John Young, Debevoise
John Young, Debevoise

The EU’s Sustainable Finance Disclosure Regulation (the “SFDR”) set out to standardise, as much as possible, fund sponsors’ approaches to measuring and reporting on the ESG themes that they incorporate in their investment strategies. The SFDR is, to that end, a disclosure regulation, requiring fund sponsors to make specific and binding commitments on their integration of ESG.

However, it also introduced a definition of “sustainable investment”, which is an investment that contributes to an environmental or social objective while not significantly harming any other objective. Funds within scope of Article 9 of SFDR are required to commit to making only sustainable investments, while funds within scope of Article 8 of SFDR may commit to a proportion of the portfolio as qualifying as sustainable investments.

Sustainable investment concept under SFDR

The “sustainable investment” concept under SFDR is clearly important. Broadly speaking, it corresponds to an investment that generates environmental or social impact. The concept’s broad parameters are illustrated by the examples of the types of environmental or social objectives given in the definition in Article 2(17) of SFDR, which includes “an investment in an economic activity that contributes to an environmental objective as measured, for example, by key resource indicators on the use of energy” or as “an investment that contributes to tackling inequality or that fosters social cohesion, or an investment in human capital or economically or socially disadvantaged communities”.

In a recent Q&A on the SFDR, published by the European Supervisory Authorities (the “ESAs”) in November 2022, it was confirmed that “it is possible for financial market participants to create their own framework for their financial products as long as they adhere to the letter of Article 2(17) SFDR”, reflecting the principle that SFDR is primarily a set of disclosure requirements. On that basis, there is no particular indication that SFDR intended to change the current bases on which sponsors define and assess social or environmental impact, although the SFDR requires sponsors to implement a consistent process under the “do no significant harm” principle and to adopt a policy always to assess the “good governance” of sustainable investments.

Impact investing

Broadly conceived, “impact” investing is investing with a view to the positive social or environmental impact generated by a company, from its products or services, its operations or its supply and distribution chains. To date, sponsors have often used third-party frameworks to qualify an investment as generating impact, such as the Impact Management Project’s framework or the Sustainable Development Investment Asset Owner Platform that underlies the United Nations Sustainable Development Goals. Each of these frameworks requires the investor to define and measure the environmental or social outcome pursued, to define the stakeholders (which may be particular groups of individuals or the planet as a whole) that benefit and to have regard to any negative outcomes generated.

The ESAs asked a series of questions on interpretation of the sustainable investment concept in SFDR in September 2022, including:

  1. whether the “economic activity being carried out by the investee company [should] in itself contribute to an environmental or social objective (for example, an issuer investing in micro-finance activities in the developing world to assist in the development of socially disadvantaged communities)”; and
  2. whether “any economic activity [can] potentially contribute to an environmental or social objective simply because it is carried on in a sustainable manner by the investee company (examples: (1) an investee company manufacturing a product in a more environmentally sustainable way than its peers/the sector, or (2) an undertaking that stands out for its social impact, for instance through its HR management or the representation of women)”.

The broad definition of “sustainable investment” in the SFDR arguably allows a sponsor to qualify an investment as sustainable either by reference to the investment’s business model (which inherently “does good”, such as social housing) or by reference to an attribute of the business (such as low-emission manufacturing). However, the ESAs’ questions have introduced uncertainty in that respect, since they are as of yet unanswered, and the scope for the Commission to interpret the text of the SFDR in a restrictive manner is unclear.

Arguably, answers to the ESAs’ questions lie in the practices adopted by impact investors to date and the external frameworks mentioned above.

For instance, the Impact Management Project has adopted its “ABC” framework, where A stands for “Act to Avoid Harm”, B for “Benefit Stakeholders”, and C for “Contribute to Solutions”. “Benefit stakeholders” is where the company generates various positive outcomes for its stakeholders (its employees, communities, all the planet and people in general), such as a manufacturer that produces goods through the use of environmentally-friendly materials and production methods or actively “up-skills” its employees. This broadly corresponds to the ESAs’ second question above and the concept of an activity “carried on in a sustainable manner” rather than causing a particular social or environmental outcome. “Contribute to Solutions” is where the company generates one or more positive outcomes for otherwise underserved people and the planet, which broadly corresponds to the ESAs’ first question above and the concept of an “economic activity being carried out by the investee company [that] in itself contributes to an environmental or social objective”.

As another example, the Sustainable Development Investment Asset Owner Platform (the “SDI AOP”) provides a useful framework for measuring impact, focused on the contribution made to the UN SDGs through companies’ products and services (“solutions that contribute to the SDGs”) and potentially through “intermediate products or services” in its supply chain. The SDI AOP identifies a company as contributing to the majority of the UN SDGs through a direct link with the company’s products and services, although a small number of UN SDGs (such as gender equality and improved working conditions) are likely to be achieved primarily through a company’s operations or “conduct”, with the framework covering “Acknowledged Transformational Leaders” who contribute in this way. Under the framework, the majority of companies are classified on the basis of the share of revenues they derive from products and services that contribute to the SDGs, while, for some types of industry, alternative measures may be more appropriate, such as capital expenditure or electricity generating capacity.

The Global Impact Investing Network (“GIIN”) provides a broad definition of impact investing, based on four key elements: “Intentionality”; investing with a range of financial return expectations (from below market to market rates of return); investing across asset classes; and a commitment to measuring and reporting on the social and environmental performance of underlying investments. The GIIN defines “Intentionality” as investing intentionally to contribute to social and environmental solutions by putting forward an investment thesis to attain specific impact goals (“solve problems and address opportunities”), with a view to differentiating impact investing from broader ESG strategies, such as “responsible investing”. The GIIN has also published its IRIS+ framework to measure impact.


Another area of debate in impact investing relates to the concept of “additionality”. This is a criterion that is frequently mentioned by impact investors and somewhat challenging to define and measure. The FCA, in its consultation paper on its forthcoming Sustainability Disclosure rules, refers to this concept as “whether a proposed activity will produce some ‘extra good’ in the future relative to a specified baseline, typically the counter-factual in which the investment has not taken place”.

Put another way, it challenges the impact investor to prove that its investment – the equity or debt contributed, the activities of the company itself, and the engagement, if any, of investor – has definitely contributed to a social or environmental outcome that would not have otherwise occurred.

The FCA’s draft rules require firms better to define the link between a fund’s investment policy and the positive environmental or social outcomes promoted, either through active investor stewardship and engagement, by directing capital to assets in order to influence their asset prices and reduce their cost of capital, or by allocating capital to assets that offer solutions to environmental or social problems. Otherwise, the FCA has currently left open as to whether to require firms to disclose evidence of “additionality” in the context of impact investing.

In practice, where an investor acquires a minority equity interest in a company on a secondary basis, it will be extremely difficult to prove a link between its investment and a particular social or environmental outcome generated by the company. This is particularly so where the investor does not take part in any stewardship or engagement actions with the company. There is a theory in this context that investment in a company on the secondary market has a positive effect on share price and thus supports the company in its primary equity issues, but little empirical evidence exists to support this.

It is easier to prove the necessary link when directly funding the company’s equity or debt, such as through “green bonds”, although, for instance, it can be challenging to demonstrate how much of a bond’s proceeds are apportioned to new projects that would have otherwise occurred versus existing projects. Under the EU’s proposed green bond regulation, proceeds of the green bonds must be “exclusively and fully allocated” to Taxonomy aligned operating or capital expenditure. Even where the investor actively engages with the company (for instance, through a board seat), it may be difficult to demonstrate that it is the investor’s stewardship that constituted the “additional” element in affecting change.

The Impact Management Project provides material on how companies assess their contribution to an environmental or social objective, pointing out that, in many cases, various actors – from competing investors to government bodies to NGOs – seek to contribute to the same set of outcomes. Separate material on “Investor contribution” describes various strategies for investors to adopt to demonstrate their “contribution”.

These strategies include broad “signalling” by investors to the market that they consider impacts; active engagement with the investee company, and investment in complex or illiquid investments perceived as risky, where the investor provides capital on terms that may not be generally available in the market or accepts a lower financial return.

The Sustainable Development Investment Asset Owner Platform does not yet explicitly include “additionality” as part of the framework, noting that measuring this is a major challenge.

Practical approaches

The differences between the various frameworks highlight the clear challenges in defining impact investing.

Existing impact investing frameworks categorise investee companies that in themselves contribute to an environmental or social objective and, to a more limited degree, companies that carry on their activities in a sustainable manner as in scope, although arguably, the “hallmark” of impact investing is the former. Investment in companies that carry on their activities in a sustainable manner, such as companies with carbon transition plans, is in principle possibly in scope of impact investing. However, arguably, almost any business activity can be said to make an indirect contribution to one or more impact goals, and questions remain as to whether investing in companies by reference to their operations falls under the broader banner of “reducing harm” or “ESG screening” instead of impact investing. There are also challenges with this type of investment on measuring the benefits generated and providing any form of “additionality” discussed above.

That said, the EU Environmental Taxonomy for climate change mitigation includes as in-scope activities like low energy manufacturing or transport infrastructure, which are activities with the highest GHG emissions and that can substantially reduce their emissions, as well as activities that are themselves inherently transitional, such as renewable energy generation. There are similar examples in the Taxonomy that cover other environmental objectives.

Sponsors producing pre-contractual disclosures under SFDR in the context of the “sustainable investment” definition are best advised to build flexibility into their approach and to rely on both their judgement as to the impact to be generated for each investment and the information subsequently reported to investors in demonstrating their contribution to particular social and environmental objectives.

As an example disclosure for an impact fund under Article 8 or Article 9 of SFDR, and noting the current uncertainty raised by the questions asked by the ESAs in 2022, a sponsor could commit to investing in companies whose business model contributes (or is expected to contribute) to one or more environmental or social objectives, either directly through its core product or service, or indirectly through a particular aspect of its operating model, such as low carbon emissions arising from a manufacturing process which otherwise generates high emissions.