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‘Green Bleaching’ and Other Unintended Consequences of SFDR


Expert insights from Mark Seaver, Chief Investment Officer, IQ-EQ Fund Management Ireland Ltd, part of the IQ-EQ Group.

There has been a lot of news on the Sustainable Finance Disclosure Regulation (SFDR) in recent weeks. Such was the uncertainty ahead of the start of the Level 2 disclosure framework at the end of last year that many exchange-traded funds (ETFs) were ‘downgraded’ by managers from Article 9 status to Article 8 ahead of the deadline. Other managers, currently following a sustainable strategy, are opting to declare as Article 6 simply to avoid the risk of scrutiny. Amid these unintended consequences, regulators are pressing ahead with broadening the disclosure framework. Here is what we have learned in the four months under the new disclosure regime.

Perhaps the most notable trend in the run up to the Level 2 deadline was the ‘downgrading’ of many funds from the Article 9 classification, which is seen as the gold standard for sustainable funds. A cynic might say, when push came to shove, that fund strategies had been found wanting in the face of the new standards. In reality, the stampede was an unintended consequence of the continuing uncertainty that exists around the very definition of sustainability and whether all investments by Article 9 funds need to be ‘sustainable’.

Many of the funds exiting Article 9 were passive trackers of the Paris Aligned and Climate Transition benchmarks. Surely, funds tracking such indexes would justify an Article 9 designation. Fund managers were not so sure and opted to play it safe and declare as Article 8 to avoid the risk of regulatory sanction. A second unintended consequence of this is that the Article 8 classification has been left looking like a ‘catch all’ repository of such a wide variety of funds that it is now meaningless.

Conscious that the whole classification system was being undermined, the European supervisory authorities (ESAs) sought clarification from the Commission on the requirements for Article 9 status. The response has just arrived and asserts that tracking these benchmarks is enough for the funds to retain Article 9 status. We may now see a rush in the opposite direction as fund managers redesignate to Article 9.

There is another option for the wary fund manager – and it has a name: ‘green bleaching’. The fact the concept exists shows the tensions and confusion within the regime. Faced with uncertainty over the definition(s) of sustainability and fear of legal sanction, a manager who is following a sustainable investment process may simply not claim to do so. Sounds misleading, right? Well, the issue is subject to some discussion in a document just published by the European Securities and Markets Authority (ESMA) detailing advice from the Securities and Markets Stakeholder Group (SMSG). The group has advised ESMA that since there ‘is no legal obligation to disclose how sustainable a product is, not claiming sustainability cannot be considered a “misrepresentation” and should not be sanctioned’. Remember, SFDR is about informing investors about how managers consider sustainability and the adverse impacts of their decisions. Green bleaching completely undermines this objective.  

The SMSG also advised that greenwashing be defined as ‘the practice of misleading investors, notably (but not limited to) in the context of gaining an unfair competitive advantage, by making an unsubstantiated ESG claim about a financial product or service’. This sounds about right. However, the issue of ‘intent’ in greenwashing is likely to require more discussion time between the parties in coming months.

While all concerned grapple with the consequence of the current regulations, ESAs are pressing ahead with new standards. A consultation paper from ESMA to financial market participants landed on desks mid-April seeking opinions on proposed revisions and additions to the Regulatory Technical Standards (RTS).

The aims under consideration include adding to the number of social Principle Adverse Impacts (PAIs), extending PAIs to the real estate sector and expanding the definition of ‘inefficient real estate’. It is evident that the ESAs are conscious of the problems gathering consistent data from companies. They are leaning heavily on the draft European Sustainability Reporting Standards (ESRS) to define the new PAIs. The data will have to be reported by all companies within scope of the Corporate Sustainability Reporting Directive (CSRD).

It is good that so much interaction between interested parties is ongoing. However, much of the confusion in the new disclosure regime is rooted in the very definition of sustainability. That is unfortunate but understandable. Sustainability is a somewhat nebulous concept. Tying new metrics to mandatory company disclosures is helpful – for fund managers, if not companies. Tackling greenwashing was one of the aims of the SFDR. If the result is green bleaching, then perhaps it would be better to review the basics before pressing on and undermining what is, at its core, a worthwhile ambition.