- Under SFDR classifications, many funds are able to brand themselves green despite having exposure to dirty stocks.
- Asset managers are frustrated the disclosure rules are creating an unfair advantage for those who aren’t taking sustainability seriously.
- The EC has acknowledged the confusion and scrapped plans to use the SFDR categorisations as options to present to clients. But the damage may be done.
The EU’s new Sustainable Finance Disclosure Regulation (SFDR) continues to raise concerns – and hackles – among industry participants.
The latest issue? Around eight in ten funds labelled as sustainable (or ‘light green’) are invested in fossil fuel companies. This has sparked dismay among some asset managers, who feel that many of their peers are gaining an undeserved advantage as a result. A continued lack of technical guidance is at least partly to blame.
“It appears that with the implementation of the SFDR, the whole world has changed. But in reality it’s recolouring old businesses with new names,” says the head of a Europe-based emerging markets-focused infrastructure asset manager.
“It’s a slap in the face, of the people who have worked hard to produce real impact, to be put in the same box as [merely reclassified] products,” he adds.
“As long as there are no hard legal requirements, the industry simply has a new reporting standard – nothing more,” he adds. There’s a hell of a lot of noise, but very little action beneath the surface.”
Since March, European fund houses have been categorising their products as non-green (Article 6), light green (Article 8) and dark green (Article 9) under SFDR. These categories dictate the required level of reporting on the environmental, social or governance (ESG) impact of the fund.
As of the end of May, 31% of all European funds had been classified as either light or dark green, up from 24% in late March, according to research firm Morningstar. Many more are expected to follow.
Most of the products classified as light green under the SFDR contain fossil fuel investments, which in a few cases account for as much as 50% of the fund’s portfolio.
Since only the principles-based rule is in place, and lawmakers are still busy drafting the technical details, a range of classification approaches have emerged. As Capital Monitor reported in May, some firms have categorised most or even all their funds as light or dark green, although others have been far more cautious.
It is not news that some ESG funds hold oil and gas stocks. But it is such issues that EU policymakers were hoping to stamp out with SFDR.
One reason for fossil fuels appearing in sustainable funds could be that the product has a social objective, such as board diversity, rather than an environmental one.
“Sustainable investment means different things to different people – climate change is one issue, but a light green fund could have any number of environmental or social objectives,” says Fong Yee Chan, head of ESG strategy at US fund giant Vanguard in London.
“There are so many different types of products – climate solution funds, divestment funds, transition funds – but there’s very little guidance on what actually constitutes an Article 8.”
This is partly because it’s such early days and firms are only reporting at an entity level right now, says Maureen Schuller, head of financials research at Dutch bank ING in Amsterdam.
“The asset managers we’ve been in contact with have definitely wanted to show that they had as many funds as possible in the dark green category, and as few as possible in the Article 6 category,” she says. “A helpful thing about the regulation is that they at least have to show that it is sustainable if they say it is.”
In reality, however, the explanation required is minimal.
There are no numerical thresholds or targets for light or dark green funds – only a change in wording. An Article 8 fund must “promote” environmental or social characteristics, while an Article 9 fund “contributes to an environmental or social objective”.
Even the most basic screening process can be enough to qualify a fund as light green.
“The articles are so wide in their definitions that managers can take any social or environmental characteristics, no matter how minimal, and market their fund as sustainable,” says Kristian Håkansson, head of product and marketing at Swedish fund house SPP.
“It’s true that investing in fossil fuels doesn’t really fit the claim of ‘sustainable’,” says Schuller. “Many have proceeded for now because we just don’t have the technical details yet. Companies can be unsustainable in so many ways. You really need data to make distinctions.
“So we may see a shift towards more environmentally or socially sustainable companies over time,” she adds. “And that would not include fossil fuels.”
Defining 'sustainable'
Yet terms such as ‘sustainable’, ‘impact’ and ‘greenwashing’ are not yet enshrined in law, leaving them open to debate – a key issue when it comes to ESG investment. That debate most often crystallises around the engagement versus divestment question.
Most conventional ESG funds are made up largely of technology stocks – Amazon, Facebook, Alphabet and the other usual suspects. These have low carbon emissions. Investors can have a much bigger impact, so the argument goes, by targeting heavy emitters with active engagement policies. But that argument only flies if active engagement can be proven – which SFDR does not require.
It also comes down to a question of who these labels are really for.
“I don’t think the average retail client investing in a ‘sustainable’ fund, according to an EU regulation, would expect to be getting up to 50% exposure to fossil fuels. But it is perfectly allowed within the regulation,” says SPP’s Håkansson. The firm, part of Norwegian asset manager Storebrand, has categorised all of its funds as Article 8 or 9.
Admittedly, the European Commission has since March acknowledged the confusion and abandoned a previous plan to use the SFDR categorisations as options to present to clients. But the damage may be done: the articles have already become a common language across the market.
A continued lack of data
A major issue is that much of the data to support SFDR classifications isn’t available yet. For instance, one of the so-called ‘principal adverse impacts’ that funds must report on is waste management. But reporting against that metric would necessitate trawling through hundreds of annual reports.
Ultimately, half of the entire European market could be classified as light or dark green in the near future, says Hortense Bioy, global director of sustainability research at Morningstar.
“There’s a lot at stake with SFDR,” she adds. “Many asset managers don’t want to be left behind or seen as not even trying to promote environmental and/or social characteristics.”
Investors, meanwhile, may remain confused about the wide range of funds classified as light green, says Bioy. “From next year it should become easier to differentiate.”
Be that as it may, a mass reclassification of products is required because they were mis-categorised in the first place – as some are envisaging – which will hardly help build trust in so-called sustainable investments.
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