift to a sustainable and net-zero economy.
What does the SFDR mean for investment funds?
As of February 2023, when the regulation came into effect, all funds must disclose their sustainability scope and categorize themselves as either an Article 6, 8 or 9 fund. The other articles making up the SFDR regulation (20 in total) do not describe fund categorizations, but relate to transparency in the financial market in other ways e.g. Article 7 makes Principal Adverse Impact (PAI) reporting mandatory for European financial market participants.
“Article 8 funds can pursue any kind of impact they want, whereas Article 9 funds must pursue impacts in line with the sustainability objectives of the EU.”
Every fund, regardless of whether it claims to be sustainability or impact oriented or not, must fall into one of three categories:
Article 6: Funds that do not have a sustainability or impact focus
Article 8: Funds that focus on at least one ESG metric (e.g. diversity), but it does not need to relate to the sustainability objectives of the EU, the fund can invest in anything (incl. oil & gas), and it is permitted to do harm vis-a-vis the sustainability objectives of the EU
Article 9: Funds that have impact toward at least one of the sustainability objectives of the EU as a primary objective, may not do harm toward the other sustainability objectives of the EU, and must document both impacts and sustainability to specified standards
The difference between Article 6, 8, and 9 funds
What’s the difference between Article 8 and 9?
While both Article 8 and Article 9 funds have impact objectives, it is important to understand that Article 8 funds can pursue any kind of impact they want, whereas Article 9 funds must pursue impacts in line with the sustainability objectives of the EU. Also, Article 8 funds can have impact objectives that are not related to the core business of the companies they invest in. As such, Article 8 is a good example of the common criticism of ESG ratings: companies in an Article 8 fund may well obtain positive ESG ratings (e.g. an oil & gas company with good policies and metrics on various ESG dimensions), while making no positive contribution to wider environmental or societal goals, or potentially causing significant harm to same. This is presumably the reason why Article 8 funds are not allowed to use “sustainability” (or other related terms) in their fund names as per ESMA’s guidelines.
This does not mean that all Article 9 funds actually deliver on their promise. Time will tell how many manage to execute properly and comply with the requirements - and how many (compliant or not) actually deliver toward positive impacts. Similarly, this does not mean that no Article 6 or 8 funds help deliver toward sustainability objectives. There are several cases of Article 8 funds that behave entirely as Article 9 funds, but are hesitant to commit to the administrative requirements of self-labeling as an Article 9 fund. Having said that, it seems reasonable to assume that funds will largely behave as their numbers imply.
What is a light green and a dark green fund?
To convey the difference between these funds, Article 8 and 9 funds have earned the labels “light green” and “dark green”. Climentum Capital can be called an Article 9 fund or a dark green fund - they mean the same thing.
“At Climentum Capital, the sustainable investment objective of our fund is climate change mitigation.”
What are the requirements of Article 9 funds?
In short, the requirements for an Article 9 fund are:
The primary investment objective is to deliver toward one or more of the sustainability objectives of the EU (see list below)
In this pursuit, the investments must not do any significant harm to any of the other sustainability objectives
The fund and its investments must live up to good governance practices, including transparently disclosing information about sustainability characteristics and societal impact
The EU sustainability objectives
The EU sustainability objectives are:
Climate change mitigation
Climate change adaptation
Sustainable use and protection of water and marine resources
Transition to a circular economy
Pollution prevention and control
Protection and restoration of biodiversity and ecosystems.
As an Article 9 fund you must specify which of the six objectives you are investing toward and which objective each specific investment is delivering towards. This prevents funds making multiple investments and trying to fit them into boxes later to earn the Article 9 label as an afterthought. A fund must also specify what this impact will look like, track progress, and report accordingly.
At Climentum Capital, the sustainable investment objective of our fund is climate change mitigation. Our impact comes from focusing on the decarbonization of industries, targeting solutions that 1) deliver at least 50% lower emissions than the dominant incumbent, 2) can deliver at least 100 KtCO2e emissions reductions per year by fund close, and/or 3) can deliver at least 100 MtCO2e emissions reductions per year at full scale by 2050.
The EU provides more detailed guidance for how to meet these qualifications, but some deem these requirements too vague.
How does a fund prove that it is an Article 9 fund?
Theoretically, any fund can claim to be Article 9. However, after labeling itself as an Article 9 fund, it opens itself to scrutiny by governing bodies in the fund’s given country and risks having the claim found false and being stripped of the label. This, in turn, is likely to create major problems with the investors in the fund, who can recall their capital and file lawsuits.
Market participants must document adherence to the Article 9 requirements via their website, in pre-contractual disclosure documentation, and in annual reports. In the case of Climentum, we have the following suite of assets:
Climentum Capital Article 9 documentation
Which investments qualify for an Article 9 fund?
This is somewhat specific to each fund, depending on its sustainable investment objective(s). As a climate tech fund, we have requirements focused on documenting emissions reductions. However most of our requirements relate to more general sustainability issues and thus resemble all other Article 9 funds.
In the case of Climentum, we have the following considerations when considering an investment:
To qualify as a sustainable investment in the Article 9 framework, Climentum requires each investment to meet at least one of the following criteria:
The solution delivers at least 50% lower carbon emissions vs. the leading incumbent solution
The solution has the potential to deliver >100 thousand tonnes of CO2e avoided emissions by 2032
The solution has the potential to deliver >100 million tonnes of CO2e avoided emissions at full scale by 2050
“Article 9 funds need to have a due diligence process that is strong enough to ensure that they live up to their Article 9 commitments.“
In addition, Climentum requires portfolio companies to:
Stay within the (Do No Significant Harm) “DNSH Thresholds” set by Climentum
Comply with the “Good Governance Policy” of Climentum
Comply with the “Exclusions Policy” of Climentum, i.e. not pivoting/expanding into excluded economic activities (e.g. weapons or pornography)
How do funds ensure that a given company meets their Article 9 requirements?
Article 9 funds need to have a due diligence process that is strong enough to ensure that they live up to their Article 9 commitments. Also, given the need to actually deliver documented impacts and ongoing sustainability (incl. doing no significant harm), funds must also actively engage with and support their portfolio companies after completing the investment.
The table below provides a high-level overview of the Climentum approach.
The Climentum approach to ensure Article 9 requirements in a company
How do Article 9 funds pursue positive societal impact without compromising financial returns?
In some circles there is a belief that embracing ESG and impact-oriented structures like Article 9 is at odds with maximizing financial returns to fund investors. On the one hand there is some logic to this, given that it costs more money to be an Article 9 fund vs. e.g. an Article 8 or 6 fund. Due diligence costs are generally higher and greater capability needs take up more resources. The expanded due diligence process can also cause investment timelines to lengthen, which can be an issue in “hot” markets and deals (when funds are competing to get into an investment opportunity). While these are costs and risks that have caused some funds to hold off on pursuing Article 9 status, there are effective ways to manage them. At Climentum we have dedicated resources allocated to highly streamlined processes, so costs are minimized and we have yet to experience a problem with an investment timeline.
It ultimately comes down to a question of whether you believe that 1) climate change is real and will have worsening effects over the coming years, and 2) the wider societal response will be to value solutions more highly (e.g. via policies and consumer behavior). If you believe in those things, you will want to invest in companies with truly impactful solutions, as these are poised to rise relatively more in value. Embracing the Article 9 framework is simply a logical way to maximize the likelihood of picking the winners. The aforementioned costs are simply a necessary part of making that optimized selection process.
“Our clear and singular impact commitment to delivering at least 1 million tons of CO2e annual avoided emissions at portfolio level is still rare among funds, even though this approach allows for greater transparency and accountability.”
What is a dual carry model?
At Climentum Capital we have a so-called “dual carry” model to ensure we meet both financial and climate impact goals. A dual carry model refers to a fund that has two main incentives, with carry indexed on both financial returns and impact delivery. Different funds set different impact targets related to different impact criteria like emissions reductions, poverty reduction, or gender equality. We, as an Article 9 climate tech fund, have set a portfolio-level target, where all of our companies combined must deliver at least 1 million tons of CO2e annual avoided emissions by the time we close the fund (earliest 2032). Failing this, we will only receive a portion of the full carry.
How effective are dual carry models?
Most funds use dual carry models where impact is determined on a case-by-case basis for each investment, which can change with advisory board approval. In effect, these targets are therefore moveable. Consequently, many funds use dual carry models as a way to claim they are impact-oriented. Meanwhile, if they fail to hit a target, they can simply be adjusted, with no real consequences for the fund. While this may be the most attractive approach for funds with impact targets that are not technically auditable to scientifically established standards (e.g. there is no engineering framework like LCA with ISO standards for measuring “poverty reduction”), we worry about the effects of this practice on the integrity of impact investing.
Our clear and singular impact commitment to delivering at least 1 million tons of CO2e annual avoided emissions at portfolio level is still rare among funds, even though this approach allows for greater transparency and accountability. As a fixed target where impact is quantifiable to established & auditable standards, we will clearly either succeed or fail, regardless of the mood in our advisory board.
However, while our approach is still the exception, we believe that it will increasingly become the norm, as funds and fund investors gain greater insights into the mechanics of impact documentation and also need to align more clearly with quantification efforts around e.g. Science Based Targets.
The impact of the SFDR
At its heart, article 9 was introduced with the intention of attracting private funding to address the major sustainability challenges, including contributing to the EU’s objective of achieving a net-zero economy.
In the EU Commission's own words, the Sustainable Finance Disclosures Regulation (SFDR) was primarily introduced to “help those investors who seek to put their money into companies and projects supporting sustainability objectives to make informed choices… [and] … to allow investors to properly assess how sustainability risks are integrated in the investment decision process.”
But the SFDR’s impact goes beyond investors. Its impact reaches all corners of society.
In this section we’ll provide more context as to why the SFDR was introduced, how it relates to other EU legislation, and the impact it will have on the key players involved.
“One way to view the relationship between Taxonomy and SFDR is to see the latter as feeding into the former. In other words: Article 9 funds that invest in early-stage companies can help their portfolio companies achieve Taxonomy Alignment when relevant. This is the approach that we at Climentum have taken.”
How does the SFDR promote EU green policy?
The SFDR is part of the EU's sustainable finance agenda, which is seen as a key pillar in supporting the successful implementation of the EU Green Deal. Approved in 2020, the European Green Deal is a set of policy initiatives aiming to promote a more sustainable European economy, with the key goal of reducing net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels, and an ultimate goal of realizing a climate-neutral economy.
The deal highlights transforming the EU into a modern, resource-efficient and competitive economy. To achieve this, it calls for investment in multiple areas of green technology, including clean energy and sustainable transportation and agriculture. This emphasis on investment implies the need for a transparent financial market so investors know which companies are truly sustainable & impactful. However, at the time of the deal’s launch in 2020, there was no standardized approach to sustainability reporting for the European financial market.
The SFDR, which came into force a little over a year after the EU Green Deal, in 2021, remedies this issue by creating a standard method of categorization for the European financial market.
The EU sustainable finance agenda
How does SFDR relate to the EU Taxonomy?
Because both pieces of regulation are related to classifying financial participants based on their sustainability and impact orientation, some confuse SFDR and the Taxonomy or believe they must be linked. The Taxonomy and SFDR were developed somewhat in parallel, so neither is foundational for the other. This has been a major cause for confusion in the industry.
Coming into force in 2020, the EU’s Taxonomy Regulation sets out four overarching conditions that an economic activity has to meet in order to qualify as sustainable. These four conditions are intertwined with the EU’s Taxonomy’s own environmental objectives, safeguards and screening criteria. You can find out more about them on the EU Commission's website.
Strictly speaking, Article 9 funds are not obliged to invest in economic activities that are Taxonomy aligned. Although this seems to be an intuitive connection, very young companies simply cannot live up to the requirements of EU Taxonomy Alignment. For example, Taxonomy Alignment often requires the company to have a full LCA developed to the highest standards to claim any impact, which is difficult and expensive for very young companies to do. It is not realistic for funds that invest in companies that are very young (Pre-Seed, Seed and even Series A) to assume any level of Taxonomy Alignment in the early years of the fund.
One way to view the relationship between Taxonomy and SFDR is to see the latter as feeding into the former. In other words: Article 9 funds that invest in early-stage companies can help their portfolio companies achieve Taxonomy Alignment when relevant. This is the approach that we at Climentum have taken.
What impact will SFDR have on fund investors?
The SFDR’s main lever is making it mandatory for funds to disclose to what extent they meet impact targets via the companies they invest in. This encourages both funds and investors into funds to reconsider their purpose and impact targets. Indeed, the advent of Articles 8 and 9 have led many fund investors (especially the larger institutional ones) to set targets for how much exposure they want to e.g. Article 9 funds, making it more attractive for fund managers to pursue such opportunities.
These categorizations are not designed to catch fund managers out, but are meant to serve as a guide, including to parties that invest in funds. As a fully committed Article 9 fund we invest in climate tech companies based on the conviction that, as the climate emergency intensifies, these solutions will become more valuable. With this profile, investors looking to allocate to funds toward addressing climate change may consider focusing on funds with a clear strategic focus in that direction - solidified with the Article 9 structure.
What impact will SFDR have on climate tech companies seeking investment?
Eligible climate tech companies may be put off by the costs of proving Article 9 suitability: the resources required to gather, validate and deliver necessary data points to meet reporting requirements, to develop and maintain LCA efforts, and prove ongoing capability. But many of these requirements are commonplace for any business, and the benefits far outweigh the costs:
Founders of climate tech companies which meet Article 9 criteria can access a larger investor group and access non-dilutive funding more easily.
Being a validated sustainability-forward company, they can expect better talent acquisition and retention.
There is potential for corporate acquirers and GFANZ-committed investors to offer an Article 9 premium in the future, which will help to boost the valuation of climate tech companies which fit Article 9.
“It is important to strike a balance between documentation & transparency requirements on the one hand and the operational burden placed on funds & companies on the other.”
What impact will SFDR have on society as a whole?
The ultimate goal of Article 9 is to bring positive societal change. With more funding being directed into sustainable & impactful solutions, a larger number of such companies are expected to grow past the early stages and succeed as businesses, delivering impact at scale.
Of course, this requires a continuous and preferably growing emergence of impact-oriented founders. Luckily, there seems to be a growing portion of both young people and seasoned professionals joining the ranks of aspiring impact entrepreneurs. At Climentum we specifically look for solutions to make industries more sustainable, low-carbon and circular. And for us, there certainly isn’t a shortage of what is commonly called “quality deal flow”. Furthermore, the fact that we operate as an Article 9 fund only seems to create a greater magnetic force between us and the founders we are looking for.
With a growing cohort of talented impact-oriented entrepreneurs as well as a growing cohort of Article 9 funds, there is room for optimism in leveraging technology and markets in the struggle for a more sustainable future.
Looking at the wider sustainable finance policy framework (incl. CSRD), there is one particular watch-out we should note: it is important to strike a balance between documentation & transparency requirements on the one hand and the operational burden placed on funds & companies on the other. If the burden is too large, adoption will be low, causing a downward spiral. Similarly, if requirements are too lax or ambiguous, impact will be too low and stakeholders will lose faith in the system - also causing a downward spiral. The situation is not perfect at this point, but the system seems to be working and hopefully the expected adjustments will improve the balance.
The future of the SFDR
The SFDR is a landmark piece of legislation in the EU’s mission to promote sustainable investing, to lay the groundwork for a greener economy that is ready to hit the EU’s net zero 2050 target.
It is also a relatively new framework that has faced some difficulties in its first years of implementation. Most of the criticism is related to vagueness, which has led to some intentional and unintentional greenwashing by funds. However, at its core, it is a positive piece of legislation whose impact should be very positive and stretch far into the future.
In this final part of our white paper, we explore the challenges surrounding the future of the SFDR and, drawing on our own experience as an Article 9 fund, share our thoughts on how it should evolve.
“The SFDR has the potential to become a stronger framework - in particular by introducing a more precise product categorization. Done properly, the SFDR would both increase its strength against greenwashing and increase its effect on channeling capital to higher-impact fund models.”
Does the SFDR prevent or promote greenwashing?
The SFDR, as a transparency framework stipulating how financial market participants must disclose sustainability information, should function as an effective tool against greenwashing.
However, the vagueness of some of the SFDR’s criteria has caused some to accuse it of opening the door to further greenwashing attempts. In 2022, Morningstar found that 23% of investment products labeled Article 8 don’t live up to the associated ESG principles.
There is some merit to these claims. When the SFDR first came into force in 2021, some funds endeavored to exploit the vagueness of the SFDR’s reporting requirements and claim Article 8 or 9 status despite having relatively weak sustainability objectives and capabilities. However, several national regulators were quick to investigate and reprimand these funds, resulting in some major upsets among fund investors. This set a new precedent and has clearly discouraged further greenwashing attempts - also because fund investors (especially the larger ones) have grown more capable of assessing funds on their sustainability and impact claims, including Article 9 commitments.
On balance, after a shaky implementation stage, the SFDR seems to now operate as a powerful tool against greenwashing in the EU.
How can the SFDR be improved upon?
The SFDR has the potential to become a stronger framework - in particular by introducing a more precise product categorization. Done properly, the SFDR would both increase its strength against greenwashing and increase its effect on channeling capital to higher-impact fund models.
To that end we participated in the formation of the “United for Impact” initiative in 2023, bringing together 47 impact funds from 16 countries to call upon the EU Commission to introduce greater clarity to the SFDR. The changes we have suggested are not about changing the fundamental aims of the SFDR - which we strongly support - but about tightening of the framework. Most notably the group is calling for a fund category that clearly states an impactful purpose. While most Article 9 funds use the label that way, there is room for less impact-oriented strategies to use the same label.
What is the EU doing to further develop the framework?
Aware of the challenges around the implementation of the SFDR in the first two years after launch in 2021, the EU commenced a formal consultation in 2023. This has since resulted in a proposal to draft a more precise product categorisation, including a new category specifically targeting impact solutions, introduced by the European Supervisory Authorities (ESAs) in June 2024. The wider proposal also includes improvements to the definition of sustainable investments and a simplification of the way disclosures are presented to investors.
How does Climentum Capital support portfolio companies in remaining aligned with Article 9?
Before we invest in a company we conduct an extensive due diligence, including all relevant sustainability and impact assessments. Once we are comfortable that the company qualifies as both impactful vis-a-vis GHG emission and sustainable vis-a-vis other sustainability objectives, we may proceed with the investment. Of course, this does not mean that the company will automatically remain both impactful and sustainable over time. This is why we provide support to our portfolio companies in this area, including impact documentation & reporting, long term impact strategy development, and ongoing strategy execution.
Part of this effort is to act as a shepherd to guide the companies through regulatory compliance, ensuring that they consistently meet Article 9 criteria and can reap the associated benefits to fundraising, talent acquisition & retention, and valuation.
In closing
With this article series we aimed to demystify SFDR and especially Article 9. We hope we have been effective in explaining why it matters and how it is suited as an instrument to effectively drive investment toward climate technologies. It certainly works for us at Climentum, where we operate as an Article 9 fund pursuing exceptional returns while transforming industries to become low-carbon, circular, and sustainable.
As we look to the future, we can easily imagine a world with less greenwashing, more impactful investing, and space for optimism in the fight against climate change. But risks persists, not least for regulatory overreach and ambiguity, causing paralysis in the ecosystem. Hopefully the constructive consultation-based process to date will deliver incremental improvements over time, strengthening and upward spiral of adoption and impact.
If you have any questions or comments, please don’t hesitate to reach out to us.
