Recent events have shown how anticipating forthcoming clarification on the application of a text that has been published since 2019 has created such confusion that many asset managers have had to reclassify a large number of their funds from Article 9 to Article 8. If the ultimate goal of a regulation is to provide a strong and credible message to the market to favour good behaviour, we can already affirm that the objective has failed with respect to SFDR.
Beyond this confusion, one must firstly observe that not only the industry but also regulators are making excessively ambitious use of Sustainable Finance Disclosure Regulation (SFDR) Articles 8 and 9, which, in the Level I text, were not created to establish labels – such labels fall under existing (e.g. Climate Transition Benchmarks (CTB)/Paris-Aligned Benchmarks (PAB) or possibly forthcoming (e.g. ESG benchmark) regulation – but simply to introduce differentiated transparency requirements for funds with different sustainability-related ambitions.
It is clear that the industry is always looking for labels, but when the texts are not designed to do this, the risk of confusion and imprecision is considerable and, along with it, the risk of greenwashing.
From that viewpoint, the European Supervisory Authorities’ (ESAs) recent Q&A on the SFDR Delegated Regulation and the interpretations that are provided therein pose a problem.
The idea that benchmarking to an EU-PAB compliant index would be enough to qualify the objectives of a fund as being consistent with the objectives included in Article 9 of the SFDR regulation and as such would dispense the fund from “a detailed explanation of the way in which the pursuit of the efforts deployed to achieve the carbon emission reduction objective is covered with a view to achieving the long-term global warming objectives set out in the Paris agreement” (Art 9.3) creates a serious opportunity for greenwashing.
All of this is based on the misconception that tracking error, which is a financial indicator that measures the volatility of the distance between a fund and its benchmark, would provide an indication on compliance with the non-financial criteria or objectives contained in the benchmark.
In very concrete terms, a fund can have very limited tracking error relative to its benchmark yet have very different objectives and/or holdings. Focusing on the existence of a reference index and relying on tracking error to qualify or disqualify a fund as sustainable seems to us to create opportunities for misinformation whereas the very objective of the SFDR was to reduce information asymmetry and improve investor information.
To avoid additional confusion, and ultimately the decredibilisation not only of the SFDR text, but also of the CTB/PAB regulation, it would be good for the regulator to clarify the conditions for using the PAB benchmark, and for this reason the term “tracking” used by the European Securities and Markets Authority (ESMA) should be replaced by “physical replication” because only full passive replication may allow for compliance with the SFDR regulation.
Beyond the confusion in terms, on the very subject of the definition of what constitutes sustainable investments as per the SFDR, we see clearly that despite the introduction of transparency requirements in relation to a swathe of sustainability indicators, the regulator is now trying to substitute labels (in relation to holdings-based restrictive criteria) for the investor’s judgment.
While this type of approach that confuses sustainable funds and sustainable assets is surely useful for qualifying thematic funds, it seems to us to be incompatible with the subject of climate alignment, which in the more ambitious forms supposes that a fund invest in companies that are not necessarily deep green but are essential to the functioning of the economy and have better climate performance than their peers, along with credible transition plans (e.g. decarbonisation of their core activities in line with science and/or repositioning towards green activities).
Ultimately, there is considerable risk that the regulator, through fear of greenwashing, organises a form of macro-greenwashing by promoting the underrepresentation of sectors that have a central role to play in the proper transition towards a low emissions and climate-resilient economy, as is already the case with the run-of-the-mill indices complying with the EU PAB criteria.
Indeed, these indices considerably underweight the electricity production sector while promoting products and services that reflect the necessary electrification of the economy.
It is surprising for the least that there has been no promotion of consistency between the consumption of electricity organised by sector reallocation and the activities of a climate-aligned benchmark, and the current or forecasted production of electricity financed by the same benchmark.
By proceeding by an accumulation of rules rather than thinking about the objectives and principles of regulation, the European Union may be failing to incentivise sustainable finance in the right way.
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