Despite efforts to define and clarify what ‘ESG funds’ are, the term’s ambiguity persists, leading to confusion and debate over the term, according to the latest report published by the CFA Institute Research and Policy Center.
The paper, How to Build a Better ESG Classification System, examines a selection of existing regulator and industry ESG fund classification frameworks in the US, the European Union and the UK, finding a lack of focus on observable features, imprecise definitions or an incomplete logical structure for assigning funds to mutually exclusive groups.
It also seeks to improve ESG fund classification through an in-depth review of current classification frameworks and definitions of fund-level features, as well as providing examples of rigorous definitions in practice.
It is hoped this will be useful for regulators establishing and tailoring rules for ESG funds, as well as for industry participants seeking to both market and select funds, offering guidelines, examples and case studies to support practitioners who must deal with the complexities of ESG fund classification in practice.
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Chris Fidler, head of global industry standards, CFA Institute, said: “There is much disagreement about how to categorically define and identify ‘ESG funds.’ When ambiguous terms like these are used in regulation to create special rules for certain kinds of funds, it can create significant uncertainty in the marketplace. The ultimate test of a classification system is to have different evaluators classify the same set of funds. If they do it the same way, a good system exists. If different evaluators assign the same fund to different groups, revisions are required.
“This paper shows how to build strong fund category definitions, and we hope it ultimately leads to clearer regulation which would benefit both fund investors and fund managers.”
The paper defines three observable features by which funds can be classified. Firstly, the existence of one or more processes that consider ESG information to improve risk-adjusted returns; secondly, the existence of one or more policies that control fund investors’ exposure and contribution to specific systemic ESG issues; and thirdly, the existence of an explicit statement of intent, and an action plan, to help bring about a target future state in environmental or social conditions and a process to measure progress.
Speaking on the UK’s Sustainability Disclosure Requirements (SDR), Fidler added: “SDR will give fund investors confidence that a sustainability labelled fund meets minimum standards set and enforced by the FCA. SDR will make it vastly easier for retail investors to identify funds with a sustainability objective.
“For funds without a sustainability label, the markets still need a reliable way to distinguish between funds that use ESG information to make risk-return decisions and funds that take a policy position on specific ESG issues. This is one of the primary needs that we explore in our new report.”
Meanwhile, on the EU’s Sustainable Finance Disclosures Regulation (SFDR), he said: “SFDR showed that conditional disclosures — for example, a disclosure that is made only when a fund has sustainable investment as its objective — gives rise to a de-facto classification system in the marketplace. This is not ideal because classification systems should be intentionally designed to meet a defined set of needs.”
“For funds without a sustainable or transition label, the markets still need a reliable way to distinguish between funds that use ESG information to make risk-return decisions and funds that take a policy position on specific ESG issues. This is one of the primary needs that we explore in our new report.”
