(Bloomberg) -- The world’s most far-reaching set of ESG investment rules is facing a wave of criticism as regulators in Britain and the European Union publicly voice their misgivings.

The UK’s Financial Conduct Authority has deliberately steered clear of some of the main features of Europe’s Sustainable Finance Disclosures Regulation, after it became clear they resulted in an ESG “contest” among fund managers rather than an exercise in transparency, Sacha Sadan, the FCA’s director of environmental, social and governance, said in an interview. 

Those comments coincided with a warning from Europe’s markets watchdog, whose head publicly urged EU officials to address the “real challenge” posed by the the bloc’s ESG rules. Among concerns voiced by the EU’s markets regulator is the lack of clarity in regulations when it comes to basic ESG concepts such as a “sustainable investment.” 

“Navigating through the many different products and offerings and understanding the differences in terms of sustainability remains extremely difficult,” Verena Ross, chair of the European Securities and Markets Authority, in a speech published on Oct. 24. 

When the EU enforced SFDR in March 2021, it was considered a milestone framework that represented the world’s most ambitious set of anti-greenwashing regulations to date. Though enforced by EU officials, the fund industry soon realized that SFDR affected investment managers in the US, UK and Asia, with all firms marketing their financial products to EU clients required to comply. 

But this year, some serious holes have been exposed in the EU’s ESG rulebook, leading to widespread anxiety across the fund management industry. EU clarifications to date have left asset managers potentially in breach of rules, and may trigger hundreds of ESG fund downgrades, several industry analyses have shown. 

“Without undermining the significant achievement that the various legislative and regulatory initiatives represent, there remains great complexity and real challenge in terms of interpretation and implementation,” Ross said.

ESMA is among EU regulators that have asked the EU Commission to clarify several corners of the bloc’s ESG rules. The Commission said earlier this month that it has received the “queries” and “will reply in due time.”

In the meantime, European authorities plan to provide some guidance as asset managers face a January deadline to comply with more detailed fund disclosure requirements. Since SFDR went into effect, EU supervisors and the EU Commission have been working on a package of so-called regulatory technical standards, which include templates for reporting investments’ negative effects on the environment, and efforts to mitigate these.

Europe’s three financial market supervisors “are preparing to issue a significant number” of so-called question-and-answer documents “in the near future” to help guide the industry on how to comply with the standards, an ESMA spokesperson said. The guidance comes after regulators found significant discrepancies in the quality of voluntary disclosures.

Sadan of the FCA singled out the fund classification system that has evolved within SFDR as something the UK regulator was keen to avoid. The EU’s three main categories -- Article 6, which means a product doesn’t have ESG properties; Article 8, whereby ESG is “promoted”; and Article 9, where ESG is the “objective” -- have been construed by fund managers as a competitive scale, Sadan said.

“With Article 6, 8 and 9, it became a contest rather than actually a reflection of different things for different consumers,” he said. 

Fund flows suggest investors might agree, as they target the highest ESG designation. Last month, Article 8 funds recorded outflows of roughly €39 billion ($39 billion), while Article 9 funds posted inflows of €4 billion, according to data compiled by Bloomberg. 

Europe’s SFDR framework “was disclosure first,” whereas the UK wants to “help consumers navigate the market,” said Mark Manning, technical specialist in the ESG division of the FCA.

The UK unveiled its own plan Tuesday for fighting greenwashing in fund management by creating three ESG labels it says will be easy for retail investors to understand. There’s “Sustainable Focus,” which invests mainly in assets that achieve a high standard of sustainability; “Sustainable Improvers,” which would invest in assets that may not be sustainable now with an aim to improve them; and “Sustainable Impact,” which targets solutions to social and environmental challenges.

“The labels are designed to be consumer accessible,” Manning said. “The qualifying criteria look to set a reasonably high bar to protect consumers from greenwashing.”

But lawyers monitoring ESG regulations are already warning clients that the UK fund proposal represents a new layer of risk. Firms face a world in which they’ll have to comply with different classifications in the UK and the EU, as well as those now being proposed by the US Securities Exchange Commisssion.

“Trying to prepare a ‘one size fits’ all offering document may prove challenging for UK managers offering their products under the UK labeling regime as well as complying with the EU SFDR and SEC proposals if distributing cross-border,” said Kirsten Lapham, a partner at the law firm Proskauer Rose LLP.

The stakes are high and the risk of being accused of greenwashing is real, she said.

“The overarching mantra firms should bear in mind is to always be thinking: Is this message clear and can it be in any way, construed as misleading?” Lapham said. 

That will be “even more important under a true labeling system,” like the one being introduced in the UK, she said. “For products that don’t adopt one of the sustainability labels, it will be crucial for firms to do a thorough screening across their products to ensure references to ESG and sustainability are removed.”

--With assistance from Leonid Bershidsky.

(Adds ESMA comment in 9th, 10th paragraphs)

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