When do sustainable fund labels become too prescriptive?

The system must be challenging yet achievable, and comprehensive yet clear to consumers

Fund labels for big issues like sustainability make everyone’s life easier, as they save advisers and investors from having to drill down into every fund to find those that meet their preferences. They also help large distributors, such as fund platforms, which may have thousands of funds and want to filter those down to a manageable number for those wanting to incorporate sustainability into their fund choices.

Once upon a time – a couple of years ago – the only “green” or “eco” labels for funds were determined at a national level across Europe and were issued on a pay-to-play basis.

To be able to attach a sustainable label to a fund entailed submitting the fund’s details (and a cheque) to a nationally mandated body. If that body determined that the fund cleared all the hurdles for their label – and they all have different qualification criteria – it would give the fund group the all-clear to use it in its marketing.

We now have the EU’s Sustainable Finance Disclosure Regulation (SFDR), which isn’t a labelling regime at all, but has become one by default, in the EU, and the Financial Conduct Authority’s (FCA) consultation paper on Sustainability Disclosure Requirements and Investment Labels looking, as the name suggests, at fund labels as a core element of sustainability disclosures in the UK.

For several years, the European Commission has been working on the criteria for an EU-wide ecolabel for investment funds, consisting of three quantitative criteria (portfolio “greenness”, environmental exclusions, and social and governance exclusions) and three qualitative criteria (engagement, enhancing investor impact, and information for retail investors).

That is all laudable, and it is right that the criteria should be challenging to meet, or you would simply end up with more accusations of greenwashing.

But when ESMA, the EU’s funds regulator, did some detailed analysis on the three quantitative criteria, they found that only 16 out of 3,000 “sustainably-oriented Ucits equity funds” would qualify for the ecolabel, based on the exclusions and the proposed greenness threshold of 50% of investee companies’ green turnover and capex, as defined by the EU taxonomy. 

That’s just over 0.5% of those funds that already claim to be sustainable.

Even if you are aiming to make a label tough to achieve, that high a hurdle seems self-defeating. What percentage of sustainably-oriented funds should be able to qualify for a label before we would hear accusations of setting the hurdle too low – 5%, 10%, 25%?

There may be unintended consequences of labelling regimes, some of which will no doubt be aired in response to the FCA’s consultation, which has just closed. These include the impact on index funds, for example.

See also: – FCA sustainable fund label proposal nuances hammered out by industry

Based on the proposals in the consultation paper, one of two outcomes for index funds seems to be possible, either of which could cause problems.

We could have every fund that tracks a sustainable index automatically qualifying for a label, even if the index holds fossil fuel companies, tobacco, airlines, etc, on a “best in class” basis. Or a fund tracking a sustainable index would not automatically qualify and so would not be able to include the name of the index it tracks in its own name.

Under the SFDR, funds that are not Article 8 or 9 can still take sustainability risks into account. But the FCA’s proposal is to ban funds that don’t qualify for a sustainability label from using any term in its marketing that might imply sustainability, so they couldn’t explain how they take those risks into account or explain how they use engagement as part of their risk management process, other than in legal disclosures.

I am strongly in favour of a fund labelling system that helps platforms, advisers and investors find their way around the myriad of different sustainable funds, but, to borrow from the FCA’s Consumer Duty paper, consumers must “be given the information they need…and presented in a way they can understand” if they are “to make informed decisions about financial products”.

The challenge is to come up with a labelling system that is challenging yet achievable, and comprehensive yet clear to end investors. Consumers need to understand what the labels mean and, while I have a feeling the first version won’t be the last, it would be better to have something good than striving for perfection.