The EU introduced its Sustainable Financial Disclosure Regime (SFDR) to crack down on financial sector greenwashing but may have replaced it with something more insidious: an expensive regulatory minefield that is unlikely to make investor sustainability choices any clearer.
Uncertainty around the SFDR’s rules have already caused 40 percent of funds registered under the EU’s most stringent ESG category, Article 9, to be reclassified as Article 8, according to Morningstar data.
It is not a good look for a framework that was created to prevent greenwashing.
For Hortense Bioy, global director of sustainability research at Morningstar, the reclassification raises questions about how useful the Article 9 definition is if funds bearing the label finally number just a few hundred. By mid-January this year, the total had already dropped from 1,080 in September to 891, or just 3.2 percent of the market.
More are likely to re-grade as investment prospectuses are reviewed, says Bioy, likely leading to Article 9 funds having a small and mid-cap company bias. As she puts it: “Less liquid, more risky, more mono-businesses – a kind of set of satellite holdings.”
That does not bode well for the sustainable transitioning of an economy. It is also classic investment bubble terrain: too many investors pushed to focus on a thin market.
It is also highly worrying because the EU’s theory of change for SFDR seems to be that market demand will shift asset managers from Article 8 to Article 9 funds as clients seek evidence of sustainability alignment with, for example, the EU’s green taxonomy.
Andreas Hoepner, professor of operational risk, banking and finance at Smurfit Graduate Business School in Dublin and a member of the Technical Expert Group that advised the EU on SFDR, believes the recent shake-out is an indication that regulatory tightening is working.
As evidence, he points to the 55 percent market share of Article 8 and 9 funds in Europe. “Asset managers are now taking this very seriously,” he says. “For an investment house to rebrand to Article 8 a fund it has sold as Article 9 is serious.
“If this was some random label with no responsibility or credibility mechanism, they could just leave it as Article 9. Because it’s actual regulation, you take the reputational hit in case your internal SFDR preparation does not yet suffice.”
Article 8 funds, he adds, could become a “squeezed middle” as a result.
As funds shift to Article 9, sustainability “additionality” and comparison is achieved via the publication of principal adverse indicators – ie anything that could damage sustainability – combined with ordinal data on sustainability progress across investee companies and fund information that is regularly updated and measured against key performance indicators.
In addition, Article 9 funds must use Climate Transition or Paris-Aligned Benchmarks, meaning they are compared with EU sustainability standards and Paris alignment.
Some fund numbers support the thesis. There has been growth in the number of Article 9 funds over the last two years (as opposed to Article 6 and 8), according to Morningstar – at least until the latest shake-out.
Article 8 funds, however, are still the dominant SFDR class. By mid-January, there were 9,717 available, with a market share of 34.6 percent.
However, in a recent report, the Securities and Markets Stakeholder Group (SMSG) that facilitates ESMA’s stakeholder consultation by providing technical advice on ESMA’s policies, says the notion of “environmental and social characteristics” for Article 8 funds is so broad “that with some degree of measurability, virtually anything can fit into it”.
That is the very definition of potential greenwashing.
The SMSG recommends that, at the very least, retail investors be protected from “greenwashing” by making Article 9 funds the sole carriers of a green classification.
It says social and ethical funds could also be included under Article 9 with the right definition and measurement. In the institutional sphere, the SMSG recommends that funds “show that they do what they say”.
In addition, just over a quarter of Article 8 funds with “sustainable” in their name are unlikely to meet forthcoming ESMA requirements on fund branding. Watch out for the next SFDR rebrand wave when Article 8 funds switch to Article 6.
Also, lest we forget, Article 6 funds – non-sustainable vehicles with minimum sustainability reporting requirements – still make up 62.2 percent of the EU funds market by number.
Nonetheless, I speak to fund managers who tell me SFDR has changed the game in terms of firms wanting to avoid being “unlabelled” on sustainability. That is important. Newly created funds in the Article 8 and 9 categories over the last two years represent between 40-50 percent of the total European funds market.
However, SFDR has also become a huge, costly administrative burden for compliance, legal and reporting teams. The cost of re-labelling funds and investment prospectuses as a result of SFDR, especially when the regulation is uncertain, adds to that.
The investment industry is already awash with onerous reporting requirements, when what is required is smart policy and appropriate information continually assessed for value.
These compliance demands can be anti-competitive. Large incumbents soak up costs where challengers cannot. In addition, businesses and asset managers concerned about the legal implications of new sustainable business lines don’t bother.
Some investors also tell me that demand from asset owners is just not there because they have yet to see the policy and investment incentive push in the EU that would drive clear financial outcomes. They say asset managers will respond accordingly by paying lip service.
The EU’s Action Plan on Sustainable Finance – of which SFDR is a key pillar – aims to “reorient capital flows towards sustainable investment”. Falling short of that aim would be bad enough. Being counterproductive for actual sustainable business outcomes would be a scandal.
Hugh Wheelan is co-founder and former managing director of Responsible Investor.