“Still early days” for transparency of light and dark vehicles under SFDR, says Morningstar.
Investors are still only receiving limited sustainability information when investing in light or dark green funds in Europe, new analysis has revealed.
Despite various attempts to improve regulatory guidance over Q3 2022, there is scant transparency and wide variations between funds, said funds data provider Morningstar’s latest quarterly report on funds regulated under the Sustainable Finance Disclosure Regulation (SFDR).
Incoming regulations taking force in January, however, are driving asset managers to gradually provide more granular detail on their funds’ sustainability credentials, including alignment with Europe’s green taxonomy. It is also forcing some funds to downgrade their claims and status.
“Although the EU Taxonomy and SFDR were designed to increase transparency and reduce opportunities for greenwashing, it’s still early days, and there is much work to do. Additional clarifications about the definition of a sustainable investment and about Article 8 and Article 9 classifications are expected soon, but in the meantime, caution and thorough due diligence remains key,” said Hortense Bioy, Global Director of Sustainable Research at Morningstar.
Initially, managers were permitted to self-certify funds as compliant with Article 8 of SFDR, which means promoting environmental or social characteristics, or Article 9, having sustainability objectives.
Through investigations, guidance and Q&As over the past quarter, regulators have attempted to provide greater clarity on the information expected from managers, often having the effect of toughening requirements. In parallel, additional expectations are being introduced, in accordance with the original legislation, from January 2023.
“Despite the fact that Article 8 and Article 9 are used as labels by many industry participants, what matters more is the understanding of the underlying investment strategies. SFDR Level II, which is coming into force in January, should help in this regard as it requires asset managers to provide more quantitative and qualitative ESG information about the investment strategies. It will start to validate and substantiate products’ stated objectives,” Bioy added.
Consumer protection rules have begun to increase transparency in Europe’s green funds market, but the process is currently revealing gaps in information which are gradually being closed.
To facilitate greater consumer access to and choice between sustainable investment options, introduced via amendments to MiFID II in August, fund producers have been sharing more detailed information with distributors via the European ESG Template (EET).
This is intended to help distributors to recommend funds containing a minimum proportion of sustainable investments, for example, or those which consider certain principal adverse impacts (PAIs).
Morningstar analysis of EET data for 61% of share classes in scope of MiFID II found that fewer than half (48%) of Article 8 and 9 funds provided information on their minimum percentage of sustainable investments, while only a third reported a minimum percentage of taxonomy alignment.
Put another way, more than half of funds do not specify the lowest level to which sustainable investments could fall, as a proportion of portfolio assets, with two thirds not able or willing to say how small a proportion of their assets are aligned with the European Commission’s environmental taxonomy.
This means that there are a lot of fund distributors unable to recommend to retail consumers, but it also suggests a large black hole in the sustainability credentials of Article 8 and 9 funds, regardless of purchaser.
“What matters is transparency,” said Bioy. “When it comes to sustainable investment exposure, asset managers should explain how they calculate it. They should disclose their methodologies.”
The study also shows wide diversity within fund categories. Thirty six percent of Article 8 funds reported a 0% minimum exposure to sustainable investments, with just 6.1% targeting an allocation of 50%. For Article 9 funds, just over 47% aim to contain at least 70% sustainable investments, with a total of 26 funds committing to 100% of their funds’ assets being sustainable.
The low number of funds targeting 100% exposure to sustainable investments suggests challenges ahead for those intending to do so in response to regulatory guidance.
The Morningstar report notes that present percentages are “difficult to gauge” due to different interpretations of sustainability in the market.
Taxonomy alignment and PAIs
In terms of taxonomy alignment, the vast majority of those Article 8 and 9 funds providing data on their EETs indicated a 0% minimum level of aligned assets. Three percent of Article 9 funds aimed for more than 10% taxonomy-aligned assets, with a total of 11 funds seeking to include a level of taxonomy-aligned assets of 60% or above.
With corporates not required to disclose the level of alignment of their business activities with the taxonomy until next year, European regulators have encouraged managers not to overstate the extent of portfolio alignment. But it is possible to assess the taxonomy alignment of certain instruments such as green bonds, due to issuer requirements, and this is reflected in the number of fixed-income Article 9 funds with relatively high alignment levels.
“Very few funds are reporting exposure to taxonomy alignment higher than 0”, said Bioy. “This is partly because the regulation doesn’t allow asset managers to use estimated data. But as the Corporate Sustainability Reporting Directive is applying only from next year and the first set of data won’t be available before 2024, asset managers are being cautious. Also, it’s worth noting that the taxonomy is still incomplete. Technical details have only be provided for two environmental objectives out of six: climate mitigation and climate adaptation.”
The overwhelming majority of funds confirm that they do consider principal adverse impacts, in line with regulation. But many of the 64 PAI fields on the EET appear to be routinely ignored.
‘Exposure to energy-efficient real estate assets’ and ‘exposure to fossil fuels extraction, storage, transport & manufacture’ are considered by less than 16% of funds, according to the Morningstar analysis.
While some managers are indeed considering all PAIs for their Article 9 funds, the report said, others have taken a selective approach and are considering only the most relevant indicators for their strategies.
“Asset managers should explain which PAIs they consider and why,” added Bioy.
Lack of definition
According to Morningstar, SFDR does not provide asset managers with sufficient guidance in defining sustainable investments, resulting in different interpretations and potential confusion for investors. As well as a lack of sustainability data from corporates, asset managers must contend with an absence of minimum thresholds for applying SFDR’s ‘do no significant harm’ condition.
There can also be significantly different outcomes if a fund takes a revenue-weighted approach to assessing the contribution of the sustainable activities of investee firms to its portfolio versus a more binary ‘pass-fail’ approach. “Products with similar mandates and portfolios will report divergent exposures to sustainable investments depending on the methodology chosen by their providers,” said Morningstar.
The three European Supervisory Authorities raised many of these issues with the European Commission in September. But it is not currently known whether the commission will comment before January 2023, when Phase II of SFDR will require managers to disclose minimum taxonomy and sustainable investment alignments and PAI considerations in precontractual documents.
In September, ESMA also issued further guidelines on facilitating customer sustainability preferences under MiFID II.
In terms of reclassifications of funds, the overwhelming majority – 315 out of 383 – upgraded from Article 6 to 8, reflecting both managers’ response to strong customer demand and the lack of a clearly defined floor for Article 8 funds. A total of 41 downgraded from Article 9 to 8; four of the ten largest funds to take this step were owned by NN Investment Partners.
Morningstar cited the influence of regulatory activity at the pan-European and national level, including an investigation by the Dutch financial regulator, interpreted by many as specifying that Article 9 funds must only include sustainable investments, rather than merely a high proportion.
AXA Investment Managers downgraded 21 strategies to Article 8 and said it would do the same for more, due to the “stricter interpretation” of Article 9 criteria under Level II of SFDR from January, albeit noting that “the notion of sustainable investment is still subject to various interpretation and no guidance had been given so far by the European regulator”.
Bioy said: “In the next few months, we expect more managers to take similar steps, unless further clarification is provided by the regulator that Article 9 funds are not required to hold 100% of sustainable investments.”
Sustainability-focused SFDR funds experienced a mixed three months ending September 2022, buffeted like all investment vehicles by geopolitical uncertainty and macroeconomic pressures, most notably spiking inflation. But combined assets (3%) and market share (53.5%) of Article 8 and 9 funds both grew.
Article 9 products recorded inflows of €12.6 billion in Q3 2022, with passive vehicles proving particularly popular, while Article 8 funds lost €28.7 billion, only slightly less than in the previous quarter. In comparison, non-green Article 6 funds suffered €62.1 billion outflows.
Despite this, Article 9 funds still account for just 5.2% of the SFDR universe by assets, with the balanced shared broadly evenly between the other two fund types.