Asset managers are trying to digest new regulatory proposals that have the potential to upend Europe’s biggest ESG fund category.
A plan by Europe’s markets watchdog, ESMA, to set quantifiable ESG and sustainable investing standards is forcing portfolio managers to rethink how they design and market an ESG fund class known as Article 8. Morningstar Inc. estimates that only 18% of Article 8 funds, which hold about $4 trillion of assets, currently meet the watchdog’s proposed threshold for sustainable investments.
There’s “a chill of realism,” blowing through the investment industry as managers digest the risks of getting environmental, social and governance designations wrong, said Matt Townsend, a partner at Allen & Overy in London. “This is starting to drive much greater caution in how products are being classified.”
It’s the latest in a wave of regulatory updates causing upheaval and triggering a sense of “mass frustration” among fund managers struggling to keep up, according to analysts at Jefferies International Ltd. There’s already been a cycle of downgrades from the EU’s top ESG class — Article 9— to Article 8, after the EU clarified its rules. Downgrading Article 8 funds, however, means forfeiting the right to market a product as ESG or sustainable.
“From a fund’s perspective, reclassifying an Article 8 fund” to the EU’s non-ESG product category, known as Article 6, “has a number of knock-on effects,” Townsend said. “It’s not straightforward.”
Martin Mager, investment funds partner at Linklaters LLP, said asset managers can’t afford to downgrade from Article 8 if they want to keep ESG clients. “Managers realize they need it in order to do their marketing,” he said.
But European regulators have made clear they’re determined to set much stricter standards around what fund managers can call ESG and sustainable. As part of that process, they’re continually updating the EU’s anti-greenwash rulebook, the Sustainable Finance Disclosure Regulation, which was first implemented in March 2021.
Under SFDR, Article 9 funds must have an ESG goal as their objective. Article 8 products need to “promote” ESG “characteristics.” It’s a broad requirement that’s led to confusion and even greenwashing allegations.
ESMA is now proposing that a fund with ESG-related words in its name have at least 80% of its holdings in investments that actually meet the strategy description. Funds with sustainable-related words in their name face an additional requirement to have at least 40% of assets that meet SFRD’s definition of a sustainable asset.
ESMA Chair Verena Ross said Nov. 18 that the watchdog’s goal is to “ensure that investors are protected against unsubstantiated or exaggerated sustainability claims.” ESMA wants to give national supervisors and asset managers “clear and measurable criteria to assess names of funds, including ESG or sustainability-related terms,” she said.
Managers who don’t live up to the ESMA thresholds for “ESG” and “sustainable” will “have to remove these words from their names,” said Hortense Bioy, Morningstar’s global director of sustainability research. “If managers want to keep these words in their funds, they will have no choice but to enhance the strategies and change the portfolios to meet the thresholds.”
Some institutional investors say they welcome the stricter standards now being proposed.
“We are in favor of having a well-defined materiality threshold for Article 8 to make sure that the SFDR doesn’t lead to regulatory-driven greenwashing,” said Anastasios Pavlos, a policy adviser at Pensions Europe, whose members oversee about $7 trillion. “Too many products with too low ESG standards are being driven to be labeled sustainable products according to the SFDR.”
And analysts monitoring the fund industry say efforts to force firms to rein in their ESG claims are urgently needed.
It’s not clear whether ESG misclassifications have been “intentional or not, or just conceptually lazy and poorly thought through,” said Patrick Wood Uribe, chief executive officer of ESG data research firm Util. But “these reclassifications are an important recognition that getting this wrong presents a risk serious enough that action is necessary.”
Luke Sussams, ESG analyst at Jefferies, said that downgrades of Article 8 products to Article 6 will follow if ESMA sets a quantitative threshold and requires managers to quantify their now “undefined contribution” to ESG. Many “will not want to quantify such an impact, not be able to quantify such a contribution or not have a contribution to quantify,” he said.
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