This week ESMA published a translation of its guidelines on the use of ESG or sustainability-related terms in fund names. Funds now have three months to comply with the guidelines, with an additional six months granted to those funds already authorised in the EU, says Tom Willman, Regulatory Lead, Clarity AI.
In May 2024, ESMA finalized its long-awaited guidelines on the use of ESG or sustainability-related terms in fund names, commonly referred to as its fund “names rule”. Following the translation of these guidelines this week, funds now have three months to comply with the guidelines, with an additional six months granted to those funds already authorized in the EU.
We support the spirit of these guidelines as they seek to ensure funds “do what they say on the tin” and should support transparency towards retail investors, by aligning fund names with the companies they invest in.
We were nevertheless aware of certain segments of the market hoping to delay the translations in anticipation of further clarifications from ESMA on what implementing these guidelines will mean in practice. We also expect there may be some teething issues as these guidelines come into force, with many funds having to either divest from certain companies or industries, amend the name of their products, or otherwise risk falling short of the guidelines’ expectations.
For example, on exclusions, Clarity AI’s research has demonstrated that – for funds using sustainability, environmental and impact-related terminology in their names – adhering to the Paris-aligned benchmark (PaB) exclusionary criteria, as per the guidelines, may be difficult. We found approximately half of these funds are invested in companies who breach these exclusions, including those exposed to fossil fuels, tobacco, controversial weapons and breaches of the UN Global Compact or OECD Guidelines for Multinational Enterprises.
Ensuring that funds are not exposed to such breaches requires rigorous data collection and ongoing monitoring that will necessitate extra resources for many in the market.
Further complexity arises in instances where asset managers are investing in fixed income instruments, such as green bonds, instead of general equity. ESMA has confirmed that making such investments does not circumvent the requirement for the issuing company to adhere to the Paris-aligned benchmark exclusionary criteria.
This may, however, cause issues for funds who have invested in instruments whose use of proceeds are intended for sustainability purposes, but whose issuer may still be at the beginning of their transition journey and exposed to legacy business lines that breach PaB exclusionary criteria.
Even after applying the exclusionary criteria, some asset managers may be unsure how to evidence their adherence to the 80% threshold related to the fund’s sustainability objective or promotion of environmental or social characteristics. Many may need to seek new data sources to ensure that their sustainability claims stand up to the extra scrutiny these guidelines will bring.
We also expect further challenges, including supervising the guidelines – where different supervisors may take differing views on whether similar terms are captured by the guidelines – and ensuring interoperability, particularly concerning the FCA’s SDR rules on naming and marketing.
In short, while these guidelines provide a basis for ensuring that the EU’s asset management industry evidences any claims it makes about the sustainability of products marketed to retail investors, we expect the road to compliance to be bumpy. Funds may need to change names, divest assets or otherwise run the risk that their investment strategy falls short of supervisory expectations.
By Tom Willman, Regulatory Lead, Clarity AI
