Regulatory complexity clogging sales for European ESG funds

Money managers in Europe are focusing on selling ESG funds that follow the least stringent disclosure requirements, while being careful about offering impact funds to investors because of what they say are vague rules and fears of accusations of greenwashing.

Managers said they are concentrating on selling Article 8 strategies with environmental or social characteristics under the European Union's Sustainable Finance Disclosure Regulation to institutional investors, rather than funds with a demonstrated sustainable impact — known as Article 9 funds – as they await further clarifications from Europe's regulators on what is considered sustainable investment under the stricter category.

SFDR also includes a category for strategies that do not take ESG risks into account when it comes to investment decisions or returns, known as Article 6.

The regulation, which came into effect in 2021, requires managers and investors to disclose in detail the environmental, social and governance impact of their investments. But as of Jan. 1, SFDR requirements entered a new phase, making fund sales even more complex for managers.

Assets in Article 8 and Article 9 funds stood at €4.6 trillion ($4.9 trillion) as of Dec. 31, up 13.5% from €4.05 trillion as of Dec. 31, 2021, according to figures from Morningstar Inc.

Under the latest wave of SFDR, known as Level 2 rules, managers must declare any principle adverse impact of their investment strategies — how their portfolio may affect the environment — for example if their portfolio companies negatively affect biodiversity in a location in which they operate.

They must also explain to investors how they assessed their funds to designate them as Article 8 or 9, using the EU's taxonomy. Right now, this taxonomy only sets criteria for the permitted carbon emissions of an investment portfolio, but this will be expanded to include other activities such as social issues.

In the absence of the required definitions of sustainable investments that meet the standards of Article 9 funds, money managers said they are being conservative in terms of committing their funds to the strictest category.

"We remain cautious about the commitments that we make because we anticipate potential changes down the road in terms of clarifications and what data we can use," said Timothee Jaulin, Paris-based head of ESG development and advocacy, special operations at Amundi.

Mr. Jaulin said not having final rules in place has not held the firm back from launching strategies, even though readjustments may be necessary.

"We have to continue doing our business and we don't hold off fund launches or fund evolution, but that requires us to be cautious in the commitments," he added. Amundi had $2.03 trillion in assets under management as of Dec. 31.

As managers declare their ESG commitments in precontractual fund marketing, they have to ensure that the declarations can be met and must use data of sufficient quality, sources said.

"For example, some (European) regulators warned us that we should be careful about using estimated data when it comes to measuring taxonomy alignment," Mr. Jaulin said.

At the same time, investors in Europe are beginning to require much more in-depth disclosures under Level 2 rules, which require reporting on how their investments contribute to carbon emissions or create water pollution.

"We are starting to see specific product demand, for example for Article 8 funds," he said, adding that investors are looking for disclosures that show a minimal level of principle adverse impact of the investments.

European investors, who are having to meet their own SFDR requirements which include new indicators, said they are currently also focusing on Article 8 funds.

"We are very much Article 8," said Johan Mellerup, director within the ESG team at the 678 billion Danish kroner ($98.6 billion) ATP, Hilleroed, Denmark, adding that ATP self-classified its investments as SFDR Article 8.

Mr. Mellerup said that investors in Europe starting this year have to report on principle adverse impact indicators under Level 2.

"It's a lot of work on data and on indicators we haven't worked on before," he added, noting that investors have to report on 16 mandatory indicators, such as their investments' impact on biodiversity, by June 30.

Also, APG Asset Management is focused on Article 8 investments due to the lack of clarification about Article 9 funds, according to Mirte Bronsdijk, senior responsible investment and governance manager at APG Asset Management, the in-house manager of the €476 billion Stichting Pensioenfonds ABP, Heerlen, Netherlands.

Ms. Bronsdijk said in a note on APG's website that the money manager hasn't classified its investments as "sustainable" according to SFDR, because the regulatory information is, so far, insufficient.

The complexity of the regulation is also creating challenges for managers' investment processes, not just fund sales.

Netherlands-based Masja Zandbergen-Albers, head of sustainability integration at Robeco, said that SFDR is asking managers to integrate double materiality — meaning how the business is affected by sustainability issues and how its activities impact society and the environment.

"It's easy to implement (ESG) restrictions, but we have to think if we can and how can we implement double materiality in investment research," she said.

"This is a challenge for us," she added.

Ms. Zandbergen-Albers added that exclusions and active ownership are "probably not enough" for Article 8 funds to make them SFDR compliant and managers must consider principle adverse impact in the investment processes as well. Robeco has €171 billion in assets under management.

To alleviate the regulatory challenges and in response to the Article 9 confusion, the European Securities and Markets Authority proposed that 80% of investments should be sustainable if managers wanted to safely label strategies as "sustainable."

However, in February the European Fund and Asset Management Association said that proposed threshold may not help address the issues faced by managers who might be called out for greenwashing.

Due to the unclear regulatory guidance, managers have made a number of moves in recent months. Morningstar data show 307 strategies representing €175 billion in assets changed SFDR status since September, as managers downgraded Article 9 funds to Article 8. Data also show that some 63% of Article 9 funds now plan to have more than 70% exposure to sustainable investments.

As a result of the confusion, Robeco downgraded about eight transition funds from Article 9 to Article 8 in 2022. Regarding ESMA's proposal, Ms. Zandbergen-Albers said: "It's a good idea that there is more clarity in terms of which funds you can call sustainable or impact."

Ms. Zandbergen-Albers thinks SFDR will have a further impact on developing new strategies and future funds for all clients, as global investors consider adopting European fund classifications.

"In Asia there is a lot of interest in how SFDR is developing, and investors are curious about classification even if it doesn't apply to them," she said.

Julie Moret, global head of sustainable investing and stewardship at Northern Trust Asset Management in London, agreed with Ms. Zandbergen-Albers about the future impact of SFDR.

The regulation is introducing "precision" in the type of capabilities managers will need to develop to qualify for certain fund categorizations, she said. "That's going to be a game-changer," she added.

Ms. Moret said the firm took a "conservative approach" by reclassifying some of its Article 9 strategies as Article 8 strategies.