ESMA Labelling Rules to Complicate Green Fund Market

Plans to introduce minimum investment thresholds could create two-tier Article 8 classification.  

Proposed anti-greenwashing rules from the European Securities and Markets Authority (ESMA) risk confusing investors holding Article 8 funds under the Sustainable Finance Disclosure Regulation (SFDR).  

In the draft guidance, which is open to feedback until 20 February 2023, the financial market regulator has said that any EU-domiciled fund with an ESG-related or impact-related label must meet an 80% sustainable investment threshold. Any funds labelled as ‘sustainable’, or any other term derived from ‘sustainable’, are additionally expected to ensure that 50% of that 80% threshold qualify as sustainable investments under SFDR.  

Minimum safeguards will also apply to funds using exclusion criteria. ESMA will undertake additional considerations for index and impact funds.  

ESMA intends to impose similar thresholds on Article 8 funds, which are defined as having sustainable characteristics under SFDR. A threshold of at least 50% sustainable investments for Article 8 funds that meet the initial minimum proportion of 80% is “an appropriate proxy”, said ESMA, noting this “is high enough to justify the use of the term sustainable or any other sustainability-related terms in their name”. 

But this would create different requirements for Article 8 funds, depending on their names or labels.  

“Despite the fact that ESMA states that these guidelines should not interfere with SFDR, it does so by adding an important minimum threshold for Article 8 funds using any ESG-related terms in their name,” Julia Vergauwen, Managing Associate of the Investment Funds Practice at law firm Linklaters, told ESG Investor 

The proposals risk creating two types of Article 8 products, she said, “those with ESG terms in their name which will be subject to minimum thresholds and those without ESG terms in their names without minimum thresholds”.  

Vergauwen added: “It could be confusing to the investors as, for example, a fund investing 75% in assets promoting environmental or social characteristics would not have any ESG indication in its name.” 

Research conducted by data provider Morningstar on ESMA’s proposals has estimated that just 18% of Article 8 funds would be eligible to label their fund as ‘sustainable’, compared to 80% of Article 9 funds, which are defined as having sustainable objectives under SFDR. 

Clouded definitions 

What constitutes a ‘sustainable investment’ under SFDR still “creates a lot of headaches”, said Vergauwen, which has implications for ESMA’s proposed rules, given that they refer to SFDR’s existing definition of sustainable investment. 

SFDR defines a sustainable investment as an investment in an economic activity contributing to an environmental or social objective, which implies further specification at the activity level and leaving room for interpretation. 

In September, the European Supervisory Authorities (ESAs) asked the European Commission to clarify its definition. 

The Commission is due to publish its evaluation of SFDR by 30 December. 

“Hopefully we will soon have more clarity around the concept of ‘sustainable investments’ which is flexible, pragmatic and disclosure-orientated, rather than adding rigid minimum requirements,” she said. 

SFDR Level 1, which went live in March 2021, asks asset managers to sort their EU-domiciled funds into progressively greener categories: Article 6, 8 or 9. Level 2, which is set to go live in January 2023, will introduce regulatory technical standards (RTSs), through which asset managers will have to justify their fund categorisations through a series of both environmental and social principal adverse impact (PAI) disclosures. 

The upcoming disclosure requirements have prompted a number of asset managers to downgrade their funds, with Morningstar noting that AXA Investment Management downgraded 21 strategies from Article 9 to Article 8, with plans to downgrade a further 24 in the near future. 

Last month, Amundi, Europe’s largest fund manager, downgraded 100 funds worth €45 billion in preparation for Level 2 rules. 

Recent analysis of 838 Article 9 conducted by a number of media firms found that almost half have at least one investment in a coal or oil and gas company. 

The ESAs have also launched a call for evidence to better understand the level of greenwashing across the sustainable investment value chain. 

Three approaches 

ESMA’s proposal for EU fund-labelling rules follows parallel developments in the US and UK. 

The US Securities and Exchange Commission (SEC) has proposed amendments to the Investment Company Act’s ‘Names Rule’, which would require a wider variety of sustainability-labelled funds to ensure at least 80% of investments are in line with their label. The SEC also aims to amend reporting rules on advisers’ and funds’ incorporation of ESG factors in their marketing materials.  

The UK’s Financial Conduct Authority (FCA) has also published a consultation on new fund labels: ‘sustainable focus’ (funds investing in sustainable assets), ‘sustainable improver’ (transition-focused funds), and ‘sustainable impact’ (funds targeting sustainable solutions). The FCA has said that funds must demonstrate alignment across sustainability objectives, KPIs, investment policies and strategies, engagement priorities, and resources and governance in order to qualify for these labels. 

The fund-labelling proposals across the three jurisdictions are not yet aligned, according to Vergauwen.  

“What is specific to the EU proposal is that it ties the use of certain fund names to minimum quantitative thresholds for asset allocation, for example, when using an ESG-related term at least 80% of the assets must be invested in ESG-promoting assets, however this is not always the case for the UK and US regimes. These differences add an extra layer of complexity for managers with cross-border distribution.” 

ESMA will be publishing the final version of its fund-labelling guidelines by mid-2023. 

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