Europe

ESG Funds’ Blurred Lines Persist Despite SFDR

Morningstar report highlights diverse approaches to classification, resulting in similar fossil fuel exposures across fund categories.

Only a third (34%) of European assets under management are currently invested in funds with sustainable objectives or characteristics, according to a new Morningstar analysis, which highlights similarities across new fund categories and predicts the proportion could rise to half within 12 months.

Funds classified under Article 8 of Europe’s Sustainable Finance Disclosure Regulation (SFDR), which are defined as promoting environmental or social characteristics alongside other factors, account for 30.3% of European fund assets. Only 3.7% of assets are invested in SFDR Article 9 funds, which count sustainability as a core investment objective.

But Morningstar noted that widely differing interpretations of SFDR’s requirements by managers is resulting in “similar strategies” appearing in both categories, and a “wide range” of ESG approaches being represented in each. However, the firm said Article 9 funds “exhibited higher sustainability credentials” in aggregate than Article 8.

Fossil fuel investments continue

The diverse interpretations to SFDR categorisation taken by managers can be seen in the similarities in fossil fuel exposures across fund types. Morningstar found that more than a quarter of (27%) of Article 9 funds had a more than 1% exposure to firms deriving more than 5% of revenues from thermal coal, compared with 19% of Article 8 funds and 22% of non-classified funds.

According to Morningstar, this is due to climate-themed Article 9 funds investing in utilities firms which have both renewable energy operations and coal-fired electricity generation activities. Similarly, as much as 33% and 30% of Article 8 and 9 portfolios, respectively, have more than 5% exposure to fossil fuel companies, versus 38% for non-classified funds, due largely to investments in oil and gas or utilities companies “that have made a commitment to transition away from their highly carbon-intensive activities and set net-zero-emissions targets”.

Morningstar described Article 8 as a “catch-all” category which includes funds with relatively few ESG-based exclusions, but also more sophisticated funds which incorporate ESG integration and engagement as well as use of carbon-intensity metrics at both the entity and portfolio level. Article 8 funds also include some thematic and impact investment vehicles similar to those classified in Article 9, only distinguished by a more “cautious” approach to SFDR compliance.

A well-established weighting among sustainable funds toward technology and health stocks was reflected in Morningstar’s analysis of Article 8 portfolio components. The most commonly held companies in Article 8 funds were Alphabet, Microsoft, Novo Nordisk, Roche and ASML, the Dutch semiconductor manufacturer.

The findings are based on an analysis of SFDR Level 1 data on nearly 82% of mutual and exchange-traded funds available in Europe as of 10 July, four months after SFDR took effect. The vast majority of Article 8 and 9 funds are actively managed, Morningstar found, with passive funds accounting for just 11% and 10% of assets respectively.

SFDR seeks to deter greenwashing and improve transparency to investors by requiring asset managers to provide information on principal adverse sustainability impacts, initially on a comply or explain basis, but with more detailed disclosures due from January 2022, when SDFR Level 2 commences.

Temporary dip in volumes

Morningstar also published a review of global sustainable fund flows which showed a 12% increase in sustainable fund assets to US$2.24 trillion in Q2 2021. Net inflows for the quarter of US$139.2 billion were 24% down on the prior quarter, despite the launch of 177 new sustainable investment products globally.

Europe, the world’s largest sustainable fund market, registered a 25% fall in inflows. But Hortense Bioy, Morningstar’s Global Director of Sustainability Research, warned against reading too much into the dip, noting a growing shift in Europe toward Article 8 and 9 funds.

“Many managers are already reporting a higher proportion of Article 8 and 9 fund assets, while others have unveiled plans to augment their Article 8 and 9 product offerings in the coming months,” she said.

“The European ESG space is going through a profound transition. As the EU Action Plan on Sustainable Finance seeks to re-orient capital flows towards sustainable activities, SFDR is creating new disclosure standards to increase transparency. Against this backdrop, asset managers are redesigning their offerings to not only meet the growing demand for ESG investments, but also contribute to a greener future.”

Last week, the Global Sustainable Investment Alliance’s (GSIA) biennial review reported a 15% rise in the share of investments managed sustainably, but said regulatory and industry practice changes in Europe and Australasia had led to weaker performance in those markets, offsetting higher levels of growth in Canada, the United States and Japan.

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