New ESMA Guidelines and the Evolution of Sustainable Finance

 

New ESMA Guidelines and the Evolution of Sustainable Finance

In May 2024, the European Securities and Markets Authority (ESMA) released its final guidelines on the use of ESG and sustainability-related terms in fund names. These guidelines mark a significant step towards increasing transparency and protecting investors from greenwashing. The updated regulations impose stricter criteria on fund managers, ensuring that sustainability claims are substantiated and accurately reflect the fund's underlying investments.

This development comes amidst growing investor demand for sustainable investment products and the European Union's broader regulatory efforts to enhance the integrity of sustainable finance. This article delves into the specifics of these new guidelines, their implications for fund managers, and how they align with the anticipated updates to the Sustainable Finance Disclosure Regulation (SFDR), often referred to as SFDR 2.0.

The Motivation Behind ESMA's Guidelines

The drive to regulate the use of ESG-related terms in fund names stems from the risk of greenwashing—a practice where funds claim to be sustainable without meeting necessary criteria. In its final report, ESMA highlights the increasing tendency of asset managers to use terms like “sustainable,” “green,” and “ESG” to attract investors, even when their investments do not necessarily align with these claims​. The guidelines aim to combat this by providing clear and measurable criteria for using such terms.

Key Components of the Guidelines

Under the new ESMA guidelines, any fund using sustainability-related terms in its name is required to allocate at least 80% of its investments towards achieving environmental, social, or sustainable investment objectives. This threshold applies consistently across all categories of ESG-related terms, whether they focus on environmental, social, or governance aspects. Additionally, the guidelines establish exclusion criteria based on the specific terms used. For instance, funds that include terms like “environmental,” “green,” or “impact” in their names must comply with the exclusions set by the Paris-aligned Benchmarks (PAB), avoiding investments in companies involved in controversial activities such as fossil fuel production or human rights violations. Meanwhile, funds that use terms related to transition, social, or governance aspects, such as “net-zero” or “transitioning,” are subject to the Climate Transition Benchmarks (CTB) exclusions, which cover a broader range of terms like “progress” and “evolution” to prevent misuse.

The guidelines have a broad application, covering all UCITS, Alternative Investment Funds (AIFs), and Money Market Funds (MMFs). This means that even funds which are not currently open to new investors must comply, potentially necessitating either adjustments to their portfolios or changes to their names. To ensure clarity, ESMA has also provided specific definitions for various ESG-related terms. Words such as “green” or “climate,” along with abbreviations like “ESG” and “SRI,” are categorized as environmental terms. Any derivation of the term “sustainable,” such as “sustainably” or “sustainability,” falls under sustainability-related terms, while terms like “impacting” or “impactful” are associated with impact investments aimed at generating a positive and measurable social or environmental impact​

Timeline for implementation

On August 21, 2024, ESMA made the Guidelines available on its website in all official EU languages, effectively starting the countdown for their implementation. For newly established funds, compliance with the Guidelines is mandatory from the date they come into effect. For funds that were already in existence before this date, managers have until May 21 2025 to ensure compliance, benefiting from a nine-month transitional period to make any necessary adjustments.

Implications for Fund Managers

These guidelines present a challenging landscape for fund managers. The 80% investment threshold, coupled with strict exclusion criteria, means that many funds will need to reassess their investment strategies and possibly rebrand to comply. This could involve significant changes in portfolio composition, particularly for funds that currently use sustainability-related terms more loosely.

According to Morningstar, approximately 4,300 EU-based funds have names that include ESG or sustainability-related terms, potentially bringing them under the scope of the new ESMA guidelines. Out of the 2,500 funds for which stock holding data is available, over 1,600 are invested in stocks that might breach the exclusion criteria set by the Paris-aligned Benchmarks (PAB) and Climate Transition Benchmarks (CTB). This implies that roughly two-thirds of these funds may need to either divest from the non-compliant stocks or undergo a rebranding process to align with the new regulations.

Furthermore, a significant majority of these funds—about 79%—are classified as Article 8 under the SFDR. Meanwhile, 21% of these funds are passively managed and collectively hold nearly $19 billion worth of potentially affected stocks. This indicates that a substantial portion of the passive investment market will be impacted by these exclusions, necessitating a strategic response from fund managers to either adjust their portfolios or alter their fund names.

 

Looking Ahead: SFDR 2.0

The introduction of these guidelines sets the stage for the forthcoming SFDR 2.0, which is expected to bring further clarity and rigor to the classification of sustainable investments. One of the anticipated changes is a stricter definition of what constitutes a “sustainable investment” under Article 2(17) of the SFDR, which could lead to many funds currently classified under Article 8 or 9 being downgraded or rebranded​.

The new version of the SFDR is likely to include:

• Stricter Criteria for Article 8 and 9 Funds: Currently, Article 8 funds promote environmental or social characteristics, while Article 9 funds have sustainable investment as their objective. SFDR 2.0 may introduce more stringent requirements, such as minimum sustainable investment thresholds or additional disclosure obligations, which could affect a significant number of funds.
• Enhanced Disclosure Requirements: There may also be an increased emphasis on reporting and transparency, requiring funds to provide more detailed information on how they achieve their sustainability objectives and how they measure impact​.

At Econopolis, we are closely monitoring these regulatory developments and fully support initiatives that promote transparency and integrity in sustainable finance. We believe that these changes will strengthen investor trust and contribute to more meaningful progress toward sustainability goals, aligning with our commitment to responsible investment practices.