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Sustainable funds face further scrutiny

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Asset managers hoping to influence the shape of European regulation which governs the marketing and distribution of sustainable funds have until 4 July to make their feelings clear.

This April the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority published a consultation paper suggesting amendments to the Sustainable Finance Disclosure Regulation (SFDR) which was introduced in March 2021 to eliminate greenwashing. 

Possible changes include improving the disclosures on how sustainable investments do not significantly harm (DNSH) the environment and society.

The effect any revision may have for asset managers as they endeavour to get impact investment funds to market, remains to be seen but according to Brendan Gallen, a funds expert at international law firm Reed Smith, the industry is currently struggling to maintain Article 9 classification, which is the most sustainable under the rules.

“There has been a real shift in the market. When SFDR came into force, there was a push [from asset managers] to get Article 9 classification. But in practice the classification is really tricky to operate because the bar is set so high.”

Since Article 9 funds must invest 100 per cent of their assets sustainably under ‘level 2’ of the regulation introduced this January, managers are unable to make certain investments which can be to the detriment of the fund’s return profile.

“We have seen funds that were initially marketed as Article 9 being reclassified as Article 8 and that seems to currently be a sweet spot that General Partners (GPs) and investors are becoming most comfortable with,” Gallen says.

Research from Bloomberg Intelligence finds that 70 per cent of all Article 9 ETFs have been downgraded to Article 8, with USD57 billion of assets across more than 70 ETFs downgraded in the fourth quarter of 2022 alone.

Unintended consequences

Gallen notes instances where rather than eradicate greenwashing, SFDR may have served to encourage it.

“In addition to funds being reclassified from Article 9 to Article 8, a key question is whether GPs are doing everything they’re supposed to, to achieve the Article 8 level, and that’s an unknown. The funds I’m working with can demonstrate, in writing and in practice, that they are doing enough in their documentation and processes.”

He continues: “But there is a potential grey area when a GP is trying to achieve a particular article under SFDR in order to attract capital but are they truly doing what they say they are doing in both writing and in practice. This is where suggestions of greenwashing have arisen.”

Gallen adds under the DNSH stipulations in SFDR, Article 9 funds are prohibited from investing in companies that need support in adapting to the green transition.

“A GP may find an asset that doesn’t have a very good carbon footprint from a climate or an impact perspective, but if they were able to invest in it, they could turn it around and do a fantastic job making it into something with a positive environmental impact. With the DNSH requirement under Article 9, GPs may not be able to acquire the asset in the first place,” he says.

European regulators have committed to delivering a final report on a revised SFDR by the end of October 2023.

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