Fund managers can use adverse impacts to assess ESG performance, say EU regulators

Separately, Article 9 funds which have significant investments in non-ESG activities may be at risk of enforcement.

The sustainability performance of EU ESG funds can be assessed on the basis of their negative impacts on environmental and social KPIs, according to a new regulatory update from EU authorities.

This means that managers of EU ESG funds can cite reductions of negative impacts on a wide gamut of sustainability considerations such as diversity, water management and responsible business conduct – known within the EU’s sustainable finance rulebook as principle adverse impacts (PAIs) – as evidence of their product’s ESG credentials.

The ruling is significant for laying out an alternative route to assess and report the sustainability performance of ESG funds but is not a fundamental departure from the underlying principles of the EU’s fund disclosure regime. The typical approach to date has been to measure the alignment of fund exposures with the EU green taxonomy.

However, product alignment to the taxonomy is just one of several factors name-checked in the EU’s overarching fund disclosure legislation, the Sustainable Finance Disclosure Regulation (SFDR). ESG funds can also “take into account” PAIs and must abide by social safeguards, such as the UN Global Compact, according to SFDR rules published in 2021.

But the latest clarification may yet invite further questions from reporting entities and other stakeholders. While the concept of PAIs has been around for more than a year, it is considered to be the most challenging element of the SFDR, both for its extensive reporting scope and corresponding data challenges, and a lack of definitions and thresholds setting acceptable limits for exposure.

Victor van Hoorn, the outgoing CEO of EU ESG sector body Eurosif, said the update posed questions in relation to how organic improvements to investee companies would be differentiated from exclusions or divestments, and how products with different-sized assets might be compared.

The regulatory update came days after EU securities watchdog ESMSA suggested that specialised ESG funds (Article 9 funds) which have significant exposure to non-ESG investments could be at risk of enforcement.

EU ESG funds can either fall under the EU’s Article 9 fund category, referring to funds that have a primary social or/and environmental goal, or the less ambitious Article 8 designation, for funds that combine traditional and sustainability-related investment objectives.

According to a briefing on enforcing the SFDR “in order to combat greenwashing”, ESMA said that national authorities could consider sanctioning Article 9 funds where “significant proportions of investments do not comply” with the EU’s environmental objectiveness.

ESMA’s briefing did not provide information on what would constitute a “significant proportion” of investments but may indicate a gradual shift in the EU’s stated position that the SFDR is purely a disclosure and transparency mechanism, and not an ESG fund-labelling scheme.

Other instances of SFDR breaches which may require enforcement by national authorities include the non-disclosure of SFDR-required metrics after the new rules enter into force, “severely misleading” disclosures, and disclosures which do not match up to product marketing.

While the SFDR does not incorporate any direct penalties for non-compliance, the introduction of the rules via delegated act means that individual member states are able to apply and enforce the rules via their existing regulatory regime.

“For the avoidance of doubt, [national regulators] remain fully responsible for determining which course of actions would be most effective and appropriate to mitigate the supervisory risks and regulatory breaches identified at the individual and collective level,” said ESMA.