What steps can European fund managers take to understand and adapt to the new raft of EU ESG regulations that are being introduced?
- The EU is using SFDR to make Europe’s asset managers a lever for achieving its Paris Agreement targets.
- It’s hoped that these regulations will speed the growth of ESG assets in Europe, with experts predicting that half the region’s investment funds will be sustainable by mid decade.
- There is concern that lack of clarity in the legislation will actually impede accurate ESG labelling for funds.
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The European fund management industry is facing a rising tide of environmental, social and governance (ESG) regulations.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) requires asset managers to disclose information about the ESG risks in their portfolios, and how they address them.
From 10 March 2021, funds came under one of three categories: article 6, 8 or 9.
Funds classified as article 6 are non-ESG. The distinction between 8 and 9 is basically light versus dark green. Article 8 are funds integrating ESG considerations but more focused on financial outcomes, while Article 9 funds are more focused on sustainable economic activities, such as reducing carbon emissions in line with the Paris Agreement.
Article 9 is not only linked to environmental objectives, but social, such as building affordable housing, or gender equality.
A fuller definition of what the European Commission considers sustainable will arrive in January 2022, as will a requirement for more comprehensive disclosures, including a ‘principal adverse sustainability impacts statement’ from fund managers. It’s not yet clear what this will involve.
Despite intimations last year that the UK would participate in SFDR, it opted out. Its regulator, the FCA, has promised its own set of regulations, and is no doubt waiting to see how things pan out with SFDR before it goes public, on the basis that it’s always less painful to learn from someone else’s mistakes than your own.
ESG regulations and the EU taxonomy
January 2022 is also when the EU taxonomy regulation comes into force.
The taxonomy is a classification system, establishing a list of environmentally sustainable economic activities. These range from climate change mitigation, through to sustainable use and protection of water and marine resources, to transition to a circular economy, waste prevention and recycling. Further, an activity that contributes to one objective must do no harm to any of the others.
At that point, listed companies with more than 500 employees must disclose what proportion of their sales and capital expenditure comply with the taxonomy’s definition of sustainability.
Fund managers will have to disclose what proportion of their portfolio’s underlying investments fall within the taxonomy. By aggregating the proportion of a fund’s investments that contribute to the EU’s environmental objectives, and adjusting them according to their weight in a portfolio, a manager can calculate the overall percentage of the fund that is invested in line with the taxonomy.
In part, this is an attempt to bring clarity to the investment industry with regard to ESG, and tackle the persistent problem of greenwashing. But its purpose goes beyond this. Taken together, these two new sets of ESG regulations are designed to help the EU meet the targets under its Green Deal, notably to decarbonise its economy by 2050.
The impact on Europe’s asset management
What impact will this have on the shape of Europe’s asset management sector? Consultancy PwC anticipates this could lead to half of European asset managers’ AUM being badged ESG by 2025.
This would represent a 28.8 percent compound annual growth rate from 2019 to 2025. While that’s quite a clip, the CACR for EU ESG for 2019 and 2020 was 30 percent and 24 percent respectively, so, while a tall order, it’s not beyond the realms of possibility.
European growth in ESG funds – AUM by asset class (EUR billion)
By introducing the two new sets of ESG regulations, the EU is making the asset management sector a lever to realise the objectives of the Paris Agreement and to integrate the UN Sustainable Development Goals.
Indeed, the influence of the new rules may stretch beyond Europe, as any international asset manager wishing to sell funds within Europe must comply, as must international companies listed on European exchanges.
Definition of articles in the SFDR
But it’s not all plain sailing to the sunny carbon-neutral uplands: not least because fund management companies are having to determine which funds fall under article 6, 8 or 9… without being certain how these categories are being defined.
Some are concerned that they lack clear definitions, especially for article 8.
For instance, there is a lack of clarity about what, concretely, is meant by the requirement for “good governance practices”, or how one demonstrates the “material” impact of security exclusion through screening.
A number of fund managers have chosen to be classified as article 6 products, or to fall under article 8 when they should be article 9, as they want to avoid to be penalised for mis-selling. Getting this wrong could be costly.
It’ll be interesting to see when the dust settles on SFDR how many funds opt for article 8 or article 9 status – light or dark green respectively. While the UK has yet to determine the shape of its ESG regulatory offering, it’ll likely not look too different – although hopefully incorporating lessons learned from the European experience.
As the demarcations become clearer, will we see a migration from light to dark green, as investors become more demanding, and wanting to see the more tangible impacts offered by the dark green article 9-classified funds, or will light green suffice?
As ESG gathers momentum, a requirement for fund managers to explain exactly how they’re implementing such principles must be a step forward. But the red tape that’s wrapping the green regulations will need some adjusting.
