Funds have increasingly adopted sustainability terminology in their names to attract investors' growing interest in sustainability-related products. Since a fund’s name can act as a deciding factor in investment decisions, guidelines and regulations have been introduced to ensure consistent use.
The European Securities and Markets Authority (ESMA) has published new guidelines responding to the growing demand for investment funds incorporating environmental, social, and governance (ESG) factors. The guidelines aim to prevent greenwashing and misleading claims about sustainability by ensuring that funds using ESG or sustainability-related terms in their names meet appropriate standards.
All competent authorities (e.g. central banks or regulatory oversight entities within ESMA countries) and financial market participants are expected to make every effort to comply with these guidelines, which will be translated into all official EU languages and are applicable three months after the translations’ publication. However, within two months of the guidelines' publication, each competent authority must notify ESMA whether or not they intend to comply with the guidelines on a ‘comply or explain’ basis. Financial market participants are not expected to notify ESMA about their compliance status.
This development follows recent trends. Last year, MSCI, a leading global investment research firm, stripped thousands of funds of their ESG status. Hundreds more were set to lose their ESG ratings, with thousands facing downgrades in an overhaul. The significant reduction in top-rated funds was estimated to limit options for ESG-focused investors, potentially increasing the prices of sustainability-labelled assets.
Key reasons for ESMA’s guidelines on funds' names
The growing demand for sustainable investments has raised concerns at ESMA regarding the potential for misleading sustainability disclosures, which can lead to greenwashing. ESMA has identified 6,490 funds with ESG-related terms in their names, accounting for 9.6% of total funds. We have outlined three key purposes behind these guidelines:
1. Investor protection:
To ensure that funds using ESG or sustainability-related terms in their names genuinely adhere to certain sustainability standards. This protects investors from unsubstantiated or exaggerated sustainability claims in fund names and provides asset managers with clear and measurable criteria to assess their ability to use ESG or sustainability-related terms.
2. Regulatory consistency:
The guidelines were published following new mandates from the recent review of the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for the Collective Investment in Transferable Securities (UCITS) Directive.
3. Market integrity:
To maintain fair and transparent marketing practices to avoid misleading investors. This connects to the broader ethical and legislative ecosystem regarding disclosures to investors and obligations to behave honestly and fairly.
It is worth noting that the guidelines' publication on 14 May 2024 reflects the market’s needs and results from active engagement and a consultation period with the investment community.
What are the main requirements in the new guidelines?
If we dive further into the guidelines, ESMA states that their purpose is to “specify the circumstances where the fund names using ESG or sustainability-related terms are unfair, unclear, or misleading.” To do so, it has set the following (simplified) requirements:
1. Use of transition, social, and governance-related terms:
Funds using these terms in their names must allocate at least 80% of their investments to meet environmental or social characteristics or sustainable investment objectives.
In addition, they have to exclude investments in companies according to the minimum standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks. This includes companies involved in controversial weapons, tobacco production, or those found violating the United Nations Global Compact principles or the OECD Guidelines for Multinational Enterprises.
2. Use of environmental or impact-related terms:
Funds using environmental or impact-related terms in their names must comply with the guidelines outlined above.
In addition, they must also exclude investments in companies that do not meet certain revenue criteria. This includes companies that derive 1% or more of their revenues from coal, 10% or more from the exploration, extraction, distribution or refining of oil, 50% or more from gas (gaseous fuels), or 50% or more from electricity generation with high greenhouse gas emissions (more than 100 g CO2e/kWh).
3. Use of sustainability-related terms:
Funds using sustainability-related terms in their names should comply with the above criteria.
In addition, they have to commit to investing meaningfully in sustainable investments. In this context, sustainable investments are investments in economic activities that contribute to environmental objectives measured by, for example, key resource efficiency indicators or impact on biodiversity or circular economy. It also includes investments in economic activities that contribute to a social objective and investments in human capital or economically or socially disadvantaged communities, provided those investments do not significantly harm any other objectives.
In addition to these criteria, the guidelines state that funds can use terms like "impact investing" only if they meet the defined thresholds and safeguards and intend to generate measurable social or environmental impact alongside financial returns. This also applies to funds using transition-related terms.
As a minimum safeguard, exclusion criteria from the Paris-Aligned Benchmarks (PAB) rules are recommended for all funds using ESG or sustainability-related terms in their names. If a fund name combines terms from more than one of these categories, all relevant guidelines should be applied.
Our comments on the guidelines
These guidelines result from extensive market dialogue and the development of sustainable finance over the past decade. They represent an important step by a credible entity to minimise the risk of greenwashing, counter backlash, and preserve the nature and objectives of sustainable finance and investments.
While we are eager to see their impact on the market, it is clear that not everyone will agree that these requirements will completely eliminate misleading sustainability claims. This is due to the inherently imprecise nature of such claims and the need for flexibility in interpreting the guidelines' terms.
The key takeaway is the ongoing and increased focus on fund managers and operators regarding what is included in their funds. There is a heightened need to train and educate their employees as these guidelines and other regulations force them to conduct deeper due diligence in new investments and maintain ongoing monitoring of existing investments in the funds.
As these guidelines come into action, we will be reflecting on the following questions:
How will these guidelines affect funds involved in transition funding?
Will obvious gaps emerge regarding the thresholds and exclusionary criteria set in the requirements?
How will these guidelines affect the number of funds using ESG-related terms in their names?
Bottom line
The ESMA guidelines are an important step toward ensuring transparency, market integrity, and preventing greenwashing. By setting clearer standards for using ESG and sustainability-related terms in fund names, ESMA aims to protect investors and maintain trust in the market.
You can read ESMA’s full guidelines here. If you are looking to further your understanding of their use, either as an investor or an asset manager, contact our team today to discuss.
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