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Morningstar says EU’s green investment label falls short

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Almost a quarter of funds that claim to "promote" sustainability under European regulations don't deserve an ESG label, according to a fresh review by market researcher Morningstar.

The analysis, which looked at funds classified as Article 8 within the EU's Sustainable Finance Disclosure Regulation, shows that 23pc don't live up to environmental, social or governance investing principles, Boya Wang, ESG analyst at Morningstar, said in an interview.

To justify an ESG tag within Morningstar's definition of the term, a fund's investment strategy can't rely only on excluding so-called sin stocks like tobacco, coal or weapons, Ms Wang said. "Many Article 8 funds will not be tagged as sustainable funds under our framework," he said.

The assessment is the latest to raise questions around a key pillar of Europe's efforts to become of global champion of sustainability. No other jurisdiction has raced ahead with such an ambitious program for transforming the entire asset management industry. But even regulators are starting to warn that the process has left too many opportunities for greenwashing.

The EU's rulebook for ESG investing, SFDR, was designed to root out asset managers' inflated sustainability claims. The framework, which was enforced in March last year, requires firms to classify their investment products under one of three categories: Article 6, which only addresses ESG risks; Article 8, which "promotes" ESG characteristics; and Article 9, which sets measurable ESG "objectives".

Arguably the vaguest of the three categories, Article 8 has become a magnet for fund managers. The latest Morningstar data reveals that asset managers have reclassified well over 600 funds previously listed as Article 6 to Article 8. A number of Article 9 funds were also downgraded to Article 8, it found. As of June, funds registered as Article 8 held €3.76trn, compared with €420bn allocated to Article 9 funds, Morningstar estimates.

The reclassifications have coincided with a crackdown by financial watchdogs on funds suspected of misstating the ESG-ness of their portfolios.

"There have been several indications from regulators to say, 'we are watching closely and we will come knocking'," said Sonali Siriwardena, partner and global head of ESG at Simmons & Simmons. Recent guidance from the EU "very clearly says one of the likely reasons for regulatory intervention would be that periodic reporting doesn't support what is said in the product document".

There's also evidence that investment clients are growing more cautious toward Article 8, as fund managers include atypical ESG sectors like defence, energy and commodities in the category. More than €29.75bn was withdrawn from Article 8 products last quarter, while roughly €5.95bn flowed into the stricter ESG category of Article 9, Morningstar data shows.

In response to stricter rules and more demanding clients, some asset managers have started removing ESG labels from funds, rather than be accused of greenwashing. In the second quarter, six funds dropped sustainability-related keywords from their names, Morningstar found.

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