The German financial supervisory authority BaFin is working on strict rules designed to prevent investment funds from declaring investments as environmentally friendly even though they are not.

This is likely to have an impact on the design of the European Union's supervisory framework.

“The German rules will probably be a good step towards the creation of European ones,” explained Thorsten Pötzsch, head of BaFin's securities supervision division.

"Sooner or later we should see a European draft for this."

The investment industry is in a historic upheaval.

Both small and institutional investors want to use their money to support the fight against climate change and social inequality.

While asset managers around the world advertise the sustainability of their portfolios, the trend, however, harbors risks of abuse due to the lack of clear definitions.

According to the BVI fund association, German investment firms managed 361 billion euros in sustainable funds at the end of June.

They thus had a 10 percent share of the German fund market as a whole. 

Vague descriptions

“We found several funds where the descriptions are so vague that you can't be sure that they are sustainable,” says Pötzsch. As an example, he cited a fund that claims to invest 75 percent of its assets in convertible bonds and select them according to ecological, ethical criteria and the aspect of good corporate governance. This is too general, says the head of the BaFin securities supervision. More details are needed on how exactly these systems are selected. 

Another asset manager described sustainability simply as “striving for long-term economic success while taking ESG principles into account,” said Pötzsch.

This, too, is "too soft and could mean anything".

In the financial market, ESG is an abbreviation for the English terms Environment, Social (social development) and Governance (corporate management).

Pötzsch did not want to comment on a report in the Wall Street Journal from the beginning of August, in which it was alleged that DWS would overstate its own ESG criteria.

"But you can assume that we will take a closer look at situations that could be unusual and check whether there are any signs of irregularities," said Pötzsch.

DWS, the investment company of Detschen Bank, has called the allegations insubstantial.

New publication requirements

The EU introduced new disclosure requirements this year, according to which fund managers must disclose the volume of money in their funds that pursue one or more ESG approaches.

These obligations will be expanded next year, but the rules do not define what exactly constitutes an ESG investment.

BaFin is not the first European supervisory authority to establish rules for when investments can be described as sustainable.

However, in some respects it sets the bar higher than authorities in other countries.

The planned rules of the German supervisory authority provide for a minimum threshold of 75 percent for investments that contribute to the achievement of ESG goals.

Germany is therefore stricter than other countries that use scoring systems or qualitative requirements.

The planned rules of BaFin are based on the EU definition of sustainability as a contribution to ecological or social goals. The former includes using energy and raw materials more efficiently, as well as reducing waste and carbon emissions. The latter relates to combating inequality, promoting social cohesion and industrial relations, and investing in human capital or economically or socially disadvantaged communities.

The industry has until September 6 to comment on the Bafin plans. The lobby of the German fund industry has declared that the threshold for ESG assets is so high that asset managers could possibly set up sustainable funds in Luxembourg instead of in Germany. "We want to create the highest possible quality of supervision," said Pötzsch. "And we're also creating something that could be beneficial in marketing these funds."