Almost a quarter of funds that claim to “promote” sustainability under European regulations do not deserve an ESG label, according to a new review by Morningstar.
The analysis, which looked at funds classified as Article 8 within the EU’s Sustainable Finance Disclosure Regulation (SFDR), shows that 23% do not live up to environmental, social or governance (ESG) investing principles.
To justify an ESG tag within Morningstar’s definition of the term, a fund’s investment strategy cannot rely only on excluding so-called sin stocks such as tobacco, coal or weapons, Boya Wang, ESG analyst EMEA at Morningstar, said in a statement.
He added, “Many Article 8 funds will not be tagged as sustainable funds under our framework.”
The assessment is the latest to raise questions around the SFDR and its attempts to mitigate greenwashing.
The regulation came into effect last year and requires asset managers to classify their investment products under one of three categories.
These include Article 6 — where there are no ESG risks relevant to investment decisions or returns; Article 8 — which promotes environmental or social characteristics or Article 9 funds, which name sustainable investment as their objective.
The latest Morningstar data reveals that asset managers have reclassified over 600 funds previously listed as Article 6 to Article 8 while a number of Article 9 funds were also downgraded to Article 8.
As of June, it showed that funds registered as Article 8 held €3.76 trillion compared with €420 billion allocated to Article 9 funds.
Market participants believe that one of the unintended consequences and criticisms is that Article 8 has become a catch-all phrase for ESG. In other words, it is too broad and could contribute to further greenwashing.
This is not the first time that Morningstar, which owns data provider Sustainalytics, has — within its own classification system — cut ESG tags from funds making sustainability claims.
Earlier this year it removed the label from more than 1,200 funds representing well over $1 trillion in assets under management.
At the time Morningstar said that the SFDR had substantially increased the volume of ESG-related disclosures in legal documents, as intended.
However, it noted, “that it has also led to confusion and suspicion of greenwashing. Many funds that place themselves into Article 8, for example, are not funds we would independently classify as sustainable funds.”
The European Securities and Markets Authority (ESMA) is hoping to inject some clarity into the overall ESG picture.
Last Friday, it said that a ‘quality label’ for market benchmarks would help prevent investors being misled by ESG claims.
Benchmarks are used by asset managers to pick investments for clients, helping to channel millions of euros into sustainable funds and projects, but the criteria behind them vary widely, leading to claims of “greenwashing”.
The EU watchdog said that the absence of clear labelling “raises questions on the inclusion of firms with a negative environmental or social impact in these benchmarks.”
ESMA was responding to a public consultation from the EU’s executive European Commission on updating rules for benchmarks.
Specifying minimum methodology standards should underpin an EU quality label, ESMA said.
“Further, ESMA believes that the introduction of an EU ESG benchmark label would be an extra supporting tool against greenwashing.”
Compilers of ESG benchmarks based outside the EU should comply with EU rules and supervision if they want investors inside the bloc to use them, in order to minimise the risk of greenwashing and regulatory arbitrage, the watchdog said.
The commission is expected to set out proposed changes to the rules in due course, which would likely need approval from the European Parliament and EU states.
Europe, albeit at the forefront, is not the only region, trying to mitigate inflated ESG claims.
The US Securities and Exchange Commission (SEC) recently published a 362 page proposal to establish standardised disclosures to ensure that registered funds are not “appearing to be something that they are not,” said SEC staffer Jessica Wachter.
The rule would require advisers to describe their use of ESG factors, strategies and methods of analysis as well as how they voted relevant proxies.
The depth and breadth of the disclosures would depend on the centrality of ESG to their strategies. Three categories have been moted including ESG integration in which ESG plays a small part, ESG focused which relies on one or more ESG factors and ESG impact designed to achieve a certain goal.
Although market participants broadly supported the SEC’s goal to standardise and enhance ESG reporting, the integration bracket came under criticism
In its response to the proposals, Morningstar called the category label “misleading” and said it could “contribute to greenwashing by making funds appear more committed to ESG factors than they are.”
It added, that the rule, as currently written, would create confusion, increase compliance costs, and could allow funds to create a false impression of sustainability levels, or greenwashing, a practice in which a firm overstates its environmental concern.
Morningstar also noted, that the “ESG integration label would include too many funds using too little ESG to be meaningful.”
In fact, it believed that “greenwashing may worsen as funds that do not necessarily consider themselves to integrate ESG factors may nonetheless be required to disclose such considerations as if they do.”
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