Is poor policy or heightened brand scrutiny to blame?
In a world where ESG factors guide investment choices and new categories of sustainability-focused funds emerge –such as the Article 6, 8, and 9 funds, under the EU’s Sustainable Finance Disclosure Regulation (SFDR)– we explore whether investors’ expectations of the companies within these funds are actually met.
Article 6, 8, and 9 funds provide asset managers and owners with the opportunity to invest in companies that align with specific sustainability objectives or characteristics, with Article 6 funds being the least restrictive and Article 9 funds expected to be the most sustainable products. Upon closer examination of the composition of these funds, it becomes evident that the majority of companies featured in Article 9 funds are also part of Article 6 funds or Article 8 funds.
Out of a sample of over 9,650 companies in Article 9 funds, only around 400 are not present in Article 6 or Article 8 funds. This pattern prompts the question: What distinguishes a company included in an Article 9 fund from one that is not?
To answer this question, we focused on controversies¹ related to human rights and compared two groups: one composed of companies included in Article 9, Article 8, and Article 6 funds, and another consisting of companies not included in Article 9 funds. In our analysis based on over 100,000 media sources, we discovered that companies within Article 9 funds are more likely to be involved in labor or a health & safety controversy compared to companies within the least sustainable category of Article 6 and Article 8 funds. However, this might not tell the full story. In fact, companies in Article 9 funds are more likely to have stronger policies regarding labor and human rights than their Article 6 and Article 8 counterparts, and the higher number of controversies might result from a higher degree of scrutiny from the public. Investors seeking a comprehensive understanding of the companies in their portfolios require granular data across multiple dimensions.
In this article, we delve further into the reasons behind the higher concentration of controversies in companies within Article 9 funds and highlight the importance of understanding the underlying indicators to make well-informed investment decisions.
SFDR Decoded: Article 6, 8 and 9 Funds
As stated above, there are several differences between Article 6 and Article 9 funds, which sit at the far ends of the spectrum outlined by the SFDR, which also includes an intermediate category of Article 8 funds. Article 9 funds have sustainable investments as their primary objective. These are sometimes referred to as “dark green” funds by the market. Article 8 funds make investments that promote either environmental or social characteristics, commonly referred to as “light green” funds. Article 6 funds comprise the rest of the fund universe. In this analysis, we focus on Article 6 and Article 9 funds since they are the most different.
It is worth clarifying that the SFDR is a disclosure regime, not a labeling regime. Therefore Article 6, 8, and 9 funds stipulate different levels of disclosure rather than representing labels (though much of the market treats them as de facto labels). This means that it is –in theory– possible for Article 6 funds to make investments that are just as sustainable (if not more) than Article 8 or 9 funds. Though we do not think this is a common practice, we can assume that Article 9 funds will invest more sustainably, showcasing a commitment to societal well-being alongside financial performance.
Analysis Overview
For our analysis, we used data for 2,400+ companies found in Article 9, Article 8, and Article 6 funds and 680+ not in Article 9 funds². All of them with headquarters in North America and Europe and a market capitalization of over $2 billion, making sure that both groups were comparable in terms of industry group mix, geographical representation, and market capitalization. We found that companies within Article 9, Article 8, and Article 6 funds have a higher concentration of human rights controversies (roughly 2 times more) than companies not included in an Article 9 fund³.
We considered that human rights-related controversies are those associated with the violation of working conditions, the violation of human rights within the company’s operations, and the sale of products with a negative impact on society. Our research found that the higher concentration of controversies within Article 9 funds persisted across the three different categories.
Note: Data shown for 2,458 companies within Article 9, Article 8, and Article 6 funds and 681 companies not in Article 9 fund. Source: Clarity AI
However, further analysis into these differences showed that size is a key factor determining the likelihood of a company having a controversy. Larger companies tend to stand out more, making them more susceptible to controversies that draw media attention. Nevertheless, when we control for size in the analysis we still find the same effect: the likelihood of having a controversy is higher for companies in Article 9 funds.
To further investigate the underlying causes of such a pattern, we analyzed the policies and processes that these companies have in place. We found that companies within Article 9 funds seem to be doing more to protect themselves against such controversies. For instance, companies in Article 9 funds have a higher percentage of human rights-related policies: these companies are 16% more likely to have a policy against forced labor, in favor of human rights, or protective of the employee's health and safety than their Article 8 and 6 counterparts.
In unraveling the intricacies of controversies within Article 9, Article 8, and Article 6 funds, our analysis paints a nuanced picture. While companies in Article 9 funds might face a higher concentration of controversies, their proactive measures reflect their commitment to addressing these challenges. Furthermore, the higher number of controversies might be a result of the fact that these companies face heightened scrutiny, leading to a higher probability that controversial issues are investigated for them.
The journey from raw data to insightful takeaways empowers investors to contextualize superficial analysis. Furthermore, it underscores the power of data-driven analysis in uncovering intricate relationships that shape the ESG landscape as the guide to informed investment decisions.
¹At Clarity AI we define controversies as any conflict between a company and its stakeholders related to ESG. In order to consistently source data on controversies, our Natural Language Processing (NLP) models analyze news published by trusted news sources and NGOs, with over 100,000 articles being reviewed on a daily basis. For this analysis, we focused on controversies of low to high severity.
²We selected a sample of funds for which we had controversy-related information for over 80% of the companies in the fund.
³We employed a Pearson’s Chi-square test to show that the differences between the two groups of companies are statistically significant
