ESG label stripped from 23% of EU sustainable funds

LONDON • Almost a quarter of funds that claim to promote sustainability under European regulations do not deserve an ESG label, according to a fresh review by market researcher Morningstar.

The analysis, which looked at funds classified as Article 8 within the European Union's Sustainable Finance Disclosure Regulation (SFDR), shows that 23 per cent do not live up to environmental, social or governance (ESG) investing principles, ESG analyst Boya Wang at Morningstar said.

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 like tobacco, coal or weapons, the analyst said.

The assessment is the latest to raise questions around a key pillar of Europe's efforts to become of global champion of sustainability. No other jurisdiction has raced ahead with such an ambitious programme for transforming the entire asset management industry. But even regulators are starting to warn that the process has left too many chances for greenwashing.

The EU's rulebook for ESG investing, SFDR, which was enforced in March last year, requires firms to classify their investment products under one of three categories: Article 6, which addresses only ESG risks; Article 8, which promotes ESG characteristics; and Article 9, which sets measurable ESG objectives.

The vaguest of the three categories, Article 8, has become a magnet for fund managers. The latest Morningstar data shows asset managers have reclassified well over 600 funds previously under Article 6 to Article 8. A number of Article 9 funds were also downgraded to Article 8. As at June, funds listed as Article 8 held €3.76 trillion (S$5.26 trillion), against €420 billion allocated to Article 9 funds, Morningstar estimated.

The reclassifications coincided with a crackdown by financial watchdogs on funds suspected of misstating the "ESG-ness" of their portfolios.

There is also evidence that investment clients are growing more cautious towards Article 8, as fund managers include atypical ESG sectors like defence, energy and commodities in the category. Over US$30 billion (S$41.6 billion) was withdrawn from Article 8 products last quarter, while roughly US$6 billion flowed into the stricter ESG category of Article 9, Morningstar data showed.

In response to stricter rules and more demanding clients, some asset managers have started removing ESG labels from funds, rather than be accused of greenwashing. In the second quarter, six funds dropped sustainability-related keywords from their names.

The European Fund and Asset Management Association, which represents the industry, said the issue stems from the absence of adequate ESG definitions. European regulators acknowledge the need to revisit some of the definitions now guiding SFDR allocations. Ms Verena Ross, chair of the European Securities and Markets Authority (ESMA), said in May that regulators are working on reducing "what one might call over-disclosure by investment funds under Article 8, to avoid misleading disclosures to investors about the greenness of a product".

Ms Ross said ESMA supports future legislative efforts to create clear criteria for financial products making sustainability disclosures. This includes potentially introducing sustainability labels for financial products.

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