EU Commission, ESMA Cause Asset Manager Regulatory “Fatigue”
ESG-labelled funds are facing increasing pressure on several fronts, while Article 9 withdrawals suffer record levels.
Concurrent changes on ESG fund regulation devised by the European Securities and Markets Authority (ESMA) and the European Commission have multiplied compliance challenges for asset managers and the wider industry.
In May, the European Commission published a summary report on a three-month 2023 consultation through which it gathering feedback on the effectiveness of the Sustainable Finance Disclosure Regulation (SFDR) over the past three years.
The commission proposed to either design and implement new criteria that would more closely align with the UK’s Sustainability Disclosure Requirements (SDR) fund labels – which asset managers were able to use as of 31 July – or formalise Article 8 and 9 as product categories. However, the report identified no clear market consensus over which option would work best.
That same month, ESMA issued guidelines requiring funds containing terms such as ‘ESG’, ‘impact’, and ‘sustainability’ in their names to meet a minimum threshold of 80% of investments in the relevant categories – similarly to the US Securities and Exchange Commission’s Names Rule – and set minimum safeguards.
This was with a view to ensure investors are protected from “unsubstantiated” or “exaggerated” sustainability claims, and provide asset managers with clear and measurable criteria regarding fund names.
However, the continuous stream of updates to SFDR has created confusion and risks eventually rendering the regime counterproductive.
“The regulatory fatigue is palpable among asset managers,” Hortense Bioy, Head of Sustainable Investing at Morningstar Sustainalytics, told ESG Investor. “The constantly evolving regulatory environment, as well as the lack of convergence between jurisdictions, are slowing down a lot of initiatives, including product development.
The expected removal of Article 8 and Article 9 from the disclosure regime and the creation of new sustainability categories herald a complete reshaping of the EU’s ESG fund market, Bioy argued.
“Greater impact of the regulation has yet to be seen, as we anticipate a wave of fund rebranding and divestments,” she said.
ESMA-fuelled evolution
Throughout H1 2024, 30 Article 8 and Article 9 funds removed ESG-related terms from their names, with more expected to drop words such as ‘ESG’ and ‘sustainable’ by the end of the year following ESMA’s final guidelines.
Last month, Dutch bank ABN AMRO found at least 16% of Article 8 and 9 funds were in breach of the new guidelines. There are an estimated 1,826 Article 6, 8 and 9 funds with ESG-related terms in their names, and 52 Article 8 and 9 funds with transition-related terms.
SFDR’s labelling system comprises three categories: Article 6 (do not integrate any sustainability), Article 8 (environmental and/or social characteristics), and Article 9 (environmental and/or social objectives) funds.
ESMA has previously called for a sustainability scale for investments as part of planned reforms to the regime devised with the European Supervisory Authorities (ESAs).
The watchdog recently also set out its long-term vision on the functioning of the EU’s Sustainable Finance Framework, emphasising the need to simplify the current SFDR framework and facilitating the creation of financial products to support the transition to a low-carbon economy. This would involve replacing the Article 8 and 9 disclosure categories with minimum basic sustainability information for all financial products, and creating a product categorisation system catering to sustainability and transition.
In addition, in June, ESMA introduced a tool enabling to better identify cases of greenwashing in the investment management industry. The solution aims to qualify greenwashing risk among investment funds – including the consistency of sustainability-related claims across fund documents, unsubstantiated use of vague ESG-related language by fund managers, and alignment between a fund name and its portfolio composition.
The regulator said it would also look for potential misalignment between funds’ disclosures and their actual investments.
Simplifying SFDR
Recent research by Morningstar Sustainalytics found that redemptions from Article 9 funds had extended into Q2 2024, reaching a record level of €6.2 billion (US$6.8 billion). This followed withdrawals of more than €4 billion in Q1, and marked a third consecutive quarter of outflows.
In contrast, Article 8 funds saw roughly €26 billion of inflows in Q2 – a jump from a restated €18 billion in Q1 – with approximately three quarters of funds reporting having made sustainable investments.
Newly launched Article 8 and 9 funds, although on the wane, represented 53% of total EU fund launches.
“The recovery for Article 8 funds is taking hold, with the fund category attracting €44 billion of net new money so far this year,” said Bioy. “However, this isn’t a great result when compared to Article 6 funds, which attracted €107 billion.”
The Article 8 funds that registered the largest inflows were those with some commitment to sustainable investment – specifically, those targeting between 0.1% and 20%.
Investors have long been divided over the future of SFDR’s Article 8 and 9 categories. A previous survey conducted by Morningstar Sustainalytics revealed that 50% of respondents wanted to see them replaced, while 39% preferred keeping them.
“We haven’t surveyed investors again, but based on industry conversations, the ESAs’ latest opinion and ESMA’s recommendations, I would expect Article 8 and 9 to be replaced,” said Bioy. “What makes the most sense at this point is that SFDR needs to be simplified. In addition to specific product categories – including ‘sustainable’ and ‘transition’ – there should be appropriate disclosures for products outside these categories to reduce greenwashing.”
More broadly, global sustainable fund flows returned to positive territory in Q2 2024 after two successive quarters of net outflows.
Looking at H2 2024, Bioy underlined the potential impact of the US presidential election in November on ESG and climate investor sentiment.
“If Trump wins, we can expect a pause in green policies in the US, which could have negative consequences outside of the [country] too,” she said.
While the Inflation Reduction Act is unlikely to be repealed, Republican candidate Trump has pledged to pull back some of the incentives granted to the renewables sector and provide more support to fossil fuel companies.
“All eyes are also on Western central banks and their pace of interest rate cuts, as these have direct implications on the financing and valuations of green projects and companies,” Bioy added.
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