(Bloomberg) -- A mass wave of downgrades that shocked investors as they watched Europe’s top ESG designation get stripped from almost $200 billion may now be reversed.

Many of the reclassifications, which saw a coveted ESG tag known as Article 9 get wiped off €175 billion ($192 billion) in funds in late 2022, appear to have been unnecessary in light of new guidance from the European Commission, according to Hortense Bioy, global director for sustainability research at Morningstar Inc.

The upheaval last year led investors and regulators alike to question the basic construction of the environmental, social and governance investing rulebook that Europe enforced more than two years ago. The Sustainable Finance Disclosure Regulation, which EU officials had hoped would serve as a global standard, has undergone a series of updates since its enforcement to address a seemingly endless list of shortcomings.

“Some market participants will think this is a complete circus,” Bioy said. It’s not clear why the EU Commission needed to “wait so long to clarify” fundamental questions around Article 9.

Last year’s downgrades, which led BlackRock Inc., Amundi SA and many others to reclassify their Article 9 funds under a weaker ESG designation known as Article 8, disproportionately affected passive strategies. The confusion set in last year as the market and even regulators struggled to interpret existing rules.

Passive funds that went from Article 9 to Article 8 because they tracked Paris-aligned benchmarks and climate-transition benchmarks now “may be required to be reclassified as Article 9,” Bioy said. 

In a report published late January, Morningstar estimated that 90% of downgraded Article 9 assets comprised equity strategies, almost half of which tracked Paris-aligned and climate-transition benchmarks. 

In its new guidance, published on Friday, the EU Commission said SFDR is “neutral” when it comes to financial product design, and that investments “that have an objective of reduction in carbon emissions can therefore fall within the scope” of Article 9. That applies “whether they use a passive or active investment strategy,” it said.

The EU Commission’s latest clarifications also seek to address the long-outstanding issue of how to define a sustainable investment. The EU’s failure to date to provide clear parameters around such a key ESG concept has drawn criticism amid concerns of greenwashing. 

The Commission said it won’t impose minimum thresholds and instead leave it to market participants to demonstrate that their claims are fair. At the same time, it warned that the disclosure framework requires “increased responsibility” on the part of market participants. 

But that could end up being costly for clients.

“For investors, the lack of explicit regulatory standards increases the time and effort required to identify financial products that both meet their sustainability preferences and protect them from greenwashing,” Stephan Kippe, an analyst at Commerzbank Research, said in a note. 

“In principle, we view the Commission’s clarifications as positive,” he said. “But they still fail to address significant fundamental flaws in the basic structure of the SFDR regime.”

Asset managers operating in the EU are also struggling to digest the details of a new proposal by the European Supervisory Authorities, which last week put a whole array of major ESG issues to a consultation that’s due to run until July 4. The ESAs, which cover markets, banks and insurers, want fund managers to provide more information on social impacts, decarbonization targets and thresholds for excluding companies. 

The ESAs also identified inconsistencies in SFDR relating to how it interacts with the EU’s taxonomy of sustainable activities. For example, a company could be partially aligned with the list of sustainable business activities yet shareholders may not be able to consider it a sustainable investment under SFDR. 

These “two parallel concepts of sustainability” mean that the regulation probably needs to be put back in the hands of EU lawmakers for a revision, the authorities said. 

Lawyers for the fund industry are already warning that the proposal represents a potentially major disruption. “People will participate heavily in the consultation because the impact is so tremendous depending on which way it goes,” said Julia Vergauwen, an attorney at Linklaters.

“The proposed changes are significant,” she said. “If they go through, they will require sufficient time to implement.”

--With assistance from John Ainger.

(Adds reference to ESA consultation, Linklaters comments in final paragraphs.)

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