ESMA Guidelines Could Force 1,600-Plus ESG Funds to Rename or Divest

To protect investors against greenwashing risk, new rules set minimum standards for funds available in the European Union that use specific ESG terms in their names.

On May 14, 2024, the European Securities and Markets Authority published final guidelines on fund names that use terms related to sustainability or environmental, social, and corporate governance criteria.

To comply, funds need to meet new portfolio requirements or change names.

We assessed the potential impact of these guidelines with Morningstar’s company- and fund-level ESG data. Download the comprehensive ESMA rules report for:

• A list of terms potentially affected by this new guidance.
• The most-held stocks potentially in breach of the regulation.
• Funds with the highest market value potentially in breach of the regulation.

The new naming rules line up with EU regulations that have set the exclusion criteria for climate-transition benchmarks and Paris-aligned benchmarks. All funds with ESG-related names will have to meet these standards.

• Minimum of 80% of investments that meet environmental or social characteristics or sustainable investment objectives.
• Exclusions of any activities related to controversial weapons.
• Exclusions of any activities related to tobacco cultivation and production.
• Exclusions of violators of the UNGC principles or OECD guidelines.
• Exclusion of companies that derive more than a certain percentage of revenues from fossil fuels.

Some funds face additional considerations.

• To keep the term “sustainable” in their names, funds need to invest “meaningfully” in sustainable investments.
• Funds using “transition”- or “impact”-related terms must meet specific qualitative requirements.

When interpreting the exclusion rules and sourcing data, managers must decide how far they must go in a company’s ownership and value chain and assess the related investment implications.

ESMA didn’t provide further guidance on what is “meaningful,” leaving interpretation up to national competent authorities.

National groups might be reluctant to set minimum thresholds of sustainable investment, as this could fragment the EU market with varying interpretations. An additional challenge is that different asset classes may require setting different thresholds.

At best, only 56% of funds with the specific term “sustainable” in their names would be able to keep the term if the minimum threshold is set at 30%.

The guidelines apply to fund managers who promote Undertakings for Collective Investment in Transferable Securities, or UCITS, and Alternative Investment Funds, or AIFs. It covers funds whose names include terms related to:

• Environmental.
• Transition.
• Impact.
• ESG.
• Sustainability.

Consistent with the scope of the Sustainable Finance Disclosure Regulation, or SFDR, the guidelines are directed at fund managers marketing funds in the European Union.

We identified around 4,300 EU funds with ESG- or sustainability-related names that may fall in the scope of the new guidelines.

Of 2,500 funds with stock holding data, we found that more than 1,600 are exposed to stocks potentially in breach of the PAB and CTB exclusion rules. This means about two-thirds of funds may need to divest from the stocks or rebrand.

The vast majority, or 79%, are classified as Article 8 funds, while 21% are passively managed, holding almost $19 billion worth of stocks potentially affected by the exclusion rules.

For most of the 1,600 funds identified as holding at least one stock in potential breach of the exclusion rules, the divestment risk is contained. About 70% hold fewer than five stocks that could potentially violate the exclusion rules.

That means 30% of funds would require more portfolio adjustments, which may be problematic depending on the type of investment strategy and portfolio size.

The sectors most affected by potential divestments include:

• Energy.
• Industrials, such as railroads, defense, and specialty chemicals.
• Basic materials.

The most affected stocks include:

• TotalEnergies (TTE), which is held by 356 in-scope funds with an aggregate value of $3.5 billion.
• Tencent Holdings (TCEHY), which is held by 167 in-scope funds with an aggregate value of $3.3 billion.
• Shell (RYDAF), which is held by 144 in-scope funds with an aggregate value of $1.4 billion.

The most affected countries, in terms of market value, would be:

• The United States.
• France.
• China.

The new guidelines will apply after they’re translated into all official languages and published on ESMA’s website. Once published, they’ll apply to new funds after three months and existing funds after nine months.

With a publication date of June 15, 2024, the guidelines could apply to new funds from Sept. 15, 2024, and existing funds from March 15, 2025.

With product involvement data in hand, asset managers have a few options in response to the impending guidelines.

• Increase allocation to sustainable investments. This option is more viable for the 70% of funds that hold fewer than five stocks potentially in breach of the benchmark guidelines. Passive funds can consider changing underlying indexes to align with the rule and keep ESG-related terms.
• Tweak sustainable-investment measurement methodologies to meet specifications.
• Reposition as transition funds, to which the less restrictive exclusions apply, if you can demonstrate a clear and measurable transition path.
• Rebrand to remove ESG-related terms. Fund flows can help firms assess investor sentiment and the impact of renaming on inflows.