ESG Confusion Prompts Rethinking of Rules

Europe’s markets watchdog is calling for a rethink of the region’s rulebook for environmental, social, and corporate governance (ESG) investing after finding that the existing framework is being misinterpreted.

At issue is the tendency of fund managers and their clients to treat the European Union’s (EU’s) disclosure regime as an ESG labeling system. Investing clients are often left with the impression that funds within a given disclosure category will deliver positive ESG results, which isn’t necessarily the case.

“The use of current sustainability disclosures under SFDR [the Sustainable Finance Disclosure Regulation] as a ‘label’ can be misleading,” Verena Ross, the chair of the European Securities and Markets Authority (ESMA), told Bloomberg. Therefore, ESMA “supports the development of simple and clear information to help investors take informed investment decisions,” she said.

The call for clarification of a key pillar of the EU’s SFDR coincides with an amendment to the EU’s revised Markets in Financial Instruments Directive (MiFID), which took effect this month. The new requirement means financial firms must make sure they understand the ESG preferences of retail investors—and actually deliver on them.

Concerns that investors are misinterpreting existing rules come as ESG increasingly finds itself a magnet for criticism. A number of prominent Republicans have started claiming that ESG represents a threat to American society. At the other end of the spectrum, some ESG industry insiders have questioned whether the movement is stringent enough in achieving its goals. Ross suggested that investors are so far unaffected by the background noise around ESG, but struck a cautionary tone.

“I do not believe that we are witnessing a significant ‘backlash’ against ESG investing in the EU,” Ross said. Still, “we need to continue to work to reinforce confidence in sustainable finance products that are responding to investors’ demands.”

The European Commission began more than three years ago working on a common sustainability label for retail financial products, but has yet to reach any conclusion. Ross said in May that ESMA would be likely to support such a step. A number of EU members, including France and Luxembourg, have already had such ESG labels for several years.

Some of the biggest asset managers have warned that retail investors are currently struggling to navigate the complicated world of ESG, as regulations remain inconsistent and incomplete.

The “landscape is evolving very quickly,” Fong Yee Chan, head of Vanguard Group Inc.’s ESG strategy for Europe, said in an interview. “In Europe, because of the sheer volume of ESG products—but also different flavors of ESG products—that has created a lot of confusion for retail clients.”

A recent report by Morningstar Inc. laid bare that asset managers are also finding ESG rules difficult to interpret. According to the market researcher, the investment management industry changed the SFDR designation of more than 700 funds last quarter, as the EU continues to clarify its rules.

The EU’s ESG investing rulebook, which was enforced in March last year, requires firms to classify their investment products under one of three categories: Article 6, which only addresses ESG risks; Article 8, which “promotes” ESG characteristics; and Article 9, which sets measurable ESG “objectives.”

The article chosen sets the bar for the kinds of disclosures a fund manager is required to make. It doesn’t guarantee an investment client that the fund is filled with a certain level of sustainable assets. A review by Morningstar, for example, found that 23 percent of Article 8 funds don’t deserve to be labeled as “ESG.”

The meteoric rise of ESG investing has led to regulatory scrutiny in other jurisdictions. In the United States, the Securities and Exchange Commission (SEC) is now working on new rules to combat inflated claims by investment funds, and in the U.K., authorities earlier this month warned hedge funds that ESG is a “priority area” and said they intend to review marketing materials distributed by the alternative investment management industry.

Investment firms that mis-classify their funds are increasingly at risk of being called out by the regulator. “There have been several indications from regulators to say, ‘We are watching closely, and we will come knocking,’” said Sonali Siriwardena, partner and global head of ESG at law firm Simmons & Simmons.

Against that backdrop, “attempts to try to simplify and help provide more transparency, ordinary speak, for investors, as well as better understanding of what constitutes an ESG label for product” would be welcomed, Chan from Vanguard said.

She also said that change is “emerging” and there are “some positive developments happening in the European landscape to help address this concern from retail clients.”

Copyright 2022 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.