Investors, regulators and other stakeholders in the capital markets are applying more scrutiny to sustainability claims made by investment firms and fund managers. To help address the question “what comprises a sustainable investment?” S&P Global Sustainable1 has developed a new framework based on the definition used in Article 2(17) of the EU Sustainable Finance Disclosure Regulation (SFDR).
In summary, the SFDR defines a sustainable investment as investing in an economic activity that contributes to one or more of the environmental or social objectives it specifies, that such investment does not significantly harm any of the objectives, and that the investee companies practice good governance.
The EU Sustainable Finance Disclosure Regulation definition
“Sustainable investment” means 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.
Source: EU Sustainable Finance Disclosure Regulation Article 2(17)
This blog unpacks the three screening criteria considered within the S&P Global SFDR Sustainable Investment Framework. At a high level, only a fraction of companies in a sample of about 12,000 meet all three criteria to be considered sustainable investments, based on the S&P Global SFDR Sustainable Investment Framework. This finding indicates there is a high bar to clear for investment firms and fund managers seeking to describe funds or other investment products as sustainable.
Step 1: Good governance screening
The entry point to the S&P Global SFDR Sustainable Investment Framework is the assessment of corporate governance practices. To pass this screen,certain primary criteria must be met. First, a company must have a comprehensive code of conduct, or the company must be a UN Global Compact signatory. Additionally, a company must also show no evidence of major controversies related to employee relations or to tax compliance. When we apply our good governance screen, this eliminates 24%of companies from the initial universe.
Step 2: Do no significant harm (DNSH) screening
A more challenging consideration to account for when categorizing sustainable investments is the concept of “do no significant harm” (DNSH).
The S&P Global SFDR Sustainable Investment Framework DNSH component begins with a focus on media scrutiny — assessing whether companies have been involved in any severe environmental, social and governance (ESG) controversies during the past three years.
Following that, the S&P Global SFDR Sustainable Investment Framework assesses companies’ involvement in controversial business activities, such as controversial weapons, coal or tobacco. S&P Global’s Business Involvement Screen dataset, which underpins the DNSH screen, measures companies’ direct and indirect exposures to specific products and services, quantified as percentages of total company revenue.
The third layer of DNSH involves a rigorous review of the environmental mandatory Principal Adverse Impacts (PAIs), as defined in an April 2022 supplement to SFDR, and assessing whether companies emit beyond intensity thresholds deemed significantly harmful. PAI intensity thresholds are established both within a company’s sector classification and on an industry-agnostic basis.
Finally, based on the Board Gender Diversity PAI, the S&P Global SFDR Sustainable Investment Framework screens out firms with more than six board members if they lack female representation. Smaller boards are exempted from this screening and the impact of sudden exclusions is mitigated by utilizing the last three years of board diversity data.
The crux of the overall DNSH component is to evaluate the extent to which companies engage in business dealings or practices that detract from the EU’s established environmental or social objectives (Table 1). For example, consider an energy company with a power generation mix relying primarily on thermal coal, undermining the EU's climate change mitigation goal due to its high carbon footprint. This hypothetical company could be screened out on the basis of a business activity (coal) or PAI intensity above the established threshold.
About 76% of the total universe of companies pass the DNSH screen on a standalone basis, with only 60% of companies clearing both the good governance and DNSH screens.
Table 1: Sustainable objectives considered in the S&P Global Sustainable SFDR Investment Framework
Objective | Theme | Source |
|---|---|---|
Climate change mitigation | Environmental | |
Climate change adaptation | ||
Sustainable use & protection of water & marine resources | ||
Transition to a circular economy | ||
Pollution prevention & control | ||
Decent work | Social | Platform for Sustainable Finance, Final Report on Social Taxonomy |
Adequate living standards & wellbeing for end users | ||
Inclusive and sustainable communities & societies |
Step 3: Positive contribution assessment
The third and final layer of the S&P Global SFDR Sustainable Investment Framework is the assessment of positive contribution. A company is deemed to make a positive contribution if it has significant involvement in business activities linked to the SFDR’s environmental or social objectives (Table 1) or has established demonstrable best practices on the environmental or social objectives throughout its entire value chain.
The business activity-based approach to measuring positive contribution focuses on materiality and predominance. Materiality is considered based on the criticality of a product or service in the achievement of a particular objective within the context of a given sector. Predominance considers whether products or services produced by a particular business activity are mainly utilized in applications relevant to a given objective.
Take residential housing development as an example of how the assessment is applied. The business activity of building residential properties materially contributes to the provision of basic housing requirements. However, given this business activity is not exclusively, or even primarily, dedicated to the construction of affordable housing, it would not be deemed a positive contributor.
The business activity-focused approach serves as a strong top-down methodology but in select cases may eliminate companies based on industry-specific factors.Therefore, we also consider the implementation of sustainability best practices within a company’s value chain. To do so, we selected six sustainability-linked questions from the S&P Global Corporate Sustainability Assessment and considered company strategy and implementation around these topics. In addition, we use the S&P Global Trucost Paris Alignment dataset to identify which companies are making a positive contribution by aligning their practices with the Paris Agreement goal of limiting the average global temperature increase to less than 2 degrees C compared to preindustrial levels.
This approach offers an alternative pathway to prove positive impact, particularly for companies operating within industries traditionally viewed as less sustainable. About 38% of the companies assessed in our universe are considered positive contributors.
When applying all three components of the S&P Global SFDR Sustainable Investment Framework — good governance, DNSH and positive contribution — to the universe of more than 12,000 companies, 24% of companies could be considered “sustainable investments.” In other words, more than three-quarters of companies in our analysis do not pass as sustainable investments.
This initial study is only a small glimpse into the evolving landscape for sustainable investment classification. This is a topic that is key for investors seeking to allocate capital sustainably and for companies seeking to attract outside investment while bolstering their corporate sustainability efforts. The S&P Global SFDR Sustainable Investment Framework is primarily intended to serve financial market participants seeking guidance on fund labeling under EU regulation; butour framework also has application in a global context, where debate around the definition of sustainable investments is ongoing.
