The publication of the final draft of the EU’s new Sustainability Finance Disclosure Regulation (SFDR) in October last year has sparked a rush among fund providers to rebrand their products as sustainable. But while the new rules are aimed at tackling greenwashing, there are early indications that not all of the funds recently marketed as green are as sustainable as they appear to be.
Under the new rules, which are set to be implemented in July, funds can be classified as either Article 6 funds, which have no sustainability target, Article 8 funds that promote some sustainability objective but do not have it as their overall agenda, or Article 9, which are funds that have the specific objective to fulfil a sustainability goal.
While the UK fund industry is no longer directly bound by EU rules, the new SFDR standards will have significant knock-on effects. Only a month after the publication, the FCA announced that it will launch its own investment taxonomy aimed at tightening reporting standards for ESG compliance in investment funds. Moreover, the EU rules do apply to investments by UK investors in EU registered funds.
Rush to rebrand
The fund industry has responded with a rush to rebrand. Funds that were initially Article 6 were swiftly reclassified as Article 8 funds, among a growing realisation that this had become the new minimum standard. This trend was accelerated by asset owners and fund of fund managers increasingly demanding a rebranding.
By the end of 2021, some 66% of all equity funds and about a quarter of all bond funds were classified as Article 9 funds, while half of all equity funds and a third of all bond funds were classified as Article 8, according to Morningstar, which tracks the adoption of SFDR rules on a quarterly basis. Overall, some 43% of funds sold in the EU, accounting for €4trn (£3.3trn) in assets, have been listed as either Article 8 or 9. Since the introduction of these new rules, more than 1,800 funds have been upgraded from article 6 to 8 or 9, according to the data provider.
However, the assessment whether a fund is Article 8 or 9-compliant is put forward by the asset managers themselves. Article 8 rules only specify that the fund should display some social and environmental characteristics. Some fund providers took this as an incentive to improve reporting standards in their fund documentation, but not change the investment strategy of the fund in question. Fund providers which have changed the documentation of their Article 8 or 9 funds but not the investment strategy risk could be accused of greenwashing, warned Morningstar. The fund ratings provider has removed more than 1,000 funds from its ESG ranking that had self-classified as Article 8 funds but failed to implement ESG criteria decisively.
Another way of assessing the effectiveness of ESG investments is by looking at the actual revenue channelled into green objectives, the mitigation of climate change, in particular. Research by sustainability technology platform Clarity AI screened a universe of 2,000 equity funds with an SFDR label and almost a third of those described themselves as Article 8 funds. It found that among these funds, less than 4% of their revenue went into green projects. The percentage was slightly higher among Article 9 funds, which had 8% green revenues, according to a whitepaper published by Clarity AI. But the research also highlighted significant variation by sector. Funds focussed on utilities generally scored much better, with 25% of their revenue allocated to green projects. In contrast, the industrials sector is flagged up as a laggard. While nearly a third of its assets qualifies for green projects, only 3.7% of its revenue is allocated to them, Clarity AI stressed.
Overall, it warns that Article 8 funds in particular fail to trigger decisive action to tackle climate change. “Investors should not be misled by Article 8 labelling of funds, which will likely not mean a higher share of green revenues than non-sustainable funds”, is the scathing conclusion of the whitepaper. The shortcoming of the EU’s Green Taxonomy bears important lessons for the UK, which is due to publish the details of its green taxonomy later this year. One insight could be that expecting asset managers to do their own homework on ESG reporting will lead to disappointing results.