(Bloomberg) --

The ESG fund class drawing in the most client cash has become too difficult to handle for a growing number of asset managers, according to lawyers advising the industry and analysts monitoring the market.

The funds in question are called Article 9, the European Union’s highest classification for investment products claiming to deliver environmental, social and governance results. Article 9 funds defied the wave of outflows that hit the wider market last year by drawing in almost $30 billion of new client money. 

But the pool of Article 9 products is shrinking fast. Asset managers removed the tag from 40% of the market in the fourth quarter alone after stricter regulatory guidance. Julia Vergauwen, an attorney at Linklaters who advises the fund industry, said several of her clients don’t want to touch Article 9 funds due to new and shifting ESG rules. And analysts such as Luke Sussams at Jefferies warn that 2023 is turning into a lost year for Article 9 issuance.

Managers are steering clear because of “the risk of greenwashing accusations, because of the level of scrutiny on Article 9,” he said. At the same time, clients can’t get enough. 

“Our numbers show that capital flows to Article 9 products in Europe were positive every single month of 2022,” Sussams said. “That is a staggering statistic.” So “those who manage to stay the course and keep Article 9 products on the market in Europe look set to benefit.” 

That’s likely to be an ever smaller group as continual waves of updates and corrections to existing ESG regulations prompt many in the industry to freeze issuance plans. The few still producing Article 9 funds are sticking with specific asset classes such as green bonds, or carbon offsets. The latest figures from Morningstar Inc. show the Article 9 market has about €330 billion ($360 billion) of client assets.

“We have some fund managers in the market who do want to go for more Article 9 funds, but there is too much regulatory uncertainty and so they are waiting,” Vergauwen said. “They’re waiting to see what the regulators come up with.”

Firms holding back on Article 9 designations include the asset management arm of BNP Paribas SA. Its Environmental Absolute Return Thematic (EARTH) fund, which has outperformed 95% of peers this year, is long renewable energy and short fossil fuels. But because EU regulators haven’t clarified how fund managers should treat derivatives in their disclosures, BNP has registered the fund under the bloc’s weaker ESG category, known as Article 8, and says it won’t revisit the decision until EU rules are clearer. 

The EU first enforced its ESG investing rulebook, the Sustainable Finance Disclosure Regulation, in March 2021. Since then, the bloc has pushed through significant updates. For Article 9 funds, the EU now only accepts portfolios with 100% sustainable investments, with some allowance for liquidity and hedging. Funds representing about $190 billion in client assets abandoned the Article 9 tag in the final months of 2022 because of the stricter guidance.

Meanwhile, the industry is still waiting for the EU to say what it means by a “sustainable investment.” 

The definition “isn’t clear,” Vergauwen said. And the EU hasn’t told the industry whether an Article 9 fund can include so-called transition assets, such as fossil-fuel producers, she said. “Nobody knows the real answer.”

The EU has acknowledged there are problems and Mairead McGuinness, the bloc’s financial markets and services commissioner, has said she plans to launch a consultation into the matter. Some, such as the French financial regulator, warn there’s not time to wait for a consultation to run its course. Instead, the EU should to go back to the original legislation and quickly fix SFDR’s problems at the source, the French say.

Regulators have tried to address the confusion by providing clarifications when they can, but are calling for a more fundamental review of SFDR. A spokesperson for the European Securities and Markets Authority told Bloomberg that ESMA “also supports” reforming SFDR via the original legislation. “We have publicly called for labels for sustainable financial products to combat greenwashing and to protect investors,” the person said.

For Professor Marc Chesney of the University of Zurich and his colleague, Adrien-Paul Lambillon, “the problem is a combination of confusion regarding the regulation and the requirements for SFDR Article 9, and of many asset managers being too ambitious on sustainability claims or purposefully misleading” because they want to attract more investor flows.

The two academics, who last month published a paper titled How Green is ‘Dark Green’? An Analysis of SFDR Article 9 Funds, said the issues around the fund class run deep. As a disclosure regulation rather than an ESG labeling system, SFDR’s emphasis on transparency “favors large corporations” because small companies often don’t have the capacity to provide the data portfolio managers need.

They also found that Article 9 funds tend to favor companies that score well on climate metrics, while paying little attention to human rights violations. And Article 9 fund managers with a regional focus often look more closely at ESG ratings and corporate speak than at an investment’s actual environmental and social footprint. That leaves them more prone to future downgrades than their global peers, they said.

Chesney and Lambillon said the way in which SFDR and Article 9 were implemented ultimately “poses greenwashing risks,” due to the EU’s failure to properly define the concept of a sustainable investment. 

What Bloomberg Intelligence Says...

On Article 9 reclassifications, “We believe that funds presenting potentially serious mislabeling risks led this first rush of downgrades, and we expect this trend to accelerate. We also expect a next wave of downgrades from Article 8 to Article 6 — a more sizable share of the market.”

Click here to see the full  report.

——Adeline Diab, BI Director of ESG Research EMEA & APAC

Analysts at Morgan Stanley said Article 9 funds will remain “a small subset of the SFDR funds compared to Article 8.” That said, “there is sufficient end-client demand” for firms to want to hold on to the designation, they said. 

“Therefore, we expect that while some funds faced with stricter requirements will choose to downgrade,” there will also be many who do what they can to be “better aligned with the regulation,” the analysts wrote.

Sussams at Jefferies at some point, the dust will settle and there’ll be an “inflection point.”

That means Article 9 products “will return to the market because there’s a market opportunity there,” he said.

--With assistance from Gina Turner and Greg Ritchie.

(Adds comment by Morgan Stanley in fourth-last paragraph.)

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