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Non-compliance with EU SFDR may require more funds to drop ESG label

© Shutterstock / Ivan MarcEU SFDR and ESG funds.

Funds using ESG and sustainable tags are coming under increased scrutiny as deadlines to meet reporting compliance loom under the EU’s Sustainable Finance Disclosure Regulation (SFDR). Analysis by Morningstar found that almost a quarter of the Article 8 listed funds don’t meet the requisite reporting or listing criteria.

The classification of funds into Article 6, 8 or 9 under the EU’s SFDR is intended to reduce attempts at greenwashing, among other factors, and protect investors from false claims on sustainability and green investments.

Article 8 appears to have the least stringent criteria of the three classifications, with many fund managers justifying investments in high-carbon or ‘brown’ sectors under engagement, transition and improver strategies.

Scrutiny by regulators over mislabelling of funds will likely increase as deadlines to comply with EU SFDR reporting standards approach, after EU Commission extended prior reporting deadlines by six months. 

How SFDR affects how financial institutions market their products

Financial institutions marketing fund products to institutions and investors that come under the jurisdiction of the EU’s SFDR authority have to classify their funds into one of three categories.

Article 6 requires asset managers to disclose the level of integration of sustainability in their funds, regardless of how they are labelled. Funds that have some form of ESG, green or sustainability labelling need to be classified under article 8 or 9.

Article 8 funds are those that promote environmental or social characteristics but don’t have them as a core investment objective.

Article 9 funds are those that have sustainability as their core investment objective, and require comprehensive and understandable related disclosures.

Article 8 funds most vulnerable to ratings and regulatory scrutiny

From the above description, it is no surprise that a large number of funds that are offering investors exposure to ESG or sustainability fall into either the Article 6 or Article 8 category. Investor and regulatory pressure will limit the growth and survival of Article 6 funds, leaving managers a choice of having to classify as Article 8 or 9.

Recent research from Morningstar shows that a majority of asset managers are reclassifying Article 6 funds to Article 8. Taxonomy rules that further require article 6 funds to state that underlying assets don’t consider EU criteria for sustainability could add to this shift.

A recent review by the firm of Article 8 funds also showed that 23% don’t meet its standards as an ESG fund, having investment in assets related to coal, tobacco or weapons. This is in addition to the 1,200 funds, managing nearly $1 trillion in assets, that were stripped of their ESG status, as reported by the FT at the beginning of 2022.

Morningstar research also shows that Article 9 funds plan to hold more sustainable investments than Article 8, with about two-thirds of the latter group a minimum exposure to sustainable investments (0-10%), and only 10% plan an over 40% exposure.

Confusing regulations and deadlines don’t help sustainable investment cause

Current SFDR rules allow for funds to be classified under article 8, if they contain investments that have simple exclusions as ESG qualifications. This is creating confusion in the market, especially given the amount of funds that flow into the category, leading asset managers and investors to push for minimum standards. 

The above suggests that SFDR timelines for compliance with disclosures, which have already been extended by 6 months, may come under further pressure. Additionally, from August 2, 2022, MiFID II requires financial advisors to consider sustainability preferences in their suitability assessments. 

Intended to provide clarity in sustainable investing and reduce opportunities for greenwashing, confusion in interpreting the EU Taxonomy and SFDR show that a lot more needs to be done. In the interim, oversight over-inflated claims about green and ESG exposure in financial products appears to be left to the likes of rating services providers, which itself has inherent risks, as seen during the global financial crisis

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