Hundreds of ETF funds have been downgraded from Article 9 to Article 8 after the EU introduced new rules on classifying sustainable investment funds.
This reclassification followed the introduction of ‘level 2’ of the EU’s Sustainable Finance Disclosure Regime (SFDR) – which gave further clarification on the definitions of Article 9 (dark green) and Article 8 (light green) funds.
A total of 307 ‘Article 9′ funds, worth £107bn, were downgraded to Article 8 in the last quarter of 2022, with a further £99bn being reclassified in January 2023.
However, further information released by the EU last month on its definition of ‘sustainable’ could see some Article 8 funds being upgraded to Article 9, raising questions about the suitability of this categorisation scheme.
A new white paper, published by sustainability data provider Matter has looked at which funds have been downgraded.
Its analysis shows these downgrades were driven by passive ETF strategies that were following Paris-aligned and climate transition benchmarks, which were previously deemed Article 9. This category, according to Matter is now largely dominated by ‘solutions-focused’ and more thematic funds.
However, Article 8 funds now include these passive funds following Paris-aligned benchmarks as well as funds that take a more generalised approach to ESG integration.
Matter is calling for a more sophisticated categorisation scheme to improve clarity for market participants and investors. This it said should have clearer definitions between three distinct sustainability strategies: funds adopting an integrated ESG approach, those following Paris-aligned (or climate transition) benchmarks, and those adopting a solutions-focused or thematic approach.
Currently, Matter says that the first two are being merged together within the broader Article 8 (light green) definitions. However if some funds get upgraded then this Article 9 (dark green) definition would not necessarily distinguish between a thematic, solutions-focused approach and passive ETFs following climate benchmarks. It adds there is a danger this latter group might dominate this category.
Matter says: “With the introduction of Level 2, SFDR has shown its potential to distinguish between fund types, creating space for funds with different approaches to sustainability to stand apart from each other, thereby increasing transparency within the EU sustainable fund landscape.”
However it added that while there was a clear definition between Article 8 and Article 9 it is not systematic at present “as it was initiated by the introduction of a 100% sustainable investments threshold for inclusion as Article 9, without accompanying clarity on what was meant by ‘sustainable investment’.”
However a more recent Q&A published by the EU said that Paris-aligned funds should be defined as ‘sustainable investments’ which may see some be reclassified as Article 9.
Matter says: “SFDR Article 8 and 9 classifications, and their accompanying definitions and guidelines, are not yet sufficiently nuanced to effectively account for the differences between funds pursuing different sustainability strategies. At present, they are stuck trying to fit three complementary yet distinct approaches to sustainability – ESG, Paris-aligned, and thematic/solutions-focussed – into two classifications.
“Of course, there is further complexity in the sustainability approaches employed by funds than the three highlighted in this analysis (best-in-class vs. exclusion vs. general integration under the banner of ‘ESG’, for example), and these should also be addressed in the long-run. It is the fundamental differences between ESG, Paris-aligned and solutions-focused, however, which must first be overcome in order for SFDR to progress beyond its current impasse.”
Matter says it analysis shows that Paris-aligned strategies tend more towards low-impact sectors which meet emissions requirements, whilst solutions-focused strategies can more freely (though not exclusively) expose investors to sectors which are transitioning or with inherent tradeoffs, therefore leading to comparatively higher negative impact.
It says: “Both are necessary approaches which often target different segments of the economy. Our analysis shows that these different approaches result in distinct sustainability outcomes.”
Matter says welcomed the review of current SFDR guidance and said this would be crucial for further improvements to this framework.
It points out that prior to the introduction of these new ‘level 2’ definitions, SFDR “had been vulnerable to accusations of greenwashing, due to fund providers self- classifying as Article 8 or 9 with little oversight or disclosure.”
But the current regime could be improved further. “There is a need for a middle ground which accounts for and delineates between the diverse routes necessary to reach a sustainable future, whilst employing realistic definitional guidance and thresholds in order to avoid greenwashing and ensure that SFDR remains rigorous. The current ongoing review of SFDR by the European Commission is crucial, therefore, if SFDR is to become the gold-standard sustainability disclosure framework that Europe needs it to be.”
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