Europe’s fund and asset management industry, seeing rapid growth in investor demand for sustainable products, is asking EU policymakers for a robust and transparent new legal framework that clearly defines how ESG and sustainability ratings for investment products are determined.
Efama, the European fund and asset management association, has called on the European Commission to create a regulatory framework for ESG ratings. The framework needs to boost clarity on the offering of sustainable investment products and needs to ensure a level playing field among EU and non-EU rating agencies.
In addition to the legal framework, the association called for a voluntary code of conduct on ESG ratings. “Compared to a legal framework, a voluntary code of conduct could hopefully be set up quickly, which could help the European Commission correctly calibrate the future legal framework based on this experience,” Efama said.
‘Avoid conflict of interest’
The new framework also needs to make sure the industry can avoid conflict of interest and preserve market integrity by setting specific requirements for internal controls and governance processes. Supervisory authorities should ensure a competitive market for ESG ratings that does not allow a small number of providers to set excessively high fees for their services.
Efama’s call is backed by new research that shows a persistent increase in investor demand for sustainable funds as defined by the EU’s Sustainable Finance Disclosure Regulation, or SFDR, which sets conditions for “light green” Article 8 funds and “dark green” Article 9 funds.
Efama’s analysis of ESG ratings assigned by Refinitiv and Morningstar to a large sample of Article 8 and 9 funds found that the average ratings for Article 9 funds “are slightly higher” than those for Article 8 funds.
‘No perfect tool’
Naviging Article 8 and 9 funds is “complex” and requires advisors and distributors to look further than merely the ESG rating. “When using ESG ratings, advisors and distributors should not rely on these in isolation as there is no perfect tool to comprehend the specific ESG characteristics of a fund.
“Our analysis has shown that even purposeful funds classified as Article 9 won’t necessarily get high ESG ratings,” said Efama. “We consider that financial advisors and fund distributors should not necessarily offer only Article 9 funds to clients expressing a strong ESG preference, and national regulatory rules should refrain from imposing such a requirement.”
Efama said that, instead of using shortcuts like going for a fund with a high rating, advisers and clients should look to understand what a fund is really trying to achieve and not use information such as ESG ratings in isolation.
Presenting policy recommendations to help ensure that the market for ESG ratings functions well in the future, Efama said funds also need to ensure that their ESG approach is aligned
with the investor’s ESG preferences, such as for example regarding controversial activities exclusions, and views on risk, like risks related to specific environment or social themes in some market conditions.
‘Really understand the product set‘
A fund with a high-quality rating may not automatically be in line with an investor’s ESG
Preferences, Efama said. Hence, advisors and distributors would be well advised to “really understand the available product set”, by using other tools such as the “European ESG Template (EET), national and international guidance, external assessment by consulting services, engagement with their stakeholders, benchmarking against peers, as well as the precontractual (SFDR templates, KIDs) and periodic reports that are the result of all the regulation the industry is implementing.”
ESG ratings aim to give an indication of the ESG quality of a fund based on a specific methodology. This allows comparison as each ESG ratings provider applies the same methodology to all the funds it assesses, but it does not allow comparison of ESG ratings across multiple providers, Efama said.
“We expect the use of ESG ratings to increase in the future, and therefore we see the need for swift development of a regulatory framework,” it said.
The regulatory framework should impose disclosures requirements in relation to the methodologies and data sources used to provide ESG ratings. Efama said the benefit of transparency is that advisors and distributors would then be able to utilise the data vendors who provide ratings most closely aligned to the approach of the fund and goals of the investor.
‘No standardisation’
Efama however stopped short of calling for a standardisation of rating methodologies.”The regulatory framework should not standardise the underlying methodologies, in order to allow providers sufficient flexibility to use a wide range of methods and approaches.”
Addressing the level playing field, Efama noted that the market for rating providers is split between a small number of very large non-EU entities on one hand, and a large number of significantly smaller EU entities on the other. Some of these larger, more established market participants have begun to acquire smaller and more specialised ESG providers.
The legal framework “should ensure that all organisations providing ESG ratings to funds domiciled in the EU are within scope,” Efama said.
Efama called on supervisory authorities in the EU to improve their understanding of the pricing and licensing frameworks for ESG ratings and ensure that the market remains competitive, but not allowing “a small number of providers to set excessively high fees for their services”.