Despite delays EU sustainable finance legislation begins to shape the market

The EU’s sustainable finance framework is already shaping the bloc’s investment landscape regardless of ongoing uncertainties around the full implementation of the new regulatory environment. But will it go far enough?

Last week people gathered for an action organized by the World Wide Fund for Nature (WWF) to protest against the European Commission's plan to classify the gas and nuclear sectors as sustainable in its taxonomy of economic sectors, in front of the European Parliament in Brussels, Stephanie Lecocq / EPA

Central to the strategy is the Sustainable Finance Disclosure Regulation (SFDR). This requires investment firms to provide greater transparency on the sustainability credentials of financial products such as green bonds or the portfolio of companies in which they are investing.

The SFDR covers a swathe of financial market participants, such as asset managers, pension funds, banks, venture capital funds, insurance companies and financial advisors.

If it does what the EU intends it to, the SFDR should remove the potential for ‘greenwashing’ – a charge which has dogged the financial industry. Some NGOs say they fear the legislation will get watered down to such an extent that it is unlikely to achieve that aim.

The idea is to provide an easy-to-understand classification for potential investors to assess funds and other financial products on the basis of the environmental, social and governance (ESG) and sustainability credentials of companies and other assets in which they are investing.

There is no obligation for firms to channel their money into sustainable investments, but the hope is that pressure from customers to go green, along with these firms’ own increasingly stringent ESG requirements, will prompt the switch.

Hortense Bioy, Director of Sustainability Research at investment research firm Morningstar, said that, despite the uncertainties, the direction of travel towards more SFDR-compliant investments is clear.

Confusion and delays

The first phase of the SFDR – known as Level 1 – was introduced in March 2021, as the EU sought to push more investment into products that would help the bloc meet its carbon emissions and other sustainability targets ahead of the COP26 climate conference.

The move drew protests from the investment industry, as market participants were required to apply the new classification to their assets, even though the rulebook on how to do so – known as the EU Taxonomy for sustainable activities – had yet to be fully introduced. The European Commission (EC) issued clarifications later in the year to help investors navigate Level 1 requirements.

The timetable for bringing in Level 2, which includes more detailed guidance on the Taxonomy and other technical standards relating to the SFDR, was pushed back on November 29, having already been previously postponed.

The EC said the introduction of the relevant act would be delayed by a further six months to 1 January 2023. However, asset managers will still be required to provide more sustainability data than now on their funds over coming months, under the Level 1 regulations.

Article 9 funds still small percentage of the market

Under the SFDR, funds need to be classified as Article 6, 8 or 9, with Article 8 and 9 funds needing varying degrees of sustainable commitments. Article 8 funds are those that simply promote “environmental or social characteristics."

The definition of an Article 9 fund is stricter, being one “that has sustainable investment… or a reduction in carbon emissions as its objective.” Funds that do not meet the sustainability criteria of either of these categories are classified as Article 6 funds.

“We've already seen inflows into Article 8 or 9 funds accelerate in recent months, driven by increased investor interest in sustainability issues and the higher number of options available,” Bioy of Morningstar told a webinar on the EU’s sustainable investment action plan held on December 2.

The firm estimates Article 8 and 9 products captured 57% of total flows into EU funds in the third quarter of 2020 compared with 44% in the second quarter.

“We estimate that Article 8 or 9 fund assets will reach close to half of total assets in scope of SFDR by the middle of next year,” Bioy said. Article 8 funds now account for around 33% of all EU fund assets, while Article 9 funds account for 3.9%, according to Morningstar.

Farewell to greenwash?

The higher share of Article 8 funds is partly a function of the lower sustainability requirements for that category, but is also a cause for concern if greenwashing fears are to be dispelled.

A number of Article 8 funds were not conceived with sustainability as a core investment principle. Bioy notes that none of the funds in Morningstar’s list of the largest ten Article 8 funds have anything in their names to suggest they have sustainability as a central objective.

These are led by the AB American Income (€21bn of assets under management) and AB Global High Yield (€17.7bn) fixed-income funds, followed by the hausInvest property fund (€16.9).

By contrast, the names of all but two of the largest ten Article 9 funds do indicate that an ESG objective is central to their strategy – these are led by Nordea 1 Global Climate and Environment (€9.8bn), Pictet Global Environment Opportunities (€9.1) and Pictet Water (€8.4). Additionally, nine of the top ten Article 9 funds are equity investors, compared to only three of the top ten Article 8 funds.

“I think this reflects some of the confusion out there, and why some market observers are saying that SFDR, especially Article 8, may have given the opportunity to some asset managers to greenwash,” Bioy noted.

“Because funds that were not marketed as green before are now claiming they are green – or at least greener than the funds that only comply with Article 6 requirements,” she said.

‘Article 8 at least lower ESG risk than the rest of the market’

While many Article 8 funds do have explicit sustainability-related targets, such as the need to achieve a higher aggregate ESG score or lower carbon intensity than a given benchmark, some do not and say only that they consider material ESG factors and engage with companies on sustainability issues, she added.

The delay to the rest of the SFDR legislation also means that, at present, when investment firms classify their funds under one article or the other, they are basing their decisions on incomplete information.
However, Bioy says the scope for asset managers to overstate the green credentials of their funds is limited by the reputational damage likely to be done if they were to be forced to downgrade them later.

“Asset managers who have classified funds as Article 8 or 9 seem confident that they will be able to comply with whatever the regulator is going to throw at them,” she said.

Morningstar’s research indicated that, whatever the shortcomings of the SFDR, Article 8 and 9 funds did at least “tend to have lower ESG risk than the rest of the funding universe,” she added.

Pressure to weaken sustainability criteria

Confusion is being fueled not just by the piecemeal way in which the legislation is being implemented, but also by heated arguments over what should be permissible investments as part of the Taxonomy.

This is particularly the case in agriculture, and the natural gas and nuclear power sectors, where several countries are worried that their economic interests could be damaged.

Natural gas investments are in the eye of the storm. Several EU states have been pushing for investments in gas-fired power to be classified as sustainable under the Taxonomy, citing the emissions reductions possible using natural gas compared to coal-fired power.

They also push the idea that gas is needed as a bridging fuel in the medium-term while low carbon energy infrastructure is put in place.

WWF said [pdf] in November that proposals in a leaked so-called ‘non-paper’ that was sent to the European Commission in late October by a group of member states could result in up to half of existing EU gas plants and many new ones being classified as ‘green’ under the EU Taxonomy if they were adopted.

Proposals on nuclear plants also in the document would result in nearly all existing EU nuclear plants being classified as ‘green’ investment, WWF added.

While the origin of the document was unclear, the Euractiv media network said France had been trying to reach a compromise on the Taxonomy that would satisfy supporters of gas and nuclear power.
A meeting of like-minded countries in October was attended by Bulgaria, Cyprus, the Czech Republic, Finland, France, Greece, Hungary, Malta, Poland, Romania, Slovakia, and Slovenia, Euractiv said.

“Resist pressures to classify gas as a sustainable investment”

Meanwhile, experts who were part of the EU’s Technical Expert Group on Sustainable Finance in 2020 said in early December 2021 that the EU should resist pressure to relax its Taxonomy criteria to include natural gas as a sustainable investment if it is serious about eliminating greenwashing.

The authors said such a decision would be at odds with moves such as the Global Methane Pledge, under which more than 100 countries, including EU states and the US, have committed to a collective goal of reducing global anthropogenic methane emissions by at least 30% from 2020 levels by 2030. Methane is a highly potent greenhouse gas and the main constituent of natural gas.

“If the EU were to relax the threshold of its Taxonomy, this would damage its scientific credibility and bring the EU from its position of climate leadership to one weaker than China and Russia,” the experts argued in an op-ed published on the Politico website.

“Should this happen, other taxonomies based on the EU Taxonomy might also take this as a signal to relax their own thresholds,” they wrote.