Until sustainability is defined, the market will take advantage of the loopholes

The Sustainable Finance Disclosure Regulation should explain to investors how their money contributes to a more sustainable world. Funds conveniently use green labels, but the term ‘sustainable’ remains very pliable. As revealed by The Great Green Investment Investigation, many ‘Dark Green’ funds do not deliver on that promise at all. Politicians and the market no longer find this to be acceptable. But they are both waiting on each other to come up with a solution.

A green world originates in the glass, steel and concrete hearts of Zuidas, Frankfurt, London and other financial centres. Banks, asset managers and investors are like gardeners: the plants they water grow faster. When sustainable companies have easy access to capital, their financing costs are lower, and they can make quicker investments. 

That is the idea behind the Sustainable Finance Disclosure Regulation (SFDR): a European regulation introduced in 2021 to make the flow of capital into sustainable initiatives easier. According to that regulation, asset managers have to assess the sustainability of their investment fund: does it contain stocks and bonds that are grey, light green or dark green?

It’s not running quite as smoothly yet. Because: what constitutes ‘sustainable’? The international research consortium The Great Green Investment Investigation (TGGII), set up by Follow the Money and Investico, previously demonstrated that some fund managers believe that even investments in the fossil fuel industry or aviation deserve a dark green qualification. 

Clearly, the rules need to be tightened. In doing so, European regulators (ESAs) are also seeking the opinion of others: until the summer of 2023, everyone can express their views on the rules that define exactly what fund managers should disclose.

Meanwhile, market players are lobbying for a thorough review of the SFDR, even though these sustainable investment rules are brand new. Furthermore, it is notable that both the European Commission and market players are shirking the responsibility of answering the question of what constitutes sustainability.   

Sustainability boom

Here is a quick recap. Since the European regulations came into force on 10 March 2021, funds rapidly turned green. By late April, there were already hundreds of light and dark green funds in the market with a combined value of 2.16 trillion euros, according to Morningstar financial data analysts.

Labelling yourself as sustainable turned out to be a great marketing tool. Investors looking for a green destination flocked to this promise of green and growth. Self-declared sustainable funds boomed, and others were set up at breakneck speed. Simply put: by mid-2022, European funds were selling half their investments as sustainable, according to Morningstar. Their combined value: 4.18 trillion euros, a figure comparable to Germany’s gross national product – or the market capitalisation of Alphabet, Walmart, Nestlé, ExxonMobil, Coca-Cola, Pfizer, ASML, Toyota, Walt Disney and Shell combined.

Investors are not to blame: they continue looking for sustainable uses for their capital

Money continued pouring in, even when stock prices fell because of the war in Ukraine, rising energy prices and high inflation. Research by the European Fund and Asset Management Association (EFAMA) shows that additional tens of billions of euros flowed into self-proclaimed sustainable funds last year.

Thus, investors are not to blame: they continue looking for sustainable uses for their capital, even in the face of economic adversity. Funds that self-classify as ‘dark green’ under the SFDR rules have easier access to money than others. 

‘Those funds are very popular and have a higher valuation,’ Joost Schmets of the European-VEB, the advocacy group for European securities owners, observes: ‘The sustainable investment business is complex. Investors want sustainable funds, but it’s a jungle out there, so they jump onto the Article 9 rating bandwagon. Such funds are supposed to feature sustainability as their core theme.’

Blatant climate damage

Due to the massive inflow of capital, Follow the Money, Investico and nine other European media outlets examined self-proclaimed sustainable funds under the banner of The Great Green Investment Investigation (TGGII). The investigation focused on these so-called Article 9 funds. This is the most sustainable category: companies whose shares or bonds are held in these funds may not cause significant harm to any form of sustainability. No human rights violations, no environmental pollution, no climate damage – nothing.

A large portion of these funds could not deliver on that sustainability promise. As many as half of all Article 9 funds in Europe were found to be investing in the fossil fuel industry or aviation: sectors that blatantly cause climate damage. 

The result of this investigation caused a torrent of criticism against those investment funds. MEPs pleaded with Parliament to tighten the rules. The French regulator advised excluding fossil fuel investments from Article 9 funds. The European-VEB also voiced its disapproval: ‘If you cannot deliver on your green promise as a fund, then don’t make that promise. Nobility obligates. You shouldn’t reap a reward you don’t deserve.’

The European Supervisory Authorities were also shocked by the result. On 12 April, they published a set of proposals commissioned by the European Commission to ‘address the problems that have arisen since the introduction of the SFDR’. In that proposal, they explicitly refer to TGGII’s research result: ‘It appears that a significant proportion of Article 9 products (...) are exposed to fossil fuels and, in particular, coal activities. (...) According to The Great Green Investment Investigation, 269 investment funds have invested in at least one company active in the coal industry.’

Greenwashing concerns

According to regulators, the abuses are partly caused by the fact that fund managers currently have ‘considerable freedom’ in deciding which investments are sustainable and which aren’t. While one fund manager readily declares the companies in his portfolio green because they emit slightly fewer greenhouse gases than average, another explicitly looks for companies favouring sustainability over financial returns. Yet both can then be classified as ‘Article 9’, i.e., dark green. Regulators are concerned that this could ‘undermine comparability’ and potentially ‘lead to greenwashing’.

‘The entire framework is based on the question: what constitutes a sustainable investment? But that question has not been answered yet’

There is no clarity on how to solve this problem; the market and politicians keep passing the buck back and forth. In a Financial Times article published in late March, some fund managers called on the European Commission to clarify the ‘unstable’ definition of sustainability. They feel that if clarity is not forthcoming, then the entire Article 9 category should be scrapped.

Randy Patisselanno of the Dutch Fund and Asset Management Association Dufas thinks it is too early to say whether that position is more widely supported among more asset managers. The current system is a difficult feat for the market, he says. ‘The whole framework is based on the question: what constitutes a sustainable investment? But that question has not been answered yet.’

Neither fish nor fowl

Pointing to politicians and saying they should scrap Article 9 astonishes some people. ‘The ink on these regulations is still wet,’ says San Lie, CEO of ASN Impact Investors. ‘If you scrap it now, we go right back to square one. Implementing this legislation has cost billions; the industry has deployed a whole army of consultants and lawyers. Are we now supposed to scratch all that? We shouldn’t want to. Then I would rather have spent that money on finding more sustainable projects.’

If a category has to be scrapped, then it should be the ‘light green’ Article 8 category Lie submits. ‘That consists of a vast range of funds. Some border on Article 9, but they didn’t quite make the cut. Other funds are very grey, and the ‘sustainable fund’ part only goes as far as their name.’ According to Lie, it is precisely this ‘neither fish nor fowl’ category that creates ambiguity among investors.

‘Of course it is difficult to find sustainable uses for capital: the world is not sustainable yet’  

Lara Cuvelier of the French NGO Reclaim Finance says: ‘Having credible article-9 funds means a lot of work to analyze companies’ activities and restricting the investment universe. But it’s definitely not unattainable. The question should rather be: Why should the European Comission lower the bar for Article 9 funds because the universe is considered too small for now, or because asset managers do not have the right systems in place to analyze companies? How would that be an incentive?’

‘The complaints from the fund industry seem somewhat pathetic,’ Schmets echoes. ‘The practicality of the regulation is obviously an important issue. But fund managers now seem mostly afraid that their work will become more difficult. Sustainable investing is not an easy task. As a fund manager, you must closely monitor the companies in your portfolio and keep the communication going.’

Who has the ball: the market or the politicians?

The short-term solutions proposed by the European Supervisory Authorities suggest they are betting on both horses at this stage. On the one hand, they believe improvement is possible if fund managers are required to disclose more information, such as reporting what thresholds they use in determining whether an investment harms the environment or people. It could improve the comparability of investment funds while fund managers still have ample freedom to determine which investments would fit into a dark green fund.

Another solution, they say, is a so-called ‘safe haven’ for investments that comply with the green taxonomy. That is the European classification system in which Europe defines which activities can and cannot be termed sustainable. Then, fund managers would no longer have to test investments that appear in the taxonomy, such as solar or wind energy and (under very specific conditions) gas, against environmental damage. This makes it easier for fund managers to determine what they are allowed to invest in and to encourage investment in these activities. Thus, the responsibility for determining what is sustainable is then in the politicians’ court.

Lastly, a proposal is on the table to keep the current rules pending a more thorough review. The regulators wrote that this would prevent ‘market disruption’ and further implementation costs for the sector. 

Public consultation

Until 3 July 2023, regulators will seek feedback via public consultation. Joost Schmets of the European-VEB hopes the financial industry will rise to the challenge. ‘What I find lacking in the fund industry is a genuine willingness to help provide investors with clearer information. Laws and regulations on sustainability are undergoing enormous changes, and the fund industry can help provide clients with more clarity. It is then inappropriate to only complain, disapprove and drag your feet. Provide clarity, show initiative. Hopefully, this consultation will help achieve that.’

Either way, the European Commission made it clear on 14 April that, for now, the responsibility for determining what constitutes a sustainable investment lies with the market. ‘Financial market participants should make their own assessment for each investment and disclose the underlying assumptions,’ it wrote in response to previously posed questions.

In doing so, it meets the wishes of at least some of the fund managers that still offer Article 9 funds. A spokesperson for Impax Asset Management said: ‘We welcome the recent clarification by the European Commission that the SFDR will focus on transparency and not impose rigid definitions of a sustainable investment.’

‘That the SFDR will be revised at some point is clear,’ MEP Bas Eickhout said on behalf of The Greens/European Free Alliance. ‘However, the European Parliament and the member states will simply have to approve it; the Commission will not do so until after the European elections in May 2024.’

Therefore, the SFDR remains in force for the time being. This means that in June 2023, European asset managers with Article 9 funds will once again have to disclose in their semi-annual reports what they invest in and how those investments prevent significant harm. Based on those reports, The Great Green Investment Investigation − the international research consortium led by Follow the Money and Investico − will reassess their portfolios. 

Translation: Delia Burggraaf