Inaccurate ESG disclosures are among the major market risks facing EU investors this year, according to the European Securities and Markets Authority (ESMA).
“The misuse of the Sustainable Finance Disclosure Regulation (SFDR) as a marketing tool could create potential risks to investors as demand for sustainable products remains strong,” the regulator said in its bi-annual trends, risks and vulnerabilities commentary published on Thursday.
The EU’s SFDR, which will fully come into force in 2023, requires fund managers to self-identify their products based on the degree of ESG integration. The most ambitious tier, called Article 9, are for funds which prioritise ESG outcomes, while funds which merely count sustainability objectives among others are classed under Article 8.
ESMA noted that the SFDR is primarily a disclosure tool and does not “include the type of requirements usually attached to voluntary labels, prompting further concerns of potential greenwashing”.
Data cited by the regulator showed that a significant proportion of funds had changed SFDR status since the introduction of the legislation, with an initial rise in the number of Article 8 funds “upgrading” to Article 9 status, followed by a string of “downgrades” back to Article 8 in Q4 2022, affecting assets valued around $139 billion.
More recent market data from Morningstar has suggested that the downgrades were driven by passive equity funds, in particular those tracking the EU’s own flagship Paris-aligned and climate transition benchmarks. The European Commission is due to advise on whether EU climate benchmarks are eligible for Article 9 classification after confusion over their status.
The warning from ESMA may mark the first time that an EU body has publicly acknowledged the recent volatility in SFDR classifications following months of headlines on the subject.
In spite of this, investor demand for products with higher perceived sustainability credentials continue to be resilient, according to ESMA, with the share of ESG assets growing almost continuously over the past four years from 8 percent in Q4 2020 to 19 percent in Q4 2022.
ESMA separately flagged research suggesting that sustainability-linked bonds could be a “free lunch” for some issuers due to the size of the penalties incurred in the event of missing an agreed sustainability goal, which it said are usually “both small compared with the coupon rate, and uncorrelated with it”.
“For these instruments to bring meaningful changes will require addressing credibility issues, including regarding the sustainability targets and penalty mechanisms,” the regulator concluded.
More broadly, ESMA has said that it will “keep the overall risk assessment across its remit at the highest level” in anticipation of a global tightening of financial conditions, high inflation levels and high commodity prices.
In UK news, the Financial Conduct Authority today announced a market survey to inform future sustainability-related regulation. Stakeholders have been invited to respond to a discussion paper covering ESG governance, remuneration, incentives and training/certification in regulated firms. The initiative is open for feedback until 10 May.