The growing complexity of Europe’s sustainable finance framework and a lack of clear guidance from EU supervisors is leading to a fragmented application of the benchmark EU regulation that determines which investment funds are sustainable and which are not. As a result, the sector is facing what Morningstar’s top ESG expert calls “The Great Reclassification”.
Many asset managers, institutional investors and sustainable finance specialists that Investment Officer has spoken to in recent months have flagged a high level of frustration with the “uneven” introduction of the EU’s sustainable finance regime and argued that policymakers have placed the industry at risk of greenwashing allegations.
In the absence of clear EU guidance from Brussels, where the European Commission has openly stated that natural gas and nuclear energy can be regarded as sustainable transition fuels, national financial supervisors are trying to fill the void, each one attempting to define its own terms. As a result, the investment industry now is acting in different ways in different countries, which risks leading to a fragmented approach across the 27 EU member states.
Categories changed
At Morningstar’s EU Investment Conference in Amsterdam, it became clear that specific national guidance measures have caused asset managers to reclassify their investment funds, changing the categories to which they belong on the SFDR. Hortense Bioy (photo), Morningstar’s global director of sustainability research, talked about “The Great Reclassification” among sustainability funds.
“There is actually a lot of confusion in the market because it’s a self classification exercise,” said Bioy in an interview. “Because the definitions provided by the regulator leave a lot of room for interpretation, asset managers have interpreted things very differently, which has led to different approaches to product classification, which also has led to greenwashing accusations. One does things one way. Others do things another way.”
The classification of funds under the SFDR is determined by Articles 6, 8 and 9. A “dark green” Article 9 fund is considered most sustainable, holding investments that seek to achieve a positive impact, while a “light green” Article 8 fund needs to include sustainable investments that do not necessarily aspire a positive impact. An Article 6 fund is considered a “brown” investment without sustainability benefits.
More than half of al EU funds “sustainable”
More than half of all investment funds in the EU are now classified as Article 8 or 9, according to Morningstar research, and some 60 percent of new fund launches during the second quarter were in these categories.
Despite widespread outflows in the broader market during the second quarter, Article 9 funds still have reported 5.9 billion euro net inflows, Morningstar said. Article 8 funds bled 30.3 billion euro in the second quarter.
During the second quarter, approximately 700 investment funds were upgraded from 6 to 8 or from 8 to 9, while 16 funds were downgraded from 9 to 8, research by Morningstar shows. No funds were downgraded to Article 6.
Bioy made clear that more downgrades are to be expected. A reclassification requires asset managers to inform their investors, although it does not mean that the actual investment approach has changed.
“It means a lot of time and effort and sometimes it is unproductive,” said Bioy. “When they talk to the regulator, they get to hear different things. It’s actually not harmonised at the moment because the European regulator has taken so much time to provide clarity and guidance. National regulators are stepping in and now they are saying different things.”
Especially Dutch investment funds have been subjected to a downward reclassification. This following guidance from regulator AFM, which a year ago said it expects an Article 9 fund to hold 100 percent of positive impact investments, and not 90 percent, as the Dutch market previously was led to believe. The 90 percent threshold is still accepted in other European countries, including Luxembourg.
Dutch exclude transitioning companies
“The Dutch regulator has actually clarified that you can only count as sustainable investment companies that are already sustainable, so you can’t include transitioning companies,” Bioy said. The Dutch regulator has clarified that that (transition, ed.) doesn’t count. But the European regulator hasn’t clarified that yet for all of Europe. And if the European regulators follow the same guidance, then it means a lot of funds, Article 9 funds, will be downgraded.”
Morningstar’s list of the ten largest Article 9 funds that were downgraded to Article 8 during the first half of this year includes seven funds marketed by NN Investment Partners, a unit of Goldman Sachs. The list is topped by the NN Enhanced Index Sustainable Equity Fund A, which holds 2.85 billion in assets, and also includes three funds sold in Europe by US investment manager Pimco.
NN IP said it adjusted the classification as a result of “evolving” regulatory requirements.
Dutch asset manager Robeco also is reported to prepare downgrades for 7 of its sustainable funds.
Nuclear and fossils included
Morningstar’s research also showed that a typical Article 9 fund holds between 70 and 90 percent in sustainable investments, while that percentage drops to between 0 and 60 percent for Article 8 funds.
Its analysis also shows that the majority of these funds are still exposed to fossil fuels and nuclear energy, although Article 8 and 9 funds in general terms tend to have a lower exposure to controversial investment activities.
Bioy said that she believes the fragmentation with different national interpretation is temporary and that a smooth and even application of the EU’s Sustainable Finance Disclosure Regulation, known as the SFDR, will eventually be in place at some time in the coming years.
“It is still early days,” she said. “We are in messy times. The regulation leaves a lot of room for interpretation and the market is moving extremely fast. Clients want certainty, but the regulator is not necessarily ready to provide certainty. I think they were probably surprised by how quickly this demand for ESG products accelerated.”
The regulator, notably the European Securities and Markets Authority, is nevertheless watching. “They need time. They need to also observe what’s happening. They don’t want to stifle innovation, so they want to see how these things are being interpreted and implemented. And then they will provide some more harmonised guidance.”