Some 25% of funds could be using terminology that will fall under the new anti-greenwashing requirements and must either comply with the guidelines or change their names, says Christopher Cembram at MainStreet Partners.
The European Securities and Markets Authority (Esma) has recently proposed new guidelines on fund naming conventions.
Clearly aimed at reducing the risk of greenwashing, the new guidelines state that funds wishing to use ESG and sustainability-related terms in their names must ensure that at least 80% of their investments exhibit environmental or social characteristics. Funds using sustainability-related terms should also invest “meaningfully” in sustainable investments.
To identify the effects of the new guidelines on the industry, MainStreet Partners conducted research on our proprietary universe of over 7,000 funds and found that close to 1,800 funds (roughly 25%) use terminology that will fall under the new requirements and must either comply with the guidelines or change their names.[1]
Looking at the breakdown of the affected funds by SFDR Articles, Article 8 funds will be the most impacted in absolute terms, comprising 67% of this bucket, which is in line with Esma’s expectations that this class posed the highest risk of greenwashing to investors.
Before delving deeper into the research, it is worth providing some context regarding the Esma guidelines.
Under the new rules, the use of certain terms will trigger different exclusions to be applied to the portfolio:
- “Environmental,” “Impact,” and “Sustainability”-related names must apply the same exclusions as Paris-aligned Benchmarks (PAB).
- “Transition,” “Social,” and “Governance”-related names must apply the same exclusions as Climate Transition Benchmarks (CTB).
- Funds using a combination of terms must apply the exclusions and thresholds cumulatively.
- If any term is “Transition”-related, the fund must follow the exclusion criteria for Climate Transition Benchmarks (CTB).
CTBs and PABs were introduced in 2020 to facilitate the transition to a sustainable economy, with PABs having noticeably more stringent exclusions that incorporate all the exclusions applicable to CTBs.
While CTBs exclude companies involved in the cultivation and production of tobacco, companies involved in any activities related to controversial firearms and companies that violate the United Nations Global Compact (UNGC) or the Organisation for Economic Cooperation and Development (OECD) Principles, PABs go further, also excluding companies that derive 1% or more of revenues from the exploration, mining, extraction, distribution, or refining of hard coal and lignite, companies that derive 10% or more of revenues from the exploration, extraction, or distribution of oil fuels, and many more.[2]
Existing funds will have a period of nine months to comply, and new funds will be required to comply within three months from when the new guidelines are translated into all official EU languages and published on Esma’s website.
So, what does this mean for the existing 1,800 funds captured by our research?
Currently, 90% of them would fall under the very stringent PAB exclusions regime, and the remainder will be subject to the relatively laxer CTB’s exclusions.
‘Trigger’ terminology
Among the impacted funds, the most common triggering terms by a wide margin were ‘ESG’ and ‘Sustainable’ and will require asset managers to comply with the stricter PAB exclusions should they wish to retain or adopt them.
The most common term for funds subject to CTB exclusions is ‘Transition’.
Based on our research, 66% of all funds that trigger either the CTB or PAB requirements are exposed to investments that breach their respective exclusions.
Other findings include:
- 72% of the funds that fall under PAB exclusions are in breach by an average of 5.7% of their AUM.
- 36% of funds that are subject to CTB criteria have holdings that fall outside the exclusions with an average of 2.3% of their AUM.
- A higher proportion of Article 9 funds’ AUM is impacted by both CTB (2.7%) and PAB (5.9%) than in Article 8 funds (2.1% and 5.6%, respectively).
This could be because the majority of Article 9 funds are focused on Environmental criteria due to the wider availability of ESG tools and data supporting environmental investments.
Sector breaches
We also found that, within funds tied to PAB requirements, Coal and Fossil Fuels were the most common violating activities, with Controversial Weapons and OECD Violations the most frequent for CTB breaches.
Our research showed that the Coal sector contributed to 49% of breaches within funds tied to PAB requirements, while Fossil Fuels contributed to 41%. Most of the breaches relating to Fossil Fuels and Coal are likely the result of tangential activities by investees rather than pure players in those fields.
The large proportion of Controversial Weapons breaches (53% of funds tied to CTB) are in part due to our strict criteria applied to this sector.
The figures were calculated by measuring the proportion of AUM invested in holdings that breach PAB or CTB criteria.
Considerable burden
The new data requirements present a considerable administrative burden on fund managers, and the increased requirements and granularity should dissuade less committed players from making unsubstantiated ESG and Sustainability claims in their funds.
Although the analysis has found that up to two thirds of the funds affected by the new guidelines are in breach, the proportion of AUM affected is relatively low.
It is most likely that fund managers will look to liquidate their holdings in entities that breach the exclusions; however, a small amount have expressed their desire to change their funds’ names.
*Christopher Cembran is a fund researcher at MainStreet Partners.
