March 7, 2022

In the Spotlight - SFDR - a case of things getting worse before they get better?

As ESG continues to grow, its meaning risks becoming lost along the way. The question is, will new EU regulation provide much needed clarity?

In the Spotlight - SFDR - a case of things getting worse before they get better?

The popularity of ESG continues to grow. However, as inflows continue and awareness surrounding sustainable investing spreads, the meaning of ESG risks becoming lost along the way. The question is, will new EU regulation provide much needed clarity?

SFDR - a case of it gets worse before it gets better? 

Much hope has been pinned on the EU SFDR to provide clarity and standards to the ESG landscape. Early signs suggest, however, that so far it may be doing the opposite.

A report published in November by Morningstar showed that after the EU’s rules on sustainable disclosures were enforced in March 2021, the European sustainable fund universe grew by 65% between June and September. 

This growth can not be attributed to an extraordinary shift towards genuine sustainability in European financial markets. It is rather because, under the SFDR, it is up to financial market participants to self classify as Article 6 (not promoting ESG characteristics), Article 8 (promoting ESG characteristics), and Article 9 (sustainability as an objective of the fund). 

The broadness of these criteria, combined with self-classification, has led to 1,800 funds being reclassified by their managers from Article 6 to Article 8 or 9. In some cases this may represent a genuine shift in the sustainability strategy in these funds, but in most cases it represented a formalisation of light touch ESG integration processes.

The issues of self-classification were made clear in our recent white paper, in which we analysed the sustainability of the 45 largest sustainability-themed ETFs which pursue a broad sustainability strategy and fall under EU regulation. All 45 of these ETFs analysed fell under Article 8 classification, whilst their sustainability varied considerably. Four of the ETFs falling under Article 8 classification actually performed worse than their non-sustainability focussed parent indexes.

This is not going unnoticed 

Whereas many headlines may still read about the continued growth of ESG, some are beginning to recognise that all is not as it seems.


Morningstar has recently culled more than 1,200 funds from its European sustainable funds list, a drop from $3.4 trillion to $2.03 trillion, after tightening their criteria for inclusion. They targeted specifically funds who ‘consider’ but do not meaningfully integrate ESG factors, as well as those with light or ambiguous language. 

This demonstrates that some are up to the reality that as the popularity of ESG increases, it is increasingly losing substance. As a recent Bloomberg Article explained, ‘Many Big ESG Funds Are Just Glorified Market Trackers.’

Market led initiatives alone will not stem the tide

This indicates a shift towards hesitancy and cautiousness. Nonetheless, as sustainability economist and investor Duncan Austin wrote recently, Voluntary Market Led Initiatives alone will not be enough to fix the ills of what he terms “externality denying capitalism”. The upside of marketing a fund as ESG is still too high (as shown by the number of funds reclassifying).

It therefore falls on regulators to mandate the shift, and expectations around SFDR and the broader EU Sustainable Finance Agenda are rightly high. They are an opportunity to set clear standards around what is meant by ‘ESG’, ‘Sustainable’, ‘Responsible’, as well as establishing demarcations between ‘promoting ESG characteristics’, ‘actively pursuing sustainability objectives’, and so on, as well as a setting standards around what this means. 

This explains the uproar around the recent classification of Nuclear and Natural Gas as sustainable energy forms in the EU Green Taxonomy. Without weighing in on the upsides and downsides of these two forms of energy, the uproar shows the genuine desire of interested stakeholders for a gold standard on sustainability, and the hope that the EU Taxonomy can provide this. Similarly, it also explains the recent concerns that have been raised by Dutch and Swedish regulators of greenwashing brought about by the self-classification stage of the SFDR. 

Regulation, of course, will need to be realistic in the short term, but these concerns from across the industry indicate the need for the EU Sustainable Finance Agenda to be strict, unambiguous, and ambitious.

There is hope

The EU, and specifically the ESMA, the European financial watchdog, is not blind to this. The ESMA is undertaking a study on disclosure requirements for Article 8 and 9 products which aims to “support supervisory convergence efforts and the identification of greenwashing cases”. It will address the difficulties in interpretation and application of regulation, and the risks this poses for greenwashing. 

Additionally, they will support the European Commission’s work on minimum sustainability criteria for Article 8 products. It is only when this and the requirements for Article 9 products are fully understood and implemented that we will understand the true power of the EU Sustainable Finance Agenda. 

On top of this, despite the criticism around the inclusion of Nuclear and Natural Gas in the EU Taxonomy, sustainability-minded investors should welcome the fact that SFDR reporting will now have to include EU Taxonomy alignment. This is a substantially stricter and more nuanced sustainability analysis than what the previous SFDR regulation mandated, and naturally, it is also substantially harder for investors to report on.

There is still a good chance the EU Sustainable Finance Agenda will be the gold standard by which sustainable finance is judged, and the benchmark against which regulation around the world is developed.

Rather than losing hope in its potential, we should take encouragement from the fact that the industry is attempting to hold it to a higher standard.


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