LONDON (BLOOMBERG) – Almost a quarter of funds that claim to “promote” sustainability under European regulations don’t deserve an “ESG” label, according to a fresh review by market researcher Morningstar.

The analysis, which looked at funds classified as Article 8 within the EU’s Sustainable Finance Disclosure Regulation (SFDR), shows that 23 per cent don’t live up to environmental, social or governance (ESG) investing principles, Boya Wang, ESG analyst at Morningstar, said in an interview.

To justify an ESG tag within Morningstar’s definition of the term, a fund’s investment strategy can’t rely only on excluding so-called sin stocks like tobacco, coal or weapons, Mr Wang said. “Many Article 8 funds will not be tagged as sustainable funds under our framework,” he said.

The assessment is the latest to raise questions around a key pillar of Europe’s efforts to become of global champion of sustainability. No other jurisdiction has raced ahead with such an ambitious programme for transforming the entire asset management industry. But even regulators are starting to warn that the process has left too many opportunities for greenwashing.

The EU’s rulebook for ESG investing, SFDR, which was enforced in March last year, requires firms to classify their investment products under one of three categories: Article 6, which only addresses ESG risks; Article 8, which “promotes” ESG characteristics; and Article 9, which sets measurable ESG “objectives.”

Arguably the vaguest of the three categories, Article 8 has become a magnet for fund managers. The latest Morningstar data reveals that asset managers have reclassified well over 600 funds previously listed as Article 6 to Article 8. A number of Article 9 funds were also downgraded to Article 8, it found. As of June, funds registered as Article 8 held 3.76 trillion euros (S$5.26 trillion), compared with 420 billion euros allocated to Article 9 funds, Morningstar estimates.

The reclassifications have coincided with a crackdown by financial watchdogs on funds suspected of misstating the ESG-ness of their portfolios.

There’s also evidence that investment clients are growing more cautious toward Article 8, as fund managers include atypical ESG sectors like defense, energy and commodities in the category. More than US$30 billion (S$41.6 billion) was withdrawn from Article 8 products last quarter, while roughly US$6 billion flowed into the stricter ESG category of Article 9, Morningstar data shows.

In response to stricter rules and more demanding clients, some asset managers have started removing ESG labels from funds, rather than be accused of greenwashing. In the second quarter, six funds dropped sustainability-related keywords from their names, Morningstar found.

The European Fund and Asset Management Association, which represents the industry, said the issue stems from the general absence of adequate ESG definitions.

European regulators have acknowledged the need to revisit some of the definitions currently guiding SFDR allocations. Verena Ross, chair of the European Securities and Markets Authority, said in May that regulators across the EU are working on reducing “what one might call over-disclosure by investment funds under Article 8, to avoid misleading disclosures to investors about the greenness of a product.”

Ms Ross said that ESMA also supports future legislative efforts to create clear criteria for financial products making sustainability disclosures. That includes potentially introducing “sustainability labels” for financial products, “in order to help generate much needed clarity for retail investors.”