CFA Institute: US Could Repeat SFDR Errors
UK regime considered more robust, but ideal framework should be based on three value propositions, says new report.
The US risks making the same mistakes as the EU’s Sustainable Finance Disclosure Regulation (SFDR) if it pursues its current ESG fund classification plans, according to the CFA Institute.
In a new report which compares the efforts of major jurisdictions to regulate sustainability-focused investment vehicles, the global body for investment professionals said more work is needed by the US Securities and Exchange Commission (SEC) to refine and clarify precisely what value propositions for each planned group of funds.
“The SEC’s framework definitions are just as ambiguous as SFDR and, if it goes forward as proposed, I imagine it would have the same problems that the EU has had,” Chris Fidler, Head of Global Industry Standards at the CFA Institute, told ESG Investor.
The US agency outlined its plans in ‘Enhanced Disclosures by Certain Investment Advisers and Investment Companies About ESG Investment Practices’ in May 2022. It defines three types of funds: integration funds consider one or more ESG factors alongside other non-ESG themes; ESG-focused funds focus on one or more ESG factor as a significant consideration; and impact funds seek to achieve a specific ESG outcome.
“US regulation follows SFDR in terms of introducing disclosure requirements for three categories of funds, but it went further by giving those categories descriptive titles,” Fidler said.
The CFA paper said the ESG-focused and impact categories are not mutually exclusive – arguing that it is not possible for a fund to be an impact fund without also technically qualifying for the ESG-focused category. The overlap would likely create confusion among fund managers, it warned.
Following ongoing political pressure on the SEC – particularly on proposed sustainability-related regulations – the rule is still in process and therefore subject to change.
The EU’s SFDR was initially introduced in 2021 as a disclosure rule, as opposed to a labelling system.
“But these rules were written in such a way that the regulation became a de facto classification scheme as an unintended consequence,” said Fidler.
As a result, SFDR’s categories – Articles 6, 8 and 9 – serve as ordinal indicators of the extent to which a fund aligns with the EU’s definition of sustainability. The CFA Institute has argued that funds should instead be classified according to their value proposition with respect to their consideration of ESG information, issues, and/or conditions. As such, SFDR is not fit for purpose, the report said.
Best-in-class
However, SFDR is also now subject to change. In September, the European Commission published a consultation seeking feedback on the current requirements of SFDR, but has received inconclusive feedback on its two proposed strategies. The commission has suggested either formally recognising the existing SFDR categories as fund labels and tweaking guidance accordingly or overhauling these categories altogether to introduce labels more aligned with the UK’s Sustainability Disclosure Requirements (SDR).
The UK’s approach is “more robust” than the EU and US, according to Fidler.
The Financial Conduct Authority (FCA) introduced four labels under its Sustainability Disclosure Requirements (SDR) regime: focus, improvers, impact and mixed goals. It has implemented a 70% minimum investment threshold and disclosure requirements for each label.
“[The FCA] thought about who their audience was – mainly retail investors – and they did consumer testing which showed that a label would work better than a category,” said Fidler. “This way, people would look for a label and know what is sustainable and what isn’t.”
Unlike the US and EU, these labels are mutually exclusive, the CFA Institute said. But the UK regime has its weaknesses, including that the labels do not cover the full universe of funds that take ESG information, issues and/or conditions into account.
Fund managers have been allowed to apply for these labels since the end of July.
More broadly, the CFA Institute said the widespread use of the phrase ‘ESG funds’ across these three jurisdictions and elsewhere is problematic.
“When ambiguous terms like these are used in regulation to create special rules for certain kinds of funds, it can create significant uncertainty in the marketplace,” Fidler said.
The report highlighted the potential risks arising from differing assumptions about the characteristics of ESG funds. While some might expect them predominantly to make ESG-focused investments or be ‘good’ for the environment or society, others may perceive ESG funds as those that take ESG-related information, issues and conditions into account – a view which also encompasses the other two.
New solution?
The proposed formula outlined by the CFA Institute for an ESG fund classification framework aims to build upon this third view.
It argues that a robust ESG product classification system can be based on three value propositions: more informed decision-making that may result in risk-adjusted returns, control over the degree of financial and reputational exposure to specific systemic ESG issues, and the opportunity to help bring about specified environmental and social conditions or outcomes.
“Fund classification is more complex and more difficult than it appears to be,” the report said. “Efforts to ‘make it simple’ are well intentioned but have not resulted in a system that works well in practice.”
The answer isn’t to align the US, UK and EU frameworks so they are identical, Fidler told ESG Investor. “But they all need to be far more robust,” he said. “Our framework is very similar to theirs – it’s just more rigorous.”
The CFA Institute’s classification system also aims to focus on characteristics including being mutually exclusive, limiting the framework to no more than seven groups of funds at any hierarchical level, and ensuring there is no subjective ordinality.
“Regulators across jurisdictions can all follow the same principles – they just need to understand how important it is to have really precise definitions,” Fidler said.
In 2021, the CFA Institute published its Global ESG Disclosure Standards for Investment Products, which was designed to help investors and their advisors to better distinguish between mutual funds and similar products, which claim to integrate ESG factors.
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