ESMA’s Guidelines on ESG Funds’ Names: A New Approach to ESG Fund Regulation

While adding ESG-related terms to funds’ names is a popular way to attract investors, regulators around the world have stepped in to address concerns related to greenwashing. Last year, the SEC expanded the Fund Names Rule by requiring Environmental, social, and governance (ESG) funds in the US  to invest 80% of the value of their assets in accordance with the investment focus suggested by ESG terms used in the fund's names. The creation of an American transparency framework that would provide more in-depth information regarding the objectives and strategies of ESG funds has been proposed but not yet adopted.

For a long time, the EU was in the opposite situation. The use of ESG terms in funds’ names was not explicitly regulated while a transparency framework for ESG funds has been in place since March 2021. Disclosure obligations of the Sustainable Finance Disclosure Regulation (SFDR) apply to funds that ‘promote environmental or social characteristics’ (light-green or Article 8 funds) and to more ambitious funds that ‘have sustainable investment as their objective’ (dark-green or Article 9 funds). The disclosure rules are meant to inform investors about what the characteristics or objectives are, how the attainment of those characteristics or objectives is measured, and to what degree the fund’s investments align with the European Commission’s criteria for environmentally sustainable economic activities when environmental characteristics are promoted or environmental objectives pursued.

On 14 May 2024, the European Securities and Markets Authority (ESMA) published Guidelines on ESG funds’ names, which will start to apply three months after the publication date, with an additional six-month transition period for existing funds.

Consistent with the threshold in the US, ESMA's guidelines indicate that for all funds with ESG-related terms in their names, 80% of the investments must meet the environmental or social characteristics for Article 8 funds or meet the sustainable investment objectives for Article 9 funds. In addition to the 80% rule, ESMA requires certain exclusions and adopted additional requirements for when the terms ‘sustainability’, ‘transition’, and ‘impact’ are used in funds’ names.

The most notable change is that funds using environmental-related terms (green, environmental, climate, ESG or socially responsible investing (SRI)), sustainability-related terms (sustainably or sustainable) and impact-related terms (impacting or impactful) in their names will have to exclude companies that generate more than 1% of revenues from activities related to coal, companies with more than 10% of revenues from activities related to oil fuels and companies with more than 50% of revenues from activities related to gaseous fuels or forms of electricity generation above specified levels of greenhouse gas intensity. The type of financial instrument through which a fund is exposed to such companies is irrelevant.

Funds that use transition-related terms (transitioning, transitional, improve, progress, evolution, transformation, or net-zero), social-related terms (social or inequality), and governance-related terms (governance or controversies) in their names do not have to apply those exclusions. ESMA considers that such exclusions would unduly restrict the investment universe and penalize some funds unnecessarily. Instead, ESMA requires exclusions based on the involvement of companies in controversial weapons, tobacco, and violations of specific UN and OECD international soft laws. These exclusions also apply to funds with names that use environmental-related, impact-related, and sustainability-related terms.

The ESMA guidelines set additional requirements for funds that use sustainability-related, transition-related, or impact-related terms in their names.

The first requirement relates to the legal standard ‘sustainable investment’ which is defined in Article 2(17) SFDR. Three conditions must be met for an investment to be considered a ‘sustainable investment’. A sustainable investment means an investment (1) in an economic activity that contributes to an environmental or social objective, (2) that does not significantly harm an environmental or social objective and (3) ensures that the investee companies follow good governance practices. The European Commission clarified that there are no minimum requirements that qualify the three conditions; the asset manager must provide an assessment for each investment and disclose the underlying assumptions. In principle, all investments of an Article 9 fund must meet the definition of sustainable investment. Such a requirement does not apply to Article 8 funds. None of the investments of an Article 8 fund have to meet the definition of sustainable investment but the fund can commit to have part of the investments meet the definition. ESMA’s guidelines on funds’ names will require that using sustainability-related terms in the name means that the fund must commit to investing meaningfully in sustainable investments.

In addition, the ESMA guidelines aim to ensure that the strategy of funds that use transition-related and impact-related terms in their names is measurable. First, for using transition-related terms in the fund’s name, the investments used to meet the 80% threshold must be on a clear and measurable path to social or environmental transition. For using impact-related terms, the investments used to meet the 80% threshold must be made with the objective to generate a positive and measurable social or environmental impact alongside a financial return.

ESMA’s guidelines for ESG funds’ names provide an additional layer of rules that complement the SFDR disclosure framework, and which are specifically aimed at reducing greenwashing risks. Some of these risks have been identified by ESMA and were deemed urgent to address, such as the exposure of funds with environmental-related terms in their names to significant investments in the fossil fuel industry. ESMA also stresses that it deliberately chose not to link the requirements for ESG funds’ names to the categorization in Article 8 funds and Article 9 funds, and that the requirements for ESG funds’ names are not meant to establish a product labelling framework for sustainable funds. According to ESMA, the creation of a label would require legislative changes. Still, ESMA’s guidelines represent a new approach to regulating ESG funds, imposing substantive requirements on investment strategies, such as mandatory exclusions.

Arnaud Van Caenegem is a PhD researcher at the Jan Ronse Institute for Company and Financial Law of the KU Leuven.