Navigating the Future of Green Investing: Europe's New ESG Fund Naming Rules Explained
Introduction
In recent years, Environmental, Social, and Governance (ESG) investing has gained significant traction as investors increasingly seek to align their investments with their values and contribute to a more sustainable future. However, the rapid growth of ESG investing has also raised concerns about "greenwashing" - the practice of making misleading or unsubstantiated claims about the environmental or social benefits of a financial product. To address these concerns, the European Securities and Markets Authority (ESMA) has recently issued new guidelines on the use of ESG-related terms in fund names. In this blog post, we will explore the implications of these guidelines for asset managers and investors.
1. What are the new ESG fund name guidelines issued by ESMA and what do they aim to achieve?
On May 14, 2024, ESMA published its final guidelines on the use of ESG or sustainability-related terms in fund names. The guidelines aim to protect investors against greenwashing and provide minimum standards for funds that use ESG-related terms in their names. The guidelines require funds using ESG or sustainability-related terms to invest a minimum of 80% of their assets in investments that meet the environmental or social characteristics or sustainable investment objectives stated in their name.
Furthermore, the guidelines mandate specific exclusions for funds using certain terms. Funds with "ESG", "SRI" (Socially Responsible Investing), or environmental terms in their names must apply the exclusions set by the EU regulation for Paris-aligned benchmarks (PAB). Funds using "transition" or "impact"-related terms are subject to additional qualitative requirements.
2. How will the new ESMA guidelines impact existing funds using ESG-related terms?
The new guidelines will have a significant impact on existing funds that use ESG or sustainability-related terms in their names. Asset managers will need to review their fund portfolios to ensure they meet the 80% threshold for ESG investments and comply with the relevant exclusion criteria. Funds that do not meet these requirements will need to either adjust their portfolios or remove the ESG-related terms from their names.
According to a study by Clarity AI, nearly half (44%) of the funds using environmental and impact terms may need to change their name or divest assets, as they are currently invested in assets that breach the PAB exclusionary criteria. The majority (82%) of these funds are classified as Article 8 funds under the Sustainable Finance Disclosure Regulation (SFDR).
3. What specific exclusions are mandated by the new ESMA guidelines for funds using ESG-related terms?
Funds using "ESG", "SRI", or environmental terms in their names must apply the PAB exclusions, which include:
a) Companies involved in controversial weapons
b) Companies involved in the cultivation and production of tobacco
c) Companies that derive 1% or more of their revenues from coal
d) Companies that derive 10% or more of their revenues from oil
e) Companies that derive 50% or more of their revenues from natural gas
f) Companies that derive 50% or more of their revenues from high greenhouse gas (GHG) intensity electricity generation (more than 100g CO2e/kWh)
Funds using "social", "governance", or "transition"-related terms can apply the less stringent Climate Transition Benchmark (CTB) exclusions, which focus on norms-based exclusions, tobacco, and controversial weapons.
4. What is the expected impact of the new guidelines on fund names in the context of fossil fuel investments?
The PAB exclusions, which apply to funds using "ESG", "SRI", or environmental terms, set strict limits on investments in fossil fuel-related activities. This means that many funds currently holding investments in coal, oil, and natural gas companies may need to divest these holdings or remove the ESG-related terms from their names.
The Clarity AI study found that the limits imposed on fossil fuel-related activities are a key driver of breaches of the PAB exclusionary criteria. This highlights the significant impact the new guidelines are likely to have on funds' exposure to fossil fuel investments.
5. What challenges do asset managers face in implementing the new ESMA guidelines on ESG fund names?
Asset managers face several challenges in implementing the new ESMA guidelines:
a) Portfolio adjustment: Asset managers will need to review and potentially adjust their fund portfolios to ensure compliance with the 80% threshold for ESG investments and the relevant exclusion criteria. This may involve divesting certain holdings and identifying suitable replacement investments.
b) Data and analysis: To thoroughly apply the exclusionary criteria, asset managers will need to have a deep understanding of the companies, industries, and revenue streams they are exposed to. This requires access to comprehensive and reliable ESG data and the ability to analyze it effectively.
c) Timeframe: The guidelines will apply three months after their translation is published on ESMA's website, with existing funds having an additional six months to make the necessary adjustments. This relatively short timeframe may pose challenges for asset managers, particularly those with large or complex portfolios.
d) Communicating with investors: Asset managers will need to communicate any changes to fund names or investment strategies to their investors clearly and transparently to maintain trust and avoid confusion.
6. How do the new ESMA guidelines compare with ESG investment practices in other regions, such as Asia?
The new ESMA guidelines represent a more stringent approach to ESG fund naming and exclusions compared to current practices in many other regions, including Asia. While some Asian jurisdictions have introduced regulations or guidelines on ESG fund disclosures and naming, they generally do not mandate specific exclusion criteria to the same extent as the ESMA guidelines.
For example, while some Asian regulations mention exclusions or negative screening as recognized ESG investment strategies, they do not typically specify the sectors or activities to be excluded. This contrasts with the detailed PAB and CTB exclusion criteria in the ESMA guidelines, which set clear thresholds for exposure to controversial weapons, tobacco, fossil fuels, and high GHG intensity electricity generation.
The ESMA guidelines' emphasis on exclusions also highlights a divergence from the approach taken by many domestic Asian ESG investors, who are less likely to apply blanket exclusions, particularly in relation to fossil fuels. This difference in approach reflects the varying stages of economic development and the challenges of transitioning to a low-carbon economy in different regions.
Conclusion
The new ESMA guidelines on the use of ESG-related terms in fund names represent a significant step towards combating greenwashing and promoting transparency in sustainable investing. However, they also pose challenges for asset managers, who will need to carefully review their fund portfolios and ensure compliance with the new requirements.
The impact of the guidelines is likely to be particularly pronounced in relation to fossil fuel investments, with many funds potentially needing to divest holdings or remove ESG-related terms from their names. As the guidelines come into force, it will be crucial for asset managers to have access to comprehensive and reliable ESG data and to communicate any changes to their investors clearly and transparently.
While the ESMA guidelines set a high bar for ESG fund naming and exclusions compared to current practices in many other regions, they also highlight the growing global focus on sustainable investing and the need for consistent and robust standards. As the landscape of ESG investing continues to evolve, it will be important for investors and regulators worldwide to learn from each other's experiences and work towards a more harmonised and effective approach to promoting sustainable finance.
