Recently, the European Supervisory Authorities (ESAs) published a list of questions to the European Commission to further clarify some important aspects of the Sustainable Finance Disclosure Regulation (SFDR), part of the EU package of measures on sustainable finance. The questions seek, among other things, clarification on the definition of “sustainable investments” and how it should be interpreted, products with CO2 emission reduction targets and the meaning of “take into consideration” in the provisions on main negative impacts . Regulators asking questions on topics at the heart of the EU Action Plan show that more work needs to be done to make this ambitious, first-of-its-kind sustainable finance legislation workable for the market and regulators and more useful for end investors. This article uses data from Morningstar and Sustainalytics to assess the implications of this ambiguity by looking at current market practices.
The concepts highlighted by the European Security Market Authority (ESMA) are key to SFDR, the broader set of EU Action Plan rules and the MiFID II changes to ESG and sustainability preferences that came into effect in August. These changes oblige an advisor to take a client’s sustainability preferences into account when providing investment advice.1 These requirements depend on some of the key concepts mentioned earlier: sustainable investments, taxonomy alignment, and key negative impacts. However, much is still unclear or unfinished. The recently published ESMA guidelines regarding MiFID II provide no guidance on how financial advisors can address the resulting ambiguity in their advice to clients.
What causes investor confusion?
A Morningstar Report on SFDR Article 8 and Article 9 demonstrate the need for further clarity and guidance. It highlights the confusion surrounding rules and definitions as the market begins to comply with applicable regulations. Asset manager data in the new European ESG Template (EET) is still fragmented (see Figure 1). However, we can draw some initial conclusions: the taxonomy’s disclosures so far are very conservative and mostly 0%, while the planned shares of sustainable investments even in Article 9 products vary widely and appear to be much less conservative. We discuss these and other findings in the next section.
Figure 1: Coverage of key EET data points for the Article 8 and Article 9 funds examined
Key Negative Impact (PAI) Considerations.
The graph above shows that 43% of respondents are considering PAIs. Given the questions posed to the European Commission by the ESAs about what it means to “consider the most significant negative impacts”, how exactly do the various financial market participants do this? The ESAs found this in their annual report of July 2022 judgement that practices do indeed vary and that there is room for improvement.
Identifying sustainable investments under the Regulation remains inconsistent
The data also shows that a significant proportion of fund managers declare a minimum share of sustainable investments for Article 8 and 9 products, even though there is no clear definition2 in SFDR, and several approaches can already be identified on the market. Some may consider an issuer to be fully sustainable if it engages in a certain minimum percentage of sustainable economic activities; others may consider an issuer sustainable for a certain engagement rate (similar to the taxonomy approach, where a company can be aligned x%). This situation leads to low comparability and makes it difficult for advisors to find suitable financial products for clients who want to invest sustainably. When advising clients, advisors are expected to compare different financial products, for example by ranking them, as suggested by ESMA in their guidelines. But how can investors rank sustainable investment products with different methodologies?
Article 9 products, which according to these ESA guidelines, are only allowed to make sustainable investments, the graph below shows that the percentages vary widely, from just over 0% to as much as 100%. This shows that some Article 9 products are at risk of having to downgrade to Article 8 to avoid being accused of greenwashing.
Figure 2: Minimum percentage of sustainable investments
Different approaches to aligning the EU taxonomy
Now, despite the lack of definition, market players appear to be much more comfortable reporting minimum sustainable investment rates than disclosing taxonomy alignment rates (although they acknowledge that the number of fund managers providing data on this in the EET is small ). Given the lack of clarity around the use of estimates, ‘equivalent information’,3 and pending guidance, most fund managers are choosing to report 0% taxonomy aligned planned investments, as shown in Figure 3. Although taxonomy alignment in the broader economy can be expected to be low (low single digits ), most funds report 0%. including those with environmental or climate objectives. We can conclude that the taxonomy in its current state may not be an effective tool to stimulate capital flows. It may take a few more years for the industry to align as we wait for greater adoption of reported data and greater clarity around the use of estimates.
Figure 3: Distribution of Article 8 and Article 9 (combined) Based on
Minimum or planned investments Sustainable taxonomy aligned
Morningstar Sustainalytics’ estimated Taxonomy alignment data anecdotally shows that even funds with potentially significant alignment rates choose to be conservative (even if their planned SRI holdings are substantial).
Figure 4: Example of comparing the income rate of a fund with minimum or planned sustainable investments
Source: estimated data from Sustainalytics Taxonomy Solution and Morningstar Direct.
Our data set also shows that banning the use of estimates, even for non-EU issuers that are not within the scope of regulation and that require their own reporting of taxonomy figures, significantly reduces the taxonomy alignment of funds with global reach would reduce. The table below shows that most connected companies are estimated to be in non-EU regions, leaving them out of scope as they are only allowed to use the reported data. Many non-EU issuers may not report taxonomy figures, which would significantly limit the applicability of this important sustainable finance tool.
Figure 5: Companies with Reconciled Revenues
Source: estimated data from the Sustainalytics Taxonomy Solution
Much work remains to be done to achieve the sustainable finance objectives of the EU Action Plan Regulations. It remains to be seen what can be achieved in this turbulent final part of the European Commission’s current mandate and whether the next Commission, coming in 2024, will be as committed to sustainable finance as the current one has been so far .
Learn how investors are working with Morningstar Sustainalytics for compliance with the EU Action Plan
Morningstar Sustainalytics is committed to supporting investors with data and solutions related to the Requirements for the EU Action Plan. Combinations of data points can be used to identify a sustainable investment as defined under the SFDR.
An SFDR Sustainable Investments Mapping file is available to allow clients to select their own inputs and thresholds for contribution, no significant harm and good governance to ensure their views and interpretations of these components can be integrated.
Combined with our industry leading EU taxonomy And SFDR PAI SolutionsMorningstar Sustainalytics offers a holistic approach to regulation to provide investors with the comprehensive and consistent data needed to complete regulatory templates such as the SFDR appendices, the European ESG Template (EET) and the MiFID II sustainability preference requirements as they come into effect become powerful. Please contact us with our client advisory team to assess your individual strategy and objectives.
1. An important missing link in this chain is the upcoming Corporate Sustainability Reporting Directive, which would introduce mandatory sustainability disclosure for companies.
2. The definition of sustainable investment in Article 2(17) is: ‘sustainable investment’ means an investment in an economic activity that contributes to an environmental objective […]or an investment in an economic activity that contributes to a social objective […]provided that such investments do not significantly impair any of these objectives and that the investee companies follow good governance practices, particularly with regard to sound management structures, employee relations, employee compensation and tax compliance.
3. The term ‘equivalent information’ was used by ESAs in a supervisory statement from March 2022, but for which there is no definition yet.