Speaking to ETF Stream, Smith said asset managers and index providers looking to create new products within ESG are hesitant “because they are worried about getting the regulation wrong”.
Authorities have consistently been trying to get to grips with the ‘vague’ definitions of the regulation with many fearing the lack of clarity could also increase the risk of greenwashing while the lack of standardised data is also causing concerns.
Earlier this year, the European Supervisory Authority (ESA) asked for several clarifications around what can be considered an Article 8 or 9 fund, despite the regulation coming into force in March 2021.
“Regulation is important because if you are innovating you are always pushing the boundaries. You need the regulator to make sure firms do not overstep those boundaries and take investment into a fund that is not appropriate,” he said.
“Where regulation can become a barrier is when it is less clear, and SFDR is unclear. With unclear regulation, nobody wants to put their head above the parapet because if it changes or is interpreted differently then you could fall foul of the regulator.”
Smith added the “unclear and contradictory information” in the ESG space means ETF issuers are unable to “push the innovation boundary”.
Instead of encouraging innovation, many believe the regulation has merely become a labelling exercise as asset managers rush to categorise their products either Article 8 or 9 in a bid to boost flows.
In Q2, 700 products changed their SFDR label with the majority upgrading from Article 6 to Article 8, according to Morningstar. Meanwhile, no funds were downgraded from Article 8 or 9 to Article 6 while just 16 were downgraded from Article 9 to Article 8.
Earlier this year, Tabula said it was becoming “laser-focused” on ESG as it shuttered two of its ETFs, adding investors had rotated into a Paris-aligned benchmark strategy instead. According to Tabula, almost 70% of its assets under management are now either Article 8 or 9.
Another issue, according to John Howchin, global ambassador of the United Nations convened Global Tailings Management Institute, is that important asset management resources are being diverted to regulation instead of focusing on other key areas.
Speaking at the Morningstar Investment Conference, Howchin said: “There is a limited resource of people that know these topics well and they are being used for the wrong reasons.
“Asset managers need to be mindful of how you use your resources and understand what the key purposes are so you do not end up just looking at the regulation.”
Rob Edwards, director of ESG product management at Morningstar Indexes, said index providers face the same challenges as issuers when creating ESG products.
“From an issuer standpoint, I can see why it is frustrating, rumours of change are going to scare people off from issuing new products as they might not meet the label in six months,” he said.
“It is almost the same for index providers. We do not know what regulation will look like a year from now so how is that going to impact our current indices in the market?”
Despite the issues, Edwards praised the regulation for creating transparency for investors and was quick to caution the European Union’s action plan on ESG was still a work-in-progress.
“From a holistic standpoint, all the regulation is not in sync yet. I am optimistic it will all converge over the next couple of years and that everything will become clearer,” he added.
Last month, Morningstar said almost a quarter of the fund’s labelled Article 8 – often described as ‘light green’ funds – under SFDR do not meet its criteria and will likely be downgraded to Article 6.
It comes as the second phase of the regulation is set to come into effect in January 2023, however, there are fears asset managers will not be ready for the new measures.
The Central Bank of Ireland recently announced it would fast-track the approval process for funds in a bid to avoid another delay, however, Edwards added that is still a possibility.
“Another delay is always possible. Expediency is great but I would guess the market is more dedicated to getting this one right,” he said.