MiFID II to Boost Green Fund Flows Despite Credibility Doubts

Nudge to retail investors introduced while concerns remain over rigour of Article 8 funds.

Changes to EU investment rules should prove a boon to green funds – but the continent’s ESG sector still has a big credibility problem.

That’s the mixed verdict of US investment bank Jefferies in its latest quarterly assessment of the European sustainable investment market, focused on funds classified under Article 8 and 9 of the EU’s Sustainable Finance Disclosure Regulation (SFDR).

By ordering asset managers and other financial services providers to check the investment preferences of their clients, especially those in the retail space, the regime change is likely to prove conducive to ESG-related investing.

Last month’s shake-up of the Markets in Financial Instruments Directive II (MiFID II) falls into two parts.

The first is the requirement that investment firms take into account the adverse impacts of their assets in relation to sustainability factors, along with showing that they have processes and internal controls that reflect sustainability risks.

When pushed, investors will go green

Second, and more importantly, they must question new and existing clients as to whether and to what degree one or more of the following three standards should be integrated into their investments.

The first is whether the client wishes to own products or instruments that qualify as environmentally sustainable under the EU’s taxonomy, which classifies economic activities in terms of their environmental impact.

Then comes the question of whether the client wishes to hold products or instruments with a minimum proportion of sustainable investments as defined by the SFDR.

Finally, firms must ask whether the client would opt for products or instruments that take into account the SFDR’s principal adverse impact indicators on sustainability factors.

Jefferies stated: “How investors respond to questions on these three investment parameters will determine the products proposed for them, and the minimum thresholds within it. It is our assertion that, when pushed, a growing number of investors will declare a preference for more exposure to sustainable investments.”

More comparability and more competition

It added: “We expect the new MiFID II sustainability rules to gradually catalyse further capital flows towards greener equities. This is partly because of the nature of the questions that investors will be asked.”

Noting that the framing of the questions to investors would tend to “nudge” them to integrate sustainability factors into investment decisions, Jefferies said MiFID II would become “a powerful driver of capital flows towards more ‘sustainable’ equities”, building on the influence of the taxonomy and SFDR, which is likely to increase as Level 2 of the regulation is introduced next year.

Elisabeth Ottawa, Deputy Head of Public Policy at Schroders, said of the MiFID II changes: The ultimate goal of the EU sustainable finance agenda is to channel more investment into sustainable assets and hence, to green the EU economy.”

The directive’s questions on client sustainability preferences should be set in context of broader policy efforts to provide investors and their intermediaries with information on the sustainability performance and impact of companies, she said.

Ottawa added: “In the next step, advisers would have to ask clients about sustainability preferences and match products accordingly. Then the investor would be confident that they invest in a financial product that matches their preferences. And since all sustainable products would need to comply with these disclosure rules, there’s more comparability and, hence, more competition between those products.”

A positive development?

But Jefferies raised a note of caution, pointing out that the new rules are coming into force at a point when the sustainability credentials of some ESG funds are open to question, despite being categorised as Article 8 or 9 under SFDR.

“We have long argued that the EU’s sustainable finance regulations will be successful in channelling capital flows towards ESG funds. One might question the degree to which this is a positive development in light of the doubts surrounding the credibility and robustness of such products during this period of transition for the sector.”

‘Light green’ Article 8 funds are required to promote environmental or social characteristics and to invest in businesses with good governance practices, while ‘dark green’ Article 9 funds are required to make a positive impact on the environment or society and to be founded on the pursuit of non-financial objectives.

While regulatory intervention has had the effect of toughening up criteria for Article 9 classification, there is no minimum standard for Article 8 funds.

Around 43% of European open-ended funds and ETFs are currently classified as Article 8 with 8% termed as Article 9. But the market is experiencing a shift due in part to regulators taking a tougher line on exaggerated claims of sustainability performance, known as ‘greenwashing’.

According to Jefferies, in the four months to the end of August, European managers downgraded 48 funds, with 30 being demoted from Article 9 to Article 8, although a similar number travelled in the opposite direction.

“From our anecdotal evidence, such an upgrade is a painstaking task now as national regulators are extremely thorough in their evaluation of products attempting to become Article 9,” the firm added.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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