Not surprisingly, Fitch noted an increased demand by investor to incorporate ESG factors in the decision process for investment funds. The credit ratings agency explained that regulations and proposals, in general, address two challenges. First, they devise a fund labelling or classification system. Then, they create a set of disclosure and reporting requirements that should be described in the investment process.
While encouraging capital flows to promote sustainable investments, the regulators are attempting to address the same basic problems and goals of minimizing greenwashing and enhancing investor transparency. Their purpose is to ensure that ESG funds do not mislead markets or investors. Furthermore, most regulators employ or refer to international standards. “So, the regulations are similar, but they are slightly different, and they all are at different development stages,” said the Fitch analysts.
Fund reclassifications: not as bad as it looks
Starting with the Sustainable Finance Disclosure Regulation, Fitch explained that the SFDR was implemented in two phases. First, it classified funds in 2021 in three different definitions, Article 6, 8 and 9 all carrying different specific disclosure requirements. Second, the goal of the Regulatory Technical Standards, a regulation applicable starting from early this year, was “to harmonise the implementation of SFDR and that it is done via the use of standardised templates and specific metrics and is quite prescriptive in their approach,” said the Fitch analysts.
Fitch noted the reclassification of funds that made some headlines in November and December with the downgrade of several fund from article 9 to article 8. In fact, Fitch observed that the assets under management of article 8 funds grew by 20% between June 2022 and December 2022 and its analysis shows that “the primary driver of this AuM increase were reclassifications from article 6 to article 8, the second driver was inflows or organic growth,” while the reclassification from article 9 to article 8 “was actually quite minimal.”
Further, the uncertainty and the confusion on SFDR are amplified when the reclassifications “are subsequently reversed, in short order” said Protheroe at SSGA. He added, “reporting remains a challenge” in particular “with the requirement to report on principal adverse impacts and the difference in methodologies across different ESG providers.”
On sustainability related disclosures and needed transparency, Fitch detects ongoing uncertainty by not only the asset managers, but also some regulators such as France, regarding the definition of a sustainable investment. To provide the much-needed clarity on SFDR, the regulator published earlier in April a Q&A report. However, the answers from the regulator demonstrate a willingness to leave significant level of discretion and interpretation to asset managers. Protheroe at SSGA believes that the revised Q&A “appears to commit funds tracking Paris line benchmarks to be classified as article 9.”
Due to the high cross-border EU and UK business for the UK fund industry, the FCA, the UK regulator, also proposed equivalency routes with SFDR and the SEC in the US
Fitch concludes the regulator is trying to find a balance between providing that needed clarity to the market, but at the same time not restraining or hindering the market from innovating in what is a relatively new space.
Other non-EU regions slowly catching up
The EU is overall perceived as “usually adopting a prescriptive approach” contrary to other regions. The UK proposal regarding ESG disclosures was released last year but it is not finalised yet. Retail funds are in scope, whereas it is at the managers’ discretion for institutional funds “if they meet certain criteria”.
The UK proposals introduced three sustainable product labels (sustainable focus, sustainable improvers and sustainable impact), product disclosures and specific fund naming rules. Importantly, “due to the high cross-border EU and UK business for the UK fund industry, the FCA, the UK regulator also proposed equivalency routes with SFDR and the SEC in the US”, Fitch said.
The Swiss have gone their own unique way with a “multitude of different self-regulators, industry authorities and councils” implementing ESG common issues on a “voluntary basis or for members of that specific organisation”, said the Fitch analysts. For instance, these entities have defined greenwashing, published a self-regulation proposal covering transparency and disclosures, but have not established a fund labelling system unlike in the other regions. Similar to the UK, the Swiss have introduced some cross-border equivalency aspects and “asset managers may opt to comply with comparable international standards.”
As for the UK, the proposal by the SEC last year have not been finalised yet. First, the regulator is suggesting different requirements for disclosure based on a fund classification (integration funds, focus ESG funds and impact funds). Fitch said that the focus ESG and ESG impact funds have more disclosure requirements than the integration funds which “integrate ESG factors alongside non-ESG factors in their investment making decisions.” Second, the proposal is to “expand upon the names rule under the 1940 Act.” Fitch specifies that “the name rule requires funds with certain names who adopt a policy to invest 80% of their assets in the investments suggested by that name.”
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. Subscribe using this link.