EU Fund Names Rules: Too Much Too Soon?
ESMA’s finalised guidance isn’t fully aligned with other jurisdictions and could be impacted by the SFDR review.
Industry pundits are concerned that guidance on fund names for EU-domiciled sustainable products may have jumped the gun ahead of a final decision on the Sustainable Finance Disclosure Regulation (SFDR).
Published on 14 May, the European Securities and Market Authority’s (ESMA) final report on fund names using ESG or sustainability-related terms aims to reduce greenwashing risk and increase transparency.
“The guidelines on funds’ names will definitively fulfil the purpose of avoiding greenwashing by using misleading terms,” according to Claudia Hoffmann, Partner in Financial Services at law firm Eversheds Sutherland.
But questions do linger on the timing of the new rules given the ongoing uncertainty around SFDR.
Fund managers have been grappling with the disclosure requirements introduced by the regime for the past three years. The European Commission conducted a review to assess whether the Article 8 and 9 categories should be formalised as fund labels, or whether the existing system should be entirely overhauled and replaced with new labels and alignment criteria.
It has since published a report outlining feedback to the consultation, which revealed no clear consensus among industry players on how to improve the framework. With the European Parliament elections now imminent, it’s unlikely further progress will be made anytime soon.
“The timing of [ESMA’s] guidance is questionable, given [the SFDR review suggests] the addition of a labelling element is a potential outcome,” said Benjamin Maconick, Managing Associate in Linklaters’ financial regulation team. “While it seems like an interim solution to concerns that funds may be labelling themselves inappropriately, the possibility of it being cut across by the outcome of the SFDR review is a concern to fund managers, who might have to change the approach of their funds multiple times over just a few years.”
ESMA’s work on the subject has been prompted by multiple examples of greenwashing among sustainability-labelled EU-domiciled funds. Between January 2020 and December 2021, the EU watchdog identified 191 European companies involved in 933 misleading communication incidents – 70% of which involved greenwashing. The body also found that the growing use of ESG-related language in fund names and documentation attracted higher inflows, thereby increasing greenwashing risks.
Making changes
The finalised guidance covers a wide range of sustainability-related terms, outlining expectations such as the requirement to exclude fossil fuel companies from funds using “impact”, “environmental” or “sustainability” in their names.
“This guidance will ensure that funds which use an ESG or sustainability term will have to invest in assets in line with that ambition, and that they do not invest in companies with revenues coming from certain sectors,” said Tom Willman, Regulatory Lead at data provider Clarity AI.
Although ESMA scrapped the 50% sustainability-related investment threshold for EU-domiciled funds using a sustainability-related name, it has kept a minimum requirement of 80% of investments for funds that claim to have an environmental, social or sustainable objective.
But, given the diversity of environmental and social characteristics and sustainable investment objectives that funds can exhibit, it is unclear whether the 80% boundary is sufficient to ensure names are aligned with their stated investment approaches, Maconick argued.
“While [the guidance] may provide a bit more assurance as to a baseline level of ESG-related commitments, investors may not be able to use fund names as a heuristic given the criteria ESMA has chosen,” he added.
Recognising the growing desire for transition-focused funds, ESMA has also clarified terms that can be used under the transition category, such as “progress” and “improving”. Investments in this category must also meet the 80% rule.
The guidelines are granular and robust, “while also leaving enough flexibility to reflect the diversity of approaches on these topics”, Pierre Garrault, Senior Policy Adviser at the European Sustainable Investment Forum (Eurosif) told ESG Investor.
There does, however, remain some ambiguity around ESG-related terms that aren’t explicitly mentioned in the guidelines – including “responsible”.
Further clarity around some of the regulatory components that underpin the guidance would further support the market in implementing the required changes, Willman suggested. “As an example, there are different interpretations of what it means to ‘promote’ environmental or social characteristics, which will be a key element for many funds,” he added.
Similar, not aligned
While ESMA’s latest guidance on fund names is similar to rules introduced in the UK and US, it isn’t completely aligned, which could introduce further challenges for global asset managers.
“The idea of having a minimum quantitative threshold of the fund aligned with ESG-type commitments is an obvious common element with equivalent rules [in other jurisdictions],” said Maconick. “However, I think there is a misalignment.”
In the US, the Securities and Exchange Commission (SEC) has also established an 80% threshold for ESG investment strategies specifically linked to the investment focus that the fund name suggests. However, ESMA’s guidelines also require a more general alignment with environmental or social characteristics, or a sustainable investment objective.
In addition, the SEC has defined three types of ESG funds to promote consistency and comparability: ESG integration, ESG-focused, and impact.
In a similar vein, the UK’s Financial Conduct Authority (FCA) has introduced four labels – focus, improvers, impact and mixed goals – for sustainability-focused funds under the Sustainability Disclosure Requirements (SDR). However, it has proposed a 70% minimum investment threshold.
“Contrary to ESMA, the FCA does not associate mandatory exclusions with the use of some terms, and instead requires disclosures on potential negative and/or social outcomes,” said Garrault.
Stop-gap
With the current iteration of SFDR likely to remain in place until at least 2028, ESMA’s fund names guidance has been welcomed as an interim “bridge” to reduce greenwashing.
“Pending the SFDR review, these guidelines are expected to improve transparency in sustainability-related investments,” said Garrault. “We strongly encourage their application by EU national competent supervisory authorities, leading to their implementation by investors to provide more consistency between funds’ names and their sustainability profile across the EU.”
Any reclassification of EU funds to reflect the new rules will likely be progressive. According to Bloomberg Intelligence, fund reclassifications have halved since peaking in early 2023. In Q1 2024, only 439 funds were recategorised, compared to 945 over the same period last year. Over 90% of these upgrades were transfers from Article 6 to Article 8, totalling US$370 billion. Meanwhile, only a handful of funds moved up to Article 9.
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