17 April, 2023 / Comment

The ESG in fund names

By Frédéric Vonner, advisory partner PwC Luxembourg

PwC's Frédéric Vonner explains the findings of ESMA's recent consultation paper on ESG fund thresholds

The ESG in fund names

According to a recent PwC report, global ESG assets under management (AUM) are expected to reach $33.9trn in 2026 in a base-case scenario, up from $18.4trn in 2021. In Europe alone, where ESG AUM stood at $12.8trn in 2021, the figure is expected to reach $19.6trn by 2026.

However, the growing investor demand for ESG investment funds has led to increased anxiety surrounding potential greenwashing. These concerns were amplified in the second half of 2022 when a large number of funds in the EU were reclassified from Article 9 (‘dark green’) to Article 8 (‘light green’) status.

To partially address this issue, the European Securities and Markets Authority (ESMA) published a consultation paper on 18 November 2022 providing guidelines on funds that include ESG- or sustainability-related terms in their names. The consultation period has recently ended, and ESMA is expected to finalise the guidelines later this year.

Generally, the ESMA consultation proposes requirements that funds’ names in fund documents or marketing communications not to be misleading and only use ESG- and sustainability-related terminology when supported in a material way by evidence of sustainability characteristics or objectives.

The proposals also seek to tackle greenwashing risks in funds, by providing quantitative thresholds for the use of ESG and sustainability related terminology in funds’ names so that marketing communications are clear, fair and not misleading.

What are the thresholds?

The ‘threshold approach’ is a crucial proposal put forward by ESMA in the guidelines. Essentially, it entails establishing minimum thresholds to showcase a sustainability-related objective and ensuring alignment with that objective.

The minimum thresholds are as follows: A fund with any ESG-related terms in its name must have at least 80% of its investments targeted towards meeting the environmental or social characteristics or sustainable investment objectives in accordance with the investment strategy’s binding elements. This threshold also applies to funds with the word ‘sustainable’ (or any term derived from the word) in their name, but such funds must also ensure that at least 50% of their investments align with the definition of ‘sustainable investment’ as stipulated by the Sustainable Finance Disclosure Regulation (SFDR), including investments aligned with the EU Taxonomy regulation.

See also: – SFDR explained: What qualifies as Article 9, 8 and 6?

There have been concerns raised around this threshold approach – namely due to the lack of justification or explanation for the quantitative thresholds proposed in the guidelines. Furthermore, the guidelines do not precisely define the terms ‘ESG-related’ or ‘sustainability-related’, which could create ambiguity and complications for asset managers marketing ESG funds.

Given the well-known data challenges in the ESG landscape, the quantitative thresholds may also have the inadvertent effect of pushing asset managers to focus only on investments where high-quality data is available, such as large cap companies, and ignore investing in other potentially sustainable companies that have not yet had the opportunity to develop adequate data collection practices. This will not only put small-cap companies at a disadvantage but will also potentially hamper efforts to promote sustainable finance in Europe.

In addition, the proposed guidelines also lack clarity on the threshold calculation methodology (numerator, denominator). The level of the sustainable investment proportion threshold (50%) cannot be set in the absence of a common definition of a sustainable investment, something that market participants are still waiting for clarity on. The same applies to the 80% threshold for an ESG-related name, which is also dependent on a clear definition and calculation methodology of such threshold.

What are the effects of the threshold approach?

Asset managers are already struggling to make sense of the sustainability-related regulations coming out in the EU and other jurisdictions. The proposed guidelines will likely require many managers to rename their funds and adjust their marketing strategies, leading to additional compliance costs.

Small- and medium-sized asset managers may not have the resources, expertise, or guidance to comply with the proposed guidelines, leading to further consolidation and dominance of the funds industry by larger managers. Additionally, certain managers may struggle to differentiate themselves from competitors if they are limited in their use of ESG- or sustainability-related terms in their fund names. This could negatively impact their ability to attract investors, ultimately limiting sustainable investments in Europe’s funds industry.

It is unclear to what extent ESMA’s proposed guidelines will be interoperable with existing national rules on funds’ names, such as the qualitative and quantitative criteria used in France and Germany. This could cause confusion for both investors and asset managers.

A step in the right direction

Most financial market participants will agree that non-misleading fund name information is important to investors. Appropriate guidelines should be in place to support an investment suitable to the needs and preferences of that investor and ESMA’s work will clearly bring more clarity to the sustainable investment landscape. We also think that clarity in fund naming can be an important enhancement to the existing SFDR.

The proposed guidelines, although challenging, represent a positive step towards promoting sustainable investments in Europe and safeguarding investors against greenwashing. These guidelines have the potential to foster trust and confidence among investors, enhance transparency in Europe’s funds industry, accelerate decarbonisation efforts, and expedite the continent’s green transition. Additionally, the guidelines may harmonize the regulations governing ESG-labelled funds across the EU and protect retail investors who prioritize ESG considerations from unknowingly investing in non-ESG sectors.

To this aim, it is crucial that the guidelines do not unnecessarily burden asset managers or restrict their ability to provide sustainable products. Invariably, stakeholders in the global asset and wealth management industry should monitor the upcoming guidelines closely, as they have the potential to usher in a new era of sustainability in Europe’s financial landscape.

A part of the Mark Allen Group.