The state of European sustainable finance has evolved rapidly in recent years. The EU Taxonomy Regulation established criteria for classifying sustainable activities, allowing for fund managers to evaluate the extent to which investments in companies' economic activities are environmentally sustainable.
The Sustainable Finance Disclosure Regulation (SFDR) endeavours to bring greater transparency to investors on sustainability factors and how sustainability risks are integrated in fund manager's investment processes. And more recently, requirements to integrate sustainability considerations in investment products through the Markets in Financial Instruments Directive (MiFID II) have been implemented.
Collectively these regulations have had an impact on the Europe domiciled fund market, ranging from product launches, to flows and the levels of transparency they provide to end investors.
The European fund market is the second largest globally after the US, with almost EUR 12 trillion in assets under management across almost 30,000 unique funds. We estimated that the majority of the assets (around EUR 7 trillion) under management in Europe are invested in ESG funds, or strategies with some sustainability related focus in portfolio construction.
The majority of fund-based capital in Europe is therefore relevant in the context of, and impacted to some degree by the EU taxonomy, SFDR and MiFID. In this piece we briefly explore how the European funds universe performs across these streams in terms of disclosures and investability.
EU Taxonomy
The EU taxonomy centres upon financial market participants reporting the percentage of environmentally sustainable investments using consistent and comparable definitions. Based on data disclosed by funds in the European ESG Template (EET) as of 30th April 2023, MSCI ESG Research found that of the 13,419 European funds analyzed, in which 6,603 were Article 8 or Article 9 funds, only 126 funds reported a figure for EU Taxonomy aligned revenue.
The overwhelming majority of Article 8 and 9 funds stated “no intent” vis-a-vis EU Taxonomy alignment in the EET reporting – 88% of Article 8 funds and 63% of Article 9 funds did not include taxonomy aligned investments. Notably, the majority of high taxonomy aligned funds were classified as Article 8 funds under SFDR, with only two being article 9, which may appear counterintuitive to impact-focused fund selectors.
All of this may be attributed to the incomplete nature of the EU Taxonomy or to the level of stringency set for sustainable activities. Although reporting volumes have increased, company disclosure data for EU Taxonomy eligibility and alignment criteria remain low. Even in the future, the extent to which non-EU companies disclosing information in line with taxonomy requirements remains to be seen. In either case, it leaves sustainability-minded fund selectors with a limited pool of options, which may be challenging for mandates that require a minimum level of EU taxonomy alignment, while balancing diversification needs.
Source: MSCI ESG Research. Fund classification and EET disclosures as of April 30 2023
SFDR
The EU SFDR (Sustainable Finance Disclosure Regulation) enacted in 2021 requires financial market participants, including wealth managers to disclose how they integrate sustainability risks alongside how they consider the potential adverse impacts of their investments on sustainability factors. SFDR also requires funds to be categorized based on their level of sustainability.
Article 8 and 9 funds now collectively account for over EUR 6 trillion in assets (55 percent of Europe fund assets). As of end of Feb 2023, there were 12x more Article 8 funds than 9 available for investors and those funds collectively hold 18x the assets.
This imbalance may continue, as updates in regulatory guidance have driven reclassifications of funds. Our analysis indicated that approximately 20 percent of SFDR classifications in European funds changed over the previous year, with a net migration from Articles 6 and 9.
On fund types, global equity strategies dominated across both Article 8 and 9 funds, however there was more diversity of choice in asset class, geographic and sectoral focus for Article 8 funds – an important consideration for wealth managers constructing portfolios from funds, and catering to clients with more ambitious sustainability preferences.
Plenty of choice in Article 8, not so much in Article 9
Source: MSCI ESG Research LLC, as of April. 30, 2023. No. of funds - Article 8: 11,369, Article 9: 973
For portfolio managers seeking to create Principle Adverse Indicator (PAI) optimized funds, disclosure levels are a key determinant. In order for wealth managers to offer their clients a graded choice of investment options, scaled to varying levels of sustainability, disclosure levels are therefore critical to consider.
Assessing the large and mid-cap investable universe revealed high dispersion on disclosure of environmental PAIs such as emissions-based metrics (Scope 1-3). European companies led the charge with over 90 percent of firms disclosing Scope 1+2 emissions. Notably, emerging markets exhibited higher disclosure levels versus the US, across Scope 1, 2 and 3 emissions, and higher versus Europe on PAI 8 - emissions to water disclosure.
On social PAIs (11-14), gender pay gap reporting was low across the board with 3.1 percent of companies globally disclosing. Europe had the highest disclosure rates for the social PAIs 30 percent, and the US marginally disclosed more than the emerging markets. Board gender diversity (PAI 13) disclosure was high across regions, however it is important to note that high disclosure does not necessarily equate to the boards of the companies having higher diversity than peers.
Environmental and Social Principle Adverse Indicators (PAI) Disclosure Levels
Source: MSCI ESG Research LLC, as of April. 30, 2023. Based on PAI disclosure and MSCI ESG Research assessments of large and mid-cap companies of regions represented by MSCI ACWI, Europe, USA and Emerging Market indexes. No. of companies per region – Global = 2,882 , Europe = 424, USA = 625 , Emerging Markets = 1,373. PAIs are defined in Annex 1, Table 1 of Commission Delegated Regulation (EU) 2022/1288. Official Journal of the European Union. 2022.
MiFID Sustainability Preferences
Under MiFID II, investment firms providing investment advice and portfolio management services are required to consider sustainability factors and risks adverse impacts of their investments. Key among the amendments introduced in MiFID II is the requirement that investment firms inquire about the individual sustainability preferences of their clients. To be able to recommend suitable products to clients, investment firms have to confirm whether a client has sustainability preferences, and if so, whether, and to what extent, one or more of the following criteria should be integrated into their investment:
- Financial instruments or products with a minimum proportion of sustainable investments that qualify as environmentally sustainable under the EU Taxonomy (Taxonomy-aligned investments)
- Financial instruments or products with a minimum proportion of sustainable investments as defined under Article 2(17) of the SFDR (sustainable investments)
- Financial products or instruments that consider principal adverse impacts on sustainability factors (SFDR Principal Adverse Impact Indicators (PAIs)), where those considerations are determined by the client or potential client
Based on data disclosed in the European ESG Template (EET) as of 30th April 2023, MSCI ESG Research found that over half of Europe domiciled funds were considering (committing to reduce or mitigate) at least one SFDR principle adverse impact indicator in their investment strategy.
Consideration of involvement-type adverse impact indicators is more likely than consideration of quantitative indicators for which thresholds are not prescribed by the SFDR regulation. Specifically, 80 percent of funds disclose considering exposure to companies active in the fossil fuel sector (PAI 4) and 93 percent consider exposure to controversial weapons (PAI 14).
On the other hand, approximately 47 percent of funds consider exposure to GHG emissions (PAI 1) and 51 percent of funds consider exposure to companies with non-renewable energy consumption and production (PAI 5). Across the board, EU-domiciled Article 9 funds have committed to manage or mitigate PAIs more so than funds without sustainable investments as their objective, likely driven by the requirement to assess the portfolio against the principle of "do no significant harm" by considering the PAIs.
Consideration of select adverse impact indicators among EU funds having disclosed a commitment to reduce or mitigate at least one SFDR PAIs
Source: MSCI ESG Research, EET disclosures as of April. 30, 2023. No. of unique EU-domiciled funds: 6,709, No. of Article 8 funds: 5,978, No. of Article 9 funds: 662. PAIs are defined in Annex 1, Table 1 of Commission Delegated Regulation (EU) 2022/1288. Official Journal of the European Union. 2022.
The state of disclosures, product choices and sustainability preferences will continue to evolve as the regulatory environment in Europe remains in flux. And while that presents a confluence of challenges for wealth managers from portfolio construction to sustainability reporting, opportunities may also arise as investors become more attuned to how sustainability risks are integrated in the investment decision process.
