Morningstar: Passive climate funds ‘could drop Article 9 designation’

Further downgrades from the highest SFDR classification are expected as the proportion of assets in ESG-designated funds crosses the 50 percent mark in Europe.

Morningstar has warned that the ongoing uncertainty over what qualifies as an Article 9 fund may lead to downgrades to Article 8, as the proportion of European fund assets in the two categories crosses the 50 percent mark for the first time.

In its latest overview of SFDR fund trends, the ESG services provider reported that almost 700 funds changed their classification under the EU’s sustainable finance disclosure regulation from Article 6 to Article 8 or 9 in the second quarter of this year, with the majority stepping from Article 6 to 8.

Despite Morningstar warning that SFDR reclassifications raised “legitimate” greenwashing concerns in a report at the start of the year, and subsequently culling 1,200 funds from its European sustainable fund universe, no funds in either the Article 8 or 9 category have reverted to Article 6, although 16 dropped from Article 9 to Article 8.

Hortense Bioy, head of sustainability research at Morningstar, said further downgrades are likely as clarifications emerge on what is permitted in an Article 9 fund. She highlighted passive funds tracking a climate benchmark as a segment to watch.

“There was a lack of clarity when SFDR was introduced last year,” she said. “Now the regulator little by little is clarifying some of the language, which is leading some asset managers to try and decide if their old interpretation matches the clarifications that are given.

“I think it’s probably only the beginning. One category of funds that are classified as [Article] 9 that are still being debated in the industry is all those funds that are passive and track climate benchmarks. There are lots of them, and it’s possible that those won’t stay at 9.”

Asked whether clients who thought they were investing in a dark green fund might be concerned to find their money was only in a light green one, Bioy said she had previously thought downgrades could bring reputational risk, although admitted, “I don’t know if that’s going to be the case, it depends on how [managers] engage with their clients, how they explain this.”

“I think they’re just going to have to educate their clients and say, well this is a fast evolving space. Initially it wasn’t really clear, now we’re getting further clarification so we have to change the way we do things.”

The funds reclassifying from dark to light green were mostly managed by NN IP, who dropped 10 funds including a sustainable equity fund with close to €3 billion. Pimco dropped four, including three debt funds with €5.5 billion between them.

NN IP said the changes were based on recent clarification from European regulators on eligible investments for funds reporting against SFDR, which hadn’t been given when it initially classified the funds. No changes have been made to the funds’ investment process.

A spokesperson said the downgrade “reflects our commitment to continuously refine and enhance product disclosures in line with industry standards as they evolve”. RI understands that Pimco made the changes for a similar reason and that none of its four funds have changed their investment process.

Article 8 funds saw their second consecutive quarter of outflows, with just over €30 billion bleeding out of the segment.

Despite these outflows – which were 10 times higher than in the first quarter of this year – more than half of European fund assets are now in an Article 8 or 9 fund for the first time. Article 9 funds continued their strong performance, with net inflows reaching €5.9 billion. Launches of new sustainable funds fell significantly quarter-on-quarter, with just 138 new launches against 239 in Q1.

Despite fears that European sustainable funds would increase their holdings of defence assets in the wake of the Russian invasion of Ukraine, the proportion of both Article 8 and 9 funds with exposure to controversial weapons has remained steady. In the Article 8 universe, 73 percent have no exposure to controversial weapons against 74 percent in the previous quarter, while the figure is 86 percent versus 87 percent for Article 9.

In other controversial areas, exposure to thermal coal has grown, with just two-thirds of Article 9 funds having zero exposure to thermal coal, a drop of 11 percentage points. Morningstar said the figures “may look surprising”, as the “do no significant harm” principle is supposed to apply to Article 9 funds. Bioy cautioned, however, that it was unclear what lay behind the shift.

As the number of upgrades continues to rise, Bioy said the key question was how long the trend will continue. With assets crossing the 50 percent mark for the first time and the number of funds at 35 percent, the question is “at what percentage this will stabilise”, she said.