Last week the influential ratings firm Morningstar stripped its 'Sustainable' label off c1,600 funds (1 in 4), and said there will be more downgrades to come.

A huge number of these funds had already declared themselves to be Article 8 (an SFDR categorisation that means ESG has been integrated into the investment process). Morningstar however has criticised these funds that “place themselves into Article 8…say they consider ESG factors in the investment process…but don’t integrate them in a determinative way for their investment selection”. 

To qualify as Article 8, a fund must not just establish and declare certain ESG policies, it must assess each holding in the fund according to 14 ‘Principal Adverse Indicators’. It's a detailed process, and the vast majority of self-declared Article 8 funds are not doing this at all.

Morningstar is just a ratings firm - but there are 2 far more concerning developments:

Regulators have had enough of these exaggerated claims.

The EU markets watchdog, ESMA, said it will create a legal definition of “greenwashing” and classify it as a type of mis-selling. When a financial regulator creates a new definition, it is invariably because they intend to weaponize it.

The FCA said back in July that many ESG funds “often contain claims that do not bear scrutiny”. This was perhaps an early warning, and penalties will follow.

The SEC is investigating DWS for possible false ESG claims on some of its funds. This shows that even in markets where sustainability is not being promoted, nor is it clearly defined, regulators are already willing to pursue unsubstantiated ESG claims as a form of mis-selling.

Investors may start to sue.

- Consider this warning from the partnership at Baker McKenzie in Los Angeles, that if people have lost money, “you’ll see plaintiffs step in. You’re hearing the rumblings. It’s not happened that much yet. But it will.”

- Simmons & Simmons in London cites cases brought by shareholders against operating companies, on ESG grounds, and the FT quotes its partner Robert Allen’s warning “you can definitely see how (a case against fund managers) can follow on”.

- North Wall Capital, which funds legal class actions, offers the alarming quote “it is certainly coming”.

What might this mean? It means that a $10bn fund, that has underperformed its benchmark by 2%, and whose advertised claims that it is ‘sustainable’ are later deemed to be misleading, could face a $200m class action claim from its investors.

Might a clear legal standard of ‘sustainable’ emerge? The law firm Bates Wells believes that the 2015 Paris Climate Accord will be the legal standard – and the recent court ruling against Shell in The Hague set this as a legal precedent. How many investment funds are using a tool like THIS to evidence that their investments are consistent with a global warming scenario ‘well below 2 degrees’ (which is the objective of the Paris Climate Accord)?

So, ESG regulatory risks and legal liabilities may be mounting for fund management firms. The easiest way for any fund management firm to mitigate these risks is to state clearly that environmental and social objectives are not promoted by the fund, nor is ESG analysis systematically integrated into the investment process. Then all these mis-selling risks fall away.

It just seems that, fearful of losing investors, very few fund management firms want to do this.

The alternative is for these firms to build, or subscribe to, data tools that will map their funds to the Paris Accord, assess them against the 14 SFDR Adverse Indicators, and enable them to explain the key ESG risks in every existing investment.

How can Integrum ESG help meet these challenges?

- Fund managers are often relying on ESG ratings they cannot understand. When a regulator or investor asks "why are you comfortable with the ESG performance of this company?" they will struggle to answer, because the ESG score that has reassured them is a set of black boxes. The Integrum ESG dashboard presents glass boxes, with the reason for every score, for every metric, and the underlying data that explains and supports the ESG rating.

- Applying a Cambridge University model, the Integrum ESG dashboard calculates the extent to which your fund is aligned to the Paris Climate Accord - and surfaces the data that supports this calculation, company by company.

- The latest Integrum ESG dashboard feature, soon to be deployed, will provide the evidence of why, or why not, your fund can be classified as Article 8. It will map and assess the alignment of every uploaded fund to the SFDR Principal Adverse Indicators, and the EU Taxonomy Objectives.

Do you want to learn more about how Integrum ESG can help you meet these challenges? If so, CLICK HERE.