Will the SFDR Prevent Greenwashing?

But what exactly does "greenwashing" mean, is greenwashing a problem for investors, and will the SFDR be enough to prevent it altogether?

What is Greenwashing?

Greenwashing is difficult to define because it’s essentially a catch-all term that means different things to different people. Just as there is no consensus on what constitutes a green investment, there is no definitive consensus on what constitutes greenwashing.

There are really two types of greenwashing – intentional and unintentional. Intentional greenwashing, as the name suggests, is when financial product providers purposefully over-state and over-sell what they’re actually providing in terms of a product’s sustainability merits. Unintentional greenwashing can be described as more of a misalignment in terms of the investor’s expectation of what ‘green’ looks like and what providers are offering.

Why has Greenwashing Become a Problem?

Putting greenwashing into context, it’s not hard to see why asset managers might be tempted to over-claim and over-sell the products they’re providing, because ESG sells.

Investors are pouring more and more money into ESG funds – in the first quarter of this year, European ESG fund flows reached record high levels of 120 billion euros; that’s 20% more than in the previous quarter. In fact, ESG funds took more than half of total European fund flows in the first quarter and in the past 12 months, fund assets have smashed through the €1 trillion mark.

This impressive growth in assets has been driven by record inflows, but also by new fund launches. Last year alone we saw more than 500 new ESG funds come to market. Managers have also responded to increased investor demand for sustainable investment options by repurposing existing conventional funds.

With this in mind, greenwashing (whether intentional or not) could be seen as a way to piggyback this growing trend and attract more investors whose interest in environmental and climate issues is at an all-time high.

How does the EU’s SFDR Come into Play?

The regulator’s mission is to protect investors. And one of the key aims of SFDR is to tackle the issue of greenwashing.

In short, the SFDR requires managers to disclose how sustainability risks are considered in their investment process, what metrics they use to assess ESG factors, and how they consider investment decisions that might result in negative effects on sustainability factors (or Principal Adverse Impacts [PAIs] in the regulators’ language). 

The SFDR will, above anything else, raise the bar for investment products - particularly those seeking to promote ESG characteristics (light green, Article 8 funds) and those with sustainable objectives (dark green, Article 9 funds) by setting strict minimum-disclosure standards. 

Practically speaking, this means that manufacturers (Financial Market Participants) and advisers will need to provide a raft of ‘entity level’ information on their public websites. And for products (funds, managed products, models), it means additional information will need to be added to pre-contractual documents and periodic publications.  

What Impact has SFDR had Since Implementation?

 At Morningstar, we have looked at how SFDR has been implemented so far, surveying a diversified sample of around 30 asset managers in the EMEA region.

The data tells us there is a wide range of practices and interpretations, with some managers, especially from France, the Nordics and the Netherlands, classifying more funds as green, either Article 8 or 9. Overall, around 23-24% of funds in Europe consider themselves as green. This is higher than expected and one might think that the regulator has given asset managers the opportunity to sell their products as green despite low levels of ESG integration. 

The Article 8 category, where the vast majority of Article 8 and 9 funds sit, represents a broad spectrum of ESG approaches, from light ESG exclusions to thematic best-in-class strategies, some of which are almost identical to strategies classified as Article 9. There certainly is still a lack of clarity on definition and classification that the regulator needs to address.

That being said, the SFDR still has the merit, through the powerful mechanism of disclosure, to force asset managers to integrate ESG risks and impact into their investment processes and to offer more sustainable options to investors. We have already seen asset managers enhance some of their strategies in order to meet Article 8 requirements. As a result, we can only expect more money to flow towards sustainable investments in the coming years.

Is the SFDR Enough to Prevent Greenwashing?

It is probably too early to pass judgment, but there are reasons to be optimistic. Asset managers have until the end of the year to comply with SFDR and they are still waiting for more details on the required adverse impact indicators. These are a key part of the regulation.

The positive aspect of the regulation is that fund managers will soon need to start reporting on green taxonomy alignment and on 18 adverse impact indicators detailing the negative effects that their investments have on society and the planet. With that level of disclosure, investors will be able to make better-informed decisions that suit their sustainability preferences. 

It’s also encouraging that of the asset managers Morningstar surveyed, many said it was essential to have as many funds as possible classified under Article 8 and 9. They see SFDR as an opportunity to demonstrate their commitment to sustainable investing.

While it may not have made a defined and instant impact on the complete prevention of ‘greenwashing’, the SFDR is undoubtedly a step in the right direction and together with the wider EU Action Plan, heralds a new era for the sustainable investing space.

Morningstar is continuing to monitor the implementation of the SFDR and its effect on the sustainable investing landscape. To learn more about the Sustainable Finance Disclosure Regulation, download our free guide.