(Bloomberg) -- As the dust settles on the wave of ESG fund downgrades that swept through Europe’s investment industry, BNP Paribas SA has managed to climb several notches up a controversial ladder.

BNP Paribas Asset Management is now the second-biggest provider of the European Union’s top environmental, social and governance fund class, known as Article 9. Its decision to ring-fence about $20 billion worth of funds from downgrades helped it overtake BlackRock Inc. and Amundi SA in the rankings. The investment arm of Banque Pictet & Cie SA remains No. 1.

The Article 9 tag was stripped from €175 billion ($190 billion) worth of funds last quarter alone and the purge isn’t finished, according to Morningstar Inc. The market researcher said last month that only 6.3% of such funds would be close to meeting the EU’s requirement that Article 9 be reserved for 100% sustainable investments, with some allowance for liquidity management and hedging.

Fund managers that resisted downgrades in the last wave now face questions as to how solid their Article 9 claims are. There are “still issues with the way these allocations are calculated,” said Hortense Bioy, global director for sustainability research at Morningstar. “Methodologies vary due to the different interpretations” of EU ESG rules.

Against the backdrop of such concerns, it has emerged that the EU Commission intends to start closely monitoring capital flows in an effort to get a better sense of how regulations are working in practice and whether adjustments are needed to existing rules, according to a person familiar with the matter.

BNPP AM, which removed the Article 9 designation from about $16 billion worth of mostly passively managed funds last year, said it’s confident it can defend the decision to leave the tag on the much bigger pool of mostly actively managed funds.

“We don’t foresee any more reclassifications in the current state of the regulation,” a spokesperson for BNPP AM told Bloomberg. 

The firm’s interpretation of Article 9 guidance means it has up to 20% in liquidity and hedging instruments in such funds, the spokesperson said. With minimum sustainable investment commitments made at the total portfolio level, “we set our commitments at 80% or 85% so they can hold true in any market conditions,” the spokesperson said.

BNPP AM, like others, also applies a so-called pass-fail approach, whereby an asset manager can choose to count an entire position as sustainable even if only a portion of its activities are in fact sustainable. (A fund manager also needs to prove that the asset does no significant harm to any of the EU’s environmental or social goals.) 

EU guidelines currently don’t set a lower threshold for how sustainable an asset needs to be in order to be eligible for the pass-fail threshold. Nor has the EU Commission provided clear guidelines on what a sustainable investment is. The bloc’s regulators have formally asked for more precise standards, and the Commission says it’s looking into the matter.

“What the industry needs is clarification on certain aspects of the definition so everyone can apply it in a more consistent way,” Bioy said.

In the meantime, Amundi, which downgraded almost all its €45 billion worth of Article 9 funds at the end of last year, went from being the world’s third-biggest provider of the products in September to No. 17 at the end of last year, Morningstar estimates. BlackRock, the world’s largest asset manager, has gone from being No. 2 to No. 5 in the Article 9 market, after downgrading €26 billion worth of such funds.

Other asset managers adopted an interpretation of EU guidelines that allowed them to avoid reclassifications. Candriam, now the third-biggest Article 9 provider, and DNB Asset Management, have resisted downgrading their Article 9 funds.

The wave of Article 9 fund downgrades has led to growth in the EU’s weaker ESG category, known as Article 8, which now sits on about €4.3 trillion in client assets. Meanwhile, Article 9 managed assets shrank 40% last quarter to €330 billion.

European regulators are now proposing a new set of restrictions on using ESG and sustainability labels. These are likely to force a new series of downgrades that will hit Article 8 funds, according to a recent analysis by Stephan Kippe, head of ESG research at Commerzbank AG.

The question now is whether investment clients will respond to the next cycle of upheaval by judging that European ESG classifications are largely meaningless, Morningstar’s Bioy said. 

“Given how small the Article 9 fund category is becoming, investors will start looking beyond the Article 8 and Article 9 classification,” she said. They’ll “focus instead on the targeted sustainable investment allocation.”

(Adds reference to EU monitoring flows in fifth paragraph)

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