European efforts to define which investments are green and which aren't received a boost Wednesday when new rules requiring fund managers to evaluate and disclose the environmental, social and corporate governance features of financial products took effect.
The Sustainable Finance Disclosure Regulation covers all European Union financial-market participants and advisers, as well as foreigners that market products to EU investors, and requires them to start collecting and reporting certain ESG data. The rules demand disclosures on how sustainability risks affect investor returns and, conversely, how investments negatively impact sustainability factors such as climate change.
By mandating greater disclosures, the SFDR intends to stamp out so-called greenwashing in the booming ESG market, where assets are poised to exceed $53 trillion by 2025, according to estimates from Bloomberg Intelligence. Fund managers have responded to an increasingly climate-conscious investor base with an ever-expanding suite of products that claim to be sustainable, a development that has created fertile ground for misrepresentation.
"I have watched with interest over the last number of months as firms that, until recently, couldn't spell out ESG, or only came across sustainability when moving between stocks and treasuries in the dictionary, have been trumpeting their developments," Niall O'Sullivan, chief investment officer for Europe, Middle East and Africa at Mercer, wrote last week in a post on the firm's website. Starting Wednesday, "we'll see who is ready for the journey and who was planning to rely on shortcuts," he said.
The SFDR is part of the EU's broader proposal to redirect capital towards more sustainable businesses. The plan also includes the development of the EU Taxonomy.
A key part of the new regulation is the classification of funds. Article 8 funds are defined as those which actively promote environmental or social characteristics, while Article 9 funds have sustainable investment as their objective, with both categories subject to higher standards of disclosure under the SFDR.
A third category of funds, so-called Article 6, is for products where the manager doesn't deem ESG risks to be relevant to investment decisions or returns and must explain why. Ulrika Hasselgren, a former sustainable finance banker who's now head of the Nordic region at ESG data company Arabesque Group in Stockholm, said she expects that given the complexity of the disclosure rules, some asset managers will initially categorize their funds as Article 6 products.
"Today is an important milestone," Ms. Hasselgren said. "It will help investors and asset managers more clearly and more sincerely describe what they do and how they will contribute to a low-carbon environment and meet the goals of the Paris agreement."
Separately, an analyst note Wednesday by Moody's Investors Service said the SFDR is credit-positive for European money managers, despite potential compliance costs and challenges.
The disclosures align with investor demand for ESG-compliant strategies — a trend that has increased due to the coronavirus pandemic — and money managers' net inflows to such strategies should be boosted by the regulation, the note said.
However, the disclosure rules are "relatively onerous, and collecting, calculating and processing sustainability-related data so that new reporting obligations are correctly fulfilled will be a challenge," Moody's noted. Most of the required data is not financial or market information, relating instead to less immediately measurable metrics such greenhouse gas emissions and human rights."
Moody's expects global money managers that distribute investment strategies in Europe to consider applying the SFDR criteria across their entire product range. "The industry-wide disclosure standards that emerge in Europe may become a benchmark for other regions," the note added.
Staff writer Sophie Baker contributed to this article.