- The classification of funds under the EU’s new sustainable finance disclosure regulation continues to confuse, despite the latest attempt at clarification.
- Experts say the lack of clarity implies fundamental issues with the text of the rules that cannot be resolved by a question-and-answer document.
- Many are now questioning the usefulness of a regulation that allows such a broad range of funds to be labelled ‘sustainable’ with so few requirements.
How funds are classified under Europe’s new sustainable finance disclosure regulation (SFDR) remains clouded in confusion despite the EU’s attempt at clarification last week, fuelling louder calls for a root-and-branch review.
Since March, European asset managers 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 ESG impact of the fund.
A range of approaches to classification have emerged, as reported by Capital Monitor, some of which seem to have questionable alignment with the rules – much to the dismay of fund houses with well-established environmentally focused investment strategies. More than 80% of light green funds contain exposure to some fossil fuels, for instance (see chart below).
Some large houses, including Amundi and BNP Paribas Asset Management, have labelled more than half of their products as light or dark green, while others have been considerably more circumspect.
We’ve now safely established that no-one really knows what an Article 8 or 9 fund is. Victor van Hoorn, Eurosif
These divergent approaches, made possible by a lack of clarity or minimum standards under the SFDR, have prompted accusations of regulator-mandated greenwashing.
So when the European Commission (EC) on 26 July published a highly anticipated Q&A – a regulatory tool often used when the basic text of a regulation is unclear – many hoped it would set the record straight on fund classification. That has not been the case.
Confusion still reigns
“The Q&A restates the law but doesn’t go any further, which reinforces the point we have been making for some time now: a more comprehensive review of the SFDR is needed,” says Victor van Hoorn, executive director at the European Sustainable Investment Forum (Eurosif).
“It’s clear that the source of confusion – the classification of funds as Article 6, 8 or 9 – is baked into the regulation, and can’t be changed via Q&A or technical standards,” he adds. “We’ve now safely established that no one really knows what an Article 8 or 9 fund is, which is down to the way the legislation is written. So we will have to go back to that.”
Eurosif is not alone in calling for a fundamental overhaul of the rules – many campaigners, fund selectors and some asset managers have similar concerns.
“It’s odd that you can make relatively small changes to a fund for it to be Article 9 compliant,” says one senior executive at an asset manager-focused on emerging market infrastructure. One potential solution, he tells Capital Monitor, could be to split Article 9 into further articles to provide more differentiation for those products with a higher level of impact.
The EC did include plans for a review of the SFDR by the end of 2022 in its renewed sustainable finance strategy published in early July. Some fund managers that have spent time implementing the regulation – imperfect as it may be – were not happy about this prospect. It increases the likelihood that products might have to be reclassified.
In fairness, SFDR is the first and easily the most comprehensive attempt to tackle greenwashing in sustainable finance by any regulator. It will inevitably take multiple amendments – and missteps – to get right, as is the case with conventional financial regulation.
Of the 20 largest Article 8 funds, only one has ESG or a related term in its title – equity fund ‘Vontobel mtx Sustainable EM Leaders’ – compared with 18 of the top 20 Article 9 funds, according to a 27 July report by research house Morningstar (see table below). Article 8 and 9 funds now account for 30.3% and 3.7%, respectively, of the roughly €3trn ($3.6trn) of Morningstar-reviewed EU fund assets. Analysts expect half of all EU-domiciled funds to be classified as either Article 8 or 9 by the end of the year.
Interestingly, the report also shows that a third of SFDR dark green funds contain thermal coal exposure. It puts that down to “the relatively high number of climate-themed funds in the article 9 category that invest in companies that have built large renewable energy operations but still operate their highly intensive coal-fired electricity generation activities".
“Looking at the number of funds being classified as sustainable, and the range of funds within them, it’s quite scary how some seem to be interpreting the SFDR,” says Lara Cuvelier, sustainable investments campaigner at Reclaim Finance. The non-government organisation (NGO) is pushing for minimum standards for funds classified as light or dark green.
To be clear, no asset manager is breaking the rules here – as the latest Q&A seems to confirm. But it certainly raises questions around the rigour of the regulation and the purpose it is serving.
How is it the industry has only just started on the ESG journey but a third of all European funds are certified as green?
As campaigners and NGOs put it: how is it that the financial industry is only just getting started on the ESG journey – and continuing to fund climate-damaging activities, including bankrolling new projects – but a third of all European funds are certified as green by the regulator?
“No asset manager would willingly launch and classify a fund that didn’t meet the minimum regulatory requirements,” says Alastair Sewell, senior director of fund and asset management at Fitch Ratings. “The question is more around those minimum regulatory standards and the way different asset managers are interpreting them.”
Fitch’s analysis expects Article 8 to become the “de facto classification” for European funds.
Different name, same thing?
Many investment houses have reclassified existing funds from Article 6 to Article 8 since March, Morningstar notes. JP Morgan Asset Management upgraded 55 such funds in May.
Such developments are consistent with Sewell’s findings. “The moment SFDR came into force, we saw managers change the names and prospectuses of a vast number of conventional funds,” he says. “It seems many used this as an opportunity to repurpose decades-old funds to capitalise on this growing demand for sustainable products.”
In practical terms, this involves revising fund prospectuses and resubmitting them to the relevant national regulator, and possibly notifying shareholders of the update. It might also involve changes to the technical features of a fund, such as the benchmark, and potential divestment from certain assets.
For equities (around 50% of Article 8 funds and 62% of Article 9), that’s fairly straightforward, but for fixed-income products (29% of Article 8; 28% of Article 9), managers would need to wait for different bond exposures to expire. That helps explain why there was not a wholesale overnight shift on 10 March.
In spring 2020, the documentation of around two-thirds of all Fitch-rated money market funds contained ESG language. This is notable because, while these are ultra-short-term cash instruments, ESG-linked products typically have a considerably longer investment time horizon. Sewell says many of these products have now been classified under Article 8.
While the classification process is working in that it provides some clarity on the differences between funds, he adds, “that’s very different from whether it goes far enough to be acceptable or useful for end investors”.
"Regulatory risk is coming"
There is clearly more work to be done, Sewell intimates. “So far, ESG has been firmly in the reputational risk realm […] but the regulatory risk is clearly coming,” he says. “There is increasingly a burden of proof on the asset managers selling these products.”
That is also the case for private sector, independent ESG rating providers, which are yet another source of confusion for ESG investors. In the past two weeks alone, several influential watchdogs have raised concerns over the transparency of such ratings, the methodologies used and the uneven coverage of products.
They include the International Organisation of Securities Commissions, European Commission and the UK's Financial Conduct Authority.
Some form of SFDR shake-up looks inevitable, raising further questions, such as: what form will it take? How many products will need to be reclassified as a result? And what will that mean for investors’ portfolios?