Charting a course through the sustainable finance forest

First published in our Turkish member association's newsletter Kurumsal Yat?r?mc?

In the world of finance, sustainable investing has taken centre stage, attracting investors who seek to align their portfolios with environmental, social, and governance (ESG) principles. However, unclear definitions and varying interpretations have led to a highly heterogeneous landscape of sustainable investments, making it difficult for investors to discern which funds truly align with their values.

One of the challenges lies in fund classification. The European Sustainable Finance Disclosure Regulation (SFDR), introduced in 2021, requires that fund managers assign their funds to one of three sustainable categories. The first category, known as "grey funds," lacks sustainability characteristics altogether. The second category, "light green funds" under Article 8 of the SFDR, incorporates ESG characteristics. The third category, "dark green funds" under Article 9, sets concrete sustainability objectives. Depending on the category, the SFDR imposes transparency requirements on fund managers. But despite the European Commission’s intention for SFDR classification to be a transparency framework rather than a labeling regime, the reality has played out differently.

Article 9 funds offer investors a stronger sustainability guarantee, especially since ESMA reiterated that the portfolio of Article 9 funds should exclusively consist of sustainable investments (100%). Up until then, many market participants were using a good faith assumption that a small portion of the portfolio of an Article 9 fund could also be invested in assets that are not considered sustainable, for portfolio management purposes. This strict interpretation, along with the anticipation of the European Commission’s further clarification of key SFDR topics, in particular regarding the concept of “sustainable investment”, prompted the fund industry to adopt a highly cautious approach and downgrade many funds from Article 9 to 8. In the second quarter of 2023, the European Commission's clarifications on the SFDR provided a more flexible approach to sustainable investment definitions, however we don’t have a view yet on how fund managers are responding.

On the other hand, Article 8 funds present a wide range of shades of green. Some fund managers incorporate minimal ESG characteristics into their investment policies, such as excluding investments in weapons and tobacco. Others aim to invest at least 95 percent of their assets in sustainable activities.

The line between Article 8 and Article 9 funds is not always clear, and gaining clarity requires a high level of investor engagement and an in-depth analysis of the complex and lengthy pre-contractual documentation of funds. Investors can also look at the website of the fund manager to understand how sustainability is being approached and how ingrained it is into their DNA. However, it is highly debatable to what extent investors actively review either the pre-contractual disclosures or the website disclosures, let alone considering both documents simultaneously. To aid end-investors, fund documentation should be simplified by regulators to enhance accessibility.

In the realm of sustainable investing, the power of words is immense. Investors might assume that funds with terms like "sustainable," "impact," or "ESG" in their names guarantee true sustainability. However, there are currently no strict regulations dictating how fund managers should incorporate references to sustainability in fund names. Discussions at the European level are underway to establish more stringent rules for fund names. The ESMA has proposed that funds with ESG-related terms in their names should exhibit at least 80 percent ESG characteristics. Additionally, funds with "sustainable" in their name should ensure that at least 50 percent of their investments are sustainable. These proposed rules do not guarantee the exclusion of greenwashing however, as many sustainable concepts still lack clear definitions. Therefore, new rules should be delayed until the SFDR review takes place. While ensuring that fund names accurately reflect the fund's characteristics is crucial, solely relying on fund names when making investment decisions is ill-advised.

In conclusion, the fund and asset management industry, along with end-investors, encounter challenges and uncertainties within the sustainable finance framework. However, there are encouraging indications of progress on the horizon. Revisions to the regulatory technical standards (RTS) of the SFDR are currently underway to address existing shortcomings, and a more comprehensive review of the SFDR is planned for the future. Additionally, the recently implemented phased-in framework of the Corporate Sustainability Reporting Directive (CSRD) aims to enhance the accessibility and reliability of ESG data. These developments, along with others, hold the potential for bringing clarity to the intricate landscape of sustainable investing and empowering investors to make better-informed decisions. As fund managers continue to adapt to new policy guidance, it is highly likely that the markets for Article 8 and Article 9 funds will remain in a state of constant change for the next few years.

Author:

Anyve Arakelijan - Regulatory Policy Advisor at EFAMA

Read more about EFAMA's work on SFDR below.