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Challenges Among Legislations for ESG Funds

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Key Takeaways

Global sustainable funds attracted USD 37 billion of net new money in the fourth quarter of 2022, compared with USD 24.5 billion of inflows in the previous quarter. (Morningstar, 2023, *Morningstar defines a strategy as a “Sustainable Investment” if it is described as focusing on sustainability, impact, or environmental, social, and governance (ESG) factors in its prospectus or other regulatory filings.) While the size of ESG funds in China remained stable (RMB¥434.634 billion) in 2022, according to CITIC Securities Research (2023). As criticism and scrutiny of ESG funds increased, so did support from the global governments to regulate the markets for ESG funds.

Following the previous delay, the EU’s Sustainable Finance Disclosure Regulation (SFDR) Level 2 Art 8 & 9 product disclosure templates have been applied since January 2023. And the European Securities and Markets Authority (ESMA) started consultation on guidelines on funds’ names using ESG or sustainability-related terms, from 18 November 2022 to 20 February 2023, with the final Guidelines expected to be issued by Q2/Q3 2023.

In addition, since SFDR does not impose minimum requirements and does not define the concept of sustainable investment. Consequently, the current Article 8 and Article 9 classification does not aim to assess the nature or extent of the manager's commitment to sustainability. The Autorité des marchés financiers (AMF), the French financial market regulator is proposing the introduction of minimum environmental requirements in European law that must be met by financial products in order to be classified as Article 8 or Article 9 under the SFDR.

Global financial regulators are moving to address issues associated with the proliferation of investment products and services marketed as ’ESG,’ ‘green’ or ‘sustainable,’ without clear rules communicating to investors the actual ESG-related attributes, methodologies, and criteria that are being considered in the funds.

While concerns and criticism over greenwashing and ESG standards piled up in the past years. The growing markets for ESG funds will continue under scrutiny by regulators and challenged by investors. For example, on November 22, 2022, the U.S. Securities and Exchange Commission (SEC) charged Goldman Sachs Asset Management for failing to follow its policies and procedures involving ESG investments. Link

Furthermore, the SEC’s order finds that, from April 2017 until February 2020, GSAM had several policies and procedures failures involving the ESG research its investment teams used to select and monitor securities. From April 2017 until June 2018, the company failed to have any written policies and procedures for ESG research in one product, and once policies and procedures were established, it failed to follow them consistently prior to February 2020. For example, the order finds that GSAM’s policies and procedures required its personnel to complete a questionnaire for every company it planned to include in each product’s investment portfolio prior to the selection; however, personnel completed many of the ESG questionnaires after securities were already selected for inclusion and relied on previous ESG research, which was often conducted in a different manner than what was required in its policies and procedures. GSAM shared information about its policies and procedures, which it failed to follow consistently, with third parties, including intermediaries and the fund’s board of trustees.

Challenges among Legislations for ESG Funds

ESG funds may not be as sustainable or ESG-aligned as you think. In the EU, the ESMA tested three key EU Ecolabel criteria on a large sample of sustainability-oriented equity funds and found that less than 1% of the sample have a portfolio greenness ratio above the proposed 50% threshold. Their experts then checked for four different types of exclusions and showed that these further reduce the share of eligible funds to 0.5%. The article also illustrates the impact of different threshold calibrations on the number of eligible funds and volumes of green finance. Looser requirements increase the potential volumes of green finance channeled through eligible funds but could damage the credibility of Ecolabel.

Under the effective EU’s Sustainable Finance Disclosure Regulation (SFDR), Article 8 of Regulation (EU) 2019/2088 remains neutral in terms of the design of financial products. It does not prescribe certain elements such as the composition of investments or minimum investment thresholds, the eligible investment targets, and neither does it determine eligible investing styles, investment tools, strategies or methodologies to be employed. And since Article 9 of Regulation (EU) 2019/2088 remains neutral in terms of the product design, investing styles, investment tools, strategies or methodologies to be employed, or other elements, the product documentation must include information on how the given mix complies with the ‘sustainable investment’ objective of the financial product in order to comply with the “no significant harm principle” of Article 2(17) of Regulation (EU) 2019/2088. (ESMA, Link)

Hence, the European Supervisory Authorities (ESAs) call for clarity with a list of additional SFDR queries requiring the interpretation of Union Law on September 2022 (Link), following the Commission’s assertion that Article 9 funds “should only make sustainable investments” has yet to be answered, causing problems for managers grappling with Level 2 disclosure requirements. However, some of the reclassifications emerged ahead of the upgraded disclosure regime SFDR Level II coming into effect in January 2023, according to Morningstar (2022, Link).

GC Insights will keep monitoring and analyzing the final guidelines once available, please follow our latest reports on the issue.

In a bid to promote transparency and prevent allegations like greenwashing, GC Insights has developed an ESG reporting platform (ESG Connector®) with SFDR compliance solutions tailored for financial institutions (FIs) under SFDR reporting pressures For FIs that are on the fences to assess ESG markets and the issue and disclosure requirements at entity and product level, we are constantly monitoring policy development trends and will keep you updated with the latest policy decisions with our Subscription Services.

ESG Connector® ESG Reporting Platform is available for demo here

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