On 31 May 2022, around 50 police officers raided the Frankfurt offices of Deutsche Bank’s asset management arm DWS, as part of an investigation into greenwashing at the company. The DWS scandal was prompted by allegations from former DWS sustainability chief turned whistleblower Desiree Fixler, who was originally hired to advance the company’s environmental, social and governance (ESG) efforts.
Fixler said DWS had misled the public and its clients by claiming that around half, or €459bn ($475.76bn) worth of assets under management were ‘ESG-integrated’, when in fact the actual figure was far lower.
This watershed moment has had a lasting impact on asset managers globally, many of whom are now fearful they could be subject to similar accusations. A core issue for investors over the past few years has been the lack of clear and globally consistent regulation around how they should label their sustainable products.
In March 2021, the EU’s Sustainable Finance Disclosure Regulation (SFDR) came into force, supported by the EU Taxonomy for sustainable investments, with the dual aim of clamping down on greenwashing and helping investors distinguish between the many sustainable investment strategies currently on offer in the EU.
Under SFDR, all EU investments fall into one of three categories: Article 8, otherwise known as ‘light green’ products that promote environmental or social elements (for example, those that use negative screening to exclude ‘dirty’ stocks like tobacco or fossil fuels); Article 9 or ‘dark green’ products, which have an overarching sustainable objective or ‘impact’; and finally, Article 6, the remaining products with no sustainable objective or tilt.
A quarterly update on the SFDR’s progress, published in October 2022 by financial data provider Morningstar, reveals the steady growth of assets classed as either Article 8 or 9 since the inception of the SFDR last spring. As of September this year, 55.3% of all assets for sale in the EU are now classed as Article 8 or 9, totalling €4.3trn. This enormous sum points to the huge appetite investors have for sustainable products.
Yet while the SFDR was designed to standardise fund classifications, some asset managers have been more liberal than others when it comes to labelling their funds as ‘sustainable'. When the SFDR first launched, for example, Dutch asset manager Robeco claimed that nearly 100% of its assets were Article 8 or 9, while others like HSBC said less than 10% of their investments fell into these categories.
The lack of binding criteria for investors under the SFDR has led to “confusion in the market and it is giving asset managers the chance to greenwash”, said Hortense Bioy, director of global sustainability research at Morningstar, in an interview with sustainable finance publication ESG Clarity earlier this year.
To counter these concerns, the EU has unveiled a raft of legislation over the past few months aimed at reducing the potential for greenwashing.
Crucially, from January 2023, existing SFDR requirements will be supplemented by SFDR 2, which requires more detailed reporting from fund managers, particularly for Article 9 funds that are supposed to, as the EU clarified in June, only contain 100% ‘sustainable investments’ as defined by Article 2 (17) in the SFDR.
In addition, under recent amendments to MiFID II, an EU investor protection framework first introduced in 2018, clients purchasing financial products in Europe must already be consulted on their "sustainability preferences". This means asset managers will have to declare the minimum proportion of "sustainable investments" in their products as defined by either the SFDR or the EU Taxonomy. In addition, they must disclose which products have "principal adverse impacts", or are harmful to the environment or people.
Unclear definition of sustainable investments under SFDR
However, one of the key issues facing asset managers is that the definition of a sustainable investment under the SFDR remains unclear.
Under the SFDR’s definition, a sustainable investment either contributes to an environmental objective as measured by key environmental indicators; for example, the use of renewable energy, or economic activities that contribute to a social objective, measured by social indicators such as how far the investment contributes to tackling inequality. Crucially, the definition has a "do no significant harm" principle, meaning these investments must not significantly harm any social or environmental objectives.
Under SFDR 2, investors will be required to report additional information on these sustainable investments, such as, for example, a description of how and to what extent investments are in economic activities that qualify as sustainable under the EU Taxonomy. However, as Morningstar notes in its report, this underlying definition of sustainable investment still leaves too much room for interpretation, especially when it comes to the "do no significant harm” principle.
On 6 September 2022, in response to the MiFID II amendments, the European Supervisory Authorities (ESA) wrote to the European Commission, warning that it could face legal challenges around the definition of sustainable investments under the SFDR.
The ESA put a series of questions to the Commission on how officials plan to quantify a sustainable investment. For example, will they apply a revenue-weighted approach or will they apply something more akin to a pass/fail approach, where a company is only counted as sustainable if the entirety of its activities have a sustainable objective?
Without answers to these questions, asset managers are currently unsure of how to act. During the last quarter, according to Morningstar’s most recent SFDR update, a large number of investors have either upgraded or downgraded the SFDR classifications of their existing fund strategies, in what Morningstar has dubbed the "Great Reclassification".
The Great Reclassification
According to Morningstar, more than 380 products have changed SFDR status in the past quarter. While most managers have upgraded their funds from Article 6 to 8, which is relatively common with asset managers keen to tweak their underlying strategies to align with more sustainable benchmarks, more surprising is that investors are now starting to downgrade their funds in order to comply with what they believe will be stricter requirements under SFDR 2.
In its report, Morningstar finds 41 funds have been downgraded from Article 9 to Article 8, up from just 16 funds in the previous quarter. Moreover, Morningstar’s Hortense Bioy told Energy Monitor we can expect this to happen more frequently in the coming months.
While some asset managers are waiting for a clear statement from the Commission on how to classify sustainable investments, others are taking a “precautionary, conservative approach" and deciding to downgrade regardless, says Bioy. Many of the latter are Dutch asset managers, she adds, because the Dutch Authority for the Financial Markets announced in September it would start investigating the status of investors’ compliance with the SFDR and the EU Taxonomy.
Persistent uncertainty around what constitutes a sustainable investment raises important questions. For example, if assets in high-emitting sectors are excluded from the sustainable investment category altogether, how will they be incentivised to reduce their emissions in line with a net-zero trajectory?
The exclusion of transition assets from sustainable investments
The current state of play is that popular climate investment strategies tend to under-weight emissions-intensive sectors.
Over the past two years, investors have shown increasing appetite for funds that follow the EU’s Climate Transition Benchmark or its Paris Aligned Benchmark (PAB), which are both designed to reduce the carbon intensity of portfolios. Companies included in these benchmarks must deliver year-on-year emissions reductions of 7%.
Morningstar data shared with Energy Monitor reveals there are now 108 index or Exchange-Traded-Funds domiciled in Europe that track one of these two benchmarks, representing €80bn in assets. The first of these funds was launched less than two years ago.
However, analysis of their underlying holdings reveals they massively overweight sectors with lower scope 1 and 2 emissions, like information technology and financials, and under-weight emissions-intensive or "high-impact" sectors like energy, utilities and materials.
Such lopsided funds are ineffective at helping the economy as a whole to transition, says Tom Steffen, a researcher at sustainable investment management company Osmosis. “[PABs are] currently forced to actively under-weight high impact sectors, such as energy, materials, and utilities [to achieve the 7% year-on-year reduction in emissions],” he argued in a research paper published by Osmosis in September.
“We need the electricity sector to transition,” Steffen told Energy Monitor. "We need the materials and industrial sectors to transition. All the heavy polluters need to either change their business model or go out of business, but you are not achieving that by opening a portfolio that consists of tech stocks and financials.”
UK regulators have devised a potential solution to the problem of how to classify companies that are in the process of transitioning. In early November, the UK’s Financial Conduct Authority released a draft consultation on its own version of the SFDR, called Sustainability Disclosure Requirements (SDR).
Among the key differences between the SDR and SFDR is that while the latter only provides two categories for sustainable investments, SDR has a third category, called "improvers", which is for those assets that are currently neither environmentally nor socially sustainable but have the potential to deliver measurable improvements over time.
It is almost certain that defining an improver will come with its own challenges, which will likely be reflected in the responses to the consultation. An additional challenge for investors with funds both domiciled in the EU and the UK will be how to map the same investments to the different categories across jurisdictions.