At the crossroads: EU sustainable finance rules

Demand for ESG investment funds in the EU remains high. However, the future is uncertain, with potentially significant changes to the EU sustainable finance regulatory framework on the horizon.

Has the demand for ESG funds continued to grow?

Since the application of the Sustainable Finance Disclosure Regulation (SFDR)[Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector] on 10 March 2021, the centrepiece of EU regulations governing ESG fund disclosures, investors’ interest has remained high. According to the EFAMA, a European fund association, Luxembourg is the main domicile for SFDR article 8 and article 9 funds.

The growth of assets within article 8 and article 9 funds increased by 1.7% during the final quarter of 2023, reaching a new milestone of EUR 5.2 trillion. They maintained a market dominance of nearly 60% of the EU market. However, article 8 and article 9 funds started encountering net outflows by the end of 2023, mirroring broader market trends linked to high interest rates, inflation and recession concerns, geopolitical risks, and government bond issuance. Considerations regarding greenwashing and the evolving regulatory landscape may also begin to have an effect on net outflows [Morningstar Guide “SFDR Article 8 and Article 9 Funds: Q4 2023 in Review”].

How does regulation impact ESG investment funds and sustainable finance?

Regulations, such as the SFDR and the Taxonomy Regulation, are intended by the EU legislator to play a crucial role in establishing green standards and requirements for ESG funds, such as transparency on the ESG criteria used and how the impact of any ESG goals is measured. They aim to prevent “greenwashing”, harmonise the applicable rules within the EU and ensure that ESG funds deliver on their promises. The SFDR is a key component of the EU Commission’s action plan on sustainable finance.

What are the challenges associated with ESG investing for investors?

Despite the SFDR, the main challenges for investors remain the difficulty of evaluating and comparing ESG funds and their ESG performance due to the lack of minimum standards and the complexity of the applicable regulations. Arguably, insufficient harmonisation between the various EU regulations governing ESG and a lack of coordination among National Competent Authorities (NCAs) when it comes to the application of the rules, remains problematic.

Looking ahead – reform of the EU sustainable finance framework?

The European Securities and Markets Authority (ESMA), the EU financial regulator, intends to publish guidelines on funds’ names using ESG or sustainability-related terms. ESMA believes that such guidelines would enhance investor protection and help combat greenwashing. The proposed guidelines provide for quantitative thresholds. Notably, if a fund has any ESG-related words in its name (e.g. “climate change”, “green”, “ESG”…), a minimum proportion of at least 80% of its investments should be used to meet the environmental or social characteristics or sustainable investment objectives. It is expected that some funds will have to change their name or adapt their investment policies in order to comply with the new requirements.

At the end of last year, the European Supervisory Authorities published a Final Report with proposed changes to the detailed implementing measures of the SFDR, the so-called “Regulatory Technical Standards” (RTS). If adopted, the many changes of “SFDR 1.5” would include new disclosures around greenhouse gas emission reduction targets and a revamp of the existing pre-contractual and periodic disclosure templates for article 8 and article 9 SFDR funds. The draft RTS are currently being reviewed by the European Commission.

In recognition that the SFDR in its current form may not be achieving its objectives, the European Commission launched a consultation on assessing the implementation of the SFDR in September 2023. Among the proposals are the introduction of binding minimum standards and a labelling regime and while the exact direction of travel is still unclear, “SFDR 2.0” could lead to significant changes of the existing rules or even the replacement of the SFDR altogether.

While overall the outlook remains positive, the next European Commission will need to get its reforms of the EU sustainable finance framework right if ESG investment funds are to remain competitive in a global context.

This article was first published in Paperjam (published in March 2024). For further information, please visit [Paperjam].