Taking a Step Down

Some ESG funds are surrendering their ‘deep green’ Article 9 label.

In a fast-changing world, new words and the concepts they describe seem to arrive with bewildering rapidity. One such, unheard of a few short years ago, is “greenwashing”, the practice of dressing up products, services or investments as being in full conformity with ESG principles – in contradiction of the underlying reality.

Lack of agreed definitions of what comprises ESG investing has made greenwashing hard to detect in a world where sustainable or responsible investment can be said to be in the eye of the beholder.

This was given a further twist by, ironically, a measure intended to bring some order to the ESG investment world, the European Union’s Sustainable Finance Disclosure Regulation (SFDR), the main provisions of which came into force in March 2021. SFDR created, among others, two categories of ESG-related funds, Article 8 and Article 9.

Funds in the former bucket are required to promote environmental or social characteristics and to invest in businesses with good governance practices, while the latter funds are required to make a positive impact on the environment or society through the explicit pursuit of sustainability-led objectives.

Initially, there was a flurry of funds classifying themselves as Article 9, the better to benefit from a surge in demand from both retail and institutional customers for financial products with a green label. More recently, however, there has been a movement in the other direction, with some managers re-classifying their products as Article 8, the so-called light-green category.

What is going on?

Deep green loses some allure

In a word, scrutiny – from regulators, from some investors and from independent researchers. In May this year, the European Securities and Markets Authority (ESMA) published a supervisory briefing that had the effect of tightening SFDR definitions. Travers Smith, a law firm, noted that a key objective of the watchdog was to “reverse greenwashing”, and quoted from the guidance: “A sustainable investment policy and/or objectives should be included in the fund documentation and the fund should be managed according to it”.

The guidance went on to state that: “Any investment strategy which supports the sustainable investment policy and/or objectives should be disclosed to investors, with an explanation of how that strategy links with the sustainable investment policy and/or objectives.”

ESMA’s clarifications are being interpreted as requiring all investments made by an Article 9 fund to support its sustainability objectives.

It explained that the new guidance will be applied by Europe’s national regulators “principally at the point they review fund documents (such as prospectuses and private placement memoranda); for example when a firm applies to an EU regulator for a marketing passport or registers under one of the many EU national private placement regimes which involve some element of substantive document review. It is also possible that some regulators will also undertake periodic thematic reviews of particular firms’ practices”.

The upshot of all this is that Article 9, the deep-green gold-standard category, has become less attractive.

Acting in good faith

According to Morningstar, the fund data and analytics provider, there were 16 such downgrades from Article 9 to Article 8 in the second quarter of this year, and observers believe the trend away from Article 9 could gather further momentum.

Hortense Bioy, Director of Sustainability Research at Morningstar, said: “New guidance at the EU level and at the national level – the Netherlands being an example – has prompted a couple of asset managers to downgrade their funds from Article 9 to Article 8. Another prompt is the stricter level of disclosures required of those in the Article 9 category. We can expect to see more of this until the process has run its course.

“There must be a limit to the extent of the downgrades but I don’t know what it is.”

Hugo Gallagher, Senior Policy Adviser at Eurosif, a pan-European body representing sustainable finance service providers, pointed the finger at vagueness in definitions of Article 9, even after ESMA’s new guidance. “It may be a bit strong to say firms are fearful of being accused of greenwashing. That may be a factor, but the real issue is the difficulty in defining sustainable investments. The definition of Article 9 is not precise and asset managers have been left to their own devices when it comes to interpreting it.

“This leads to discomfort in the market as no two definitions of sustainable investments will be the same. Many asset managers are acting in good faith but are concerned that their clients may not share their definition of sustainable investments and that it may not align with that of other financial market participants.”

Morningstar’s Q2 2022 research highlights diversity of interpretation among managers. While more than half of Article 9 funds had allocations to sustainable investments of more than 70%, 40% had allocations of less than 50% of the fund, and the allocations of only 2.3% topped 90% of the fund.

At the European Fund and Asset Management Association (EFAMA), Vincent Ingham, Director of Regulatory Policy, sees benefits from the tightening of guidance. “Asset managers are still seeing high demand for sustainable investments, particularly from institutional investors and mandates, therefore this is still a strong growth area for them.

Second guessing the regulator

“Reclassifications of funds from Article 9 to 8 are mostly a result of on-going regulatory guidance from the European Commission and national regulators which has provided more clarity. As firms align themselves with the updated rule set, this is a positive development for the industry,” said Ingham.

“With a current lack of clear labelling standards, SFDR’s disclosure classifications are often used as an indication of the ESG credentials of a fund, however this is not what they were designed for.”

While some managers are exercising discretion over claims they can no longer support, in light of newer guidance, others are doubling down.

Bioy at Morningstar noted: “Some asset managers prefer to go the other way, trying to avoid a downgrade by pursuing strategies that would allow them to remain in the Article 9 classification. But it is very hard to meet Article 9 criteria. If regulators want Article 9 funds to have 100% sustainable investments, we will need to have a methodology that gets us there.”

A study of European ESG Templates for around 6,000 Article 9 funds and share classes found that just 79 had set 100% as the minimum level of sustainable investments, while 168 had set a minimum if 90%, with the vast majority leaving the field blank. According to FE fundinfo, which conducted the analysis, even if those funds with no stated minimum end up with close to 100% sustainable investments, “that still means that at least 1,500 funds might need to review their Article 9 status”.

Eurosif’s Gallagher believes the very demanding criteria for Article 9 classification are partly behind the move. “In this context, it is not realistic to require Article 9 funds to invest exclusively in ‘sustainable investments’. Article 8 is more comfortable for them. A lot of Article 9 funds are considering re-classifying as Article 8, which has more flexibility and less chance of incurring regulatory action. You can still have a very ambitious fund within Article 8.”

Another prompt for re-classification from Article 9 to Article 8 may be the pending introduction of the so-called Level 2 requirements of the SFDR. Originally planned to come into effect at the start of this year, they have now been postponed until January 2023.

Under Level 2, Article 9 funds will be required to report on their environmental objective to highlight how they have impacted the environment, whereas Article 8 products will face less onerous pre-contractual and periodic product disclosures.

US crackdown reverberates

Should the industry do more to self-police dubious ESG claims? Ingham says: “At EFAMA we are working closely together with our members, regulators and other stakeholders to promote a regulatory framework that eliminates the risk of ‘greenwashing’ as much as possible and ensures there is clarity and reliability for everyone in the value chain, from companies to asset managers, to distributors, to investors.”

Greenwashing is far from an exclusively European problem. In May, the US regulator, the Securities and Exchange Commission (SEC), published two proposals to tackle the problem. The first set of changes, in the commission’s words, “seek to facilitate enhanced disclosure of ESG issues to clients and shareholders”.

The proposed amendments are designed “to create a consistent, comparable, and decision-useful regulatory framework for ESG advisory services and investment companies to inform and protect investors while facilitating further innovation in this evolving area of the asset management industry”.

The second bring the contents of the fund closer in line with its description, increasing investor protection “by improving and clarifying the requirement for certain funds to adopt a policy to invest at least 80% of their assets in accordance with the investment focus that the fund’s name suggests”.

These changes – in the wake of enforcement action against DWS among others – have reverberated on this side of the Atlantic, where sustainable investing accounts for a larger share of the market. In Q2 2022, assets in Article 8 and 9 funds accounted for more than half of the European investment market, despite collective assets 9 declining by 6.4% to €4.18 trillion at the end of June,

One UK market insider said the moves from the SEC means some managers have reconsidered their Article 9 classification, adding: “The main benefit of a re-classification is that, under Article 8, there is no minimum requirement for sustainable investment, but there is still the opportunity to promote the ESG characteristics of the fund.”

[This story was updated on 15/9/2022 to remove a reference to information reported in a Bloomberg story, which is no longer accurate].

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