ESMA sets stricter guidelines for ESG and sustainability-related fund names

The European Securities and Markets Authority (ESMA) has introduced new guidelines for investment funds that use ESG (environmental, social and governance) or sustainability-related terms in their names.

These guidelines are a direct response to the growing concern about greenwashing in the financial sector, where funds may misleadingly market themselves as sustainable.

The new rules set out clear criteria that funds must meet to ensure their names accurately reflect their investment strategies and commitments to sustainability.

ESMA's new naming guidelines

ESMA has issued comprehensive guidelines that set clear thresholds and criteria for the use of ESG or sustainability-related terms in fund names (see our ESG Knowledge Update July 2024). These guidelines include:

1. Environmental-related terms: Funds using terms related to the environment, such as "green," "climate," or abbreviations like "ESG" or "SRI” (socially responsible investment), must meet an 80% threshold linked to the proportion of investments in relation to the environmental or social characteristics promoted by the fund, pursuant to Article 8 Sustainable Finance Disclosure Regulation (SFDR), or sustainable investment objectives of the fund, pursuant to Article 9 of the SFDR. Additionally, these funds must exclude investments in companies involved in controversial activities as defined by the EU Paris-Aligned Benchmark (PAB) rules.
2. Social and governance-related terms: For funds using social or governance-related terms, such as "social," "equality," or "governance.", the same 80% threshold applies. However, these funds must only adhere to the exclusion criteria pursuant to the Climate Transition Benchmark (CTB), which is less restrictive than the PAB exclusions.
3. Sustainability-related terms: Funds whose names include the term "sustainable" or terms derived from that word must not only meet the 80% investment threshold but also commit to investing a meaningful portion of their assets in sustainable investments as defined by the SFDR. This category emphasises a strong commitment to sustainability, beyond merely meeting environmental or social characteristics. Funds falling under this category must commit to invest meaningfully in sustainable investments within the meaning of SFDR.
4. Impact-related terms: Funds that use terms such as "impact" or "impact investing" must meet the 80% threshold and adhere to the PAB exclusion criteria. Further, such funds must demonstrate that their investments are on a clear and measurable path to social or environmental transition or are intended to generate positive, measurable social or environmental impacts alongside financial returns.
5. Transition-related terms: Recognising the importance of transition strategies, ESMA includes terms like "transition," "progress," "evolution," or "net-zero" in its guidelines. Funds using these terms must meet the 80% threshold and apply the CTB exclusions, which allow for some flexibility regarding investments in companies that are on a clear and measurable path to environmental or social transition

Combinations of terms

The guidelines also address funds that use a combination of ESG or sustainability-related terms in their names. The level of applicability of the rules depends on the type of combination: for example, a fund combining an environmental- and a social-related term must meet the prescribed 80% threshold and ensure that its investments are in line with the PAB exclusion list.

Where a fund uses ESG- or sustainability-related terms in combination with transition-related terms, the fund will only have to fulfil the minimum requirements for transition-related terms (being the 80% threshold and adherence to the less strict CTB exclusion list).

The 80% quotas relate to the net asset value (NAV) of the fund. The NAV is calculated as the sum of all the valued assets in a fund minus all liabilities.

Impact on the financial sector

The new guidelines address the increasing risk of greenwashing, where funds claim to be more environmentally or socially responsible than they actually are. By imposing stricter criteria on the use of ESG and sustainability terms, ESMA aims to protect investors and ensure that they can trust that funds with such labels genuinely align with their advertised characteristics.

This move is expected to create a more transparent market and could lead to a re-evaluation of fund names and strategies across the industry. Furthermore, the introduction of specific categories such as impact and transition terms reflects the evolving landscape of sustainable finance.

These categories acknowledge that not all sustainable investments are the same and that investors should be able to differentiate between funds that are merely ESG-compliant and those that aim for a higher standard of impact or are focused on supporting the transition to a sustainable economy.

However, some uncertainties that already existed in the draft guidelines which were up for consultation, are still not resolved: funds using sustainability-related terms must commit to invest “meaningfully” in sustainable investments within the meaning of SFDR. The term “meaningfully” leaves much room for interpretation, it is not clear what it takes to meet this requirement.

This issue has been picked up by national regulators, for example, BaFin in Germany, indicating that the term “meaningfully” is currently being discussed within ESMA in order to achieve an EU-wide understanding.

Funds whose names include impact-related terms must demonstrate that their investments are on a “clear and measurable path to social or environmental transition”.

Here, BaFin notes that ESMA does not provide specific requirements for such a transition path. Therefore, there is no "transition template" for the different industries that want to embark on a transition path and raise capital for it.

Instead, portfolio companies can individually define their respective transition projects and (interim) goals. However, this information must be comprehensible and verifiable. As an example, BaFin names Science-Based Targets (SBT). With these SBTs, which are scientifically based (climate) targets, portfolio companies can, for instance, set emission reduction goals.

Such information created by portfolio companies can not only help fund managers to adjust their risk management and assessment precisely but also may serve as a basis for concise disclosure in the fund’s pre-contractual disclosures pursuant to SFDR.

Compliance timeline and industry adjustments

ESMA published translations of its guidelines on funds’ names in all official EU languages on 21 August 2024 on its website. They will come into effect three months after publication, that is, on 21 November 2024. National competent authorities are required to notify ESMA whether they will comply, will not comply but intend to do so, or do not comply and do not intend to do so within two months of the publication (until 21 October 2024).

Before the publication of the German version of the guidelines, BaFin published a statement making clear that it is already considering ESMA’s guidelines when processing applications to authorise AIFMs or UCITs ManCos to launch funds in Germany.

Funds that already existed before the application of the guidelines are granted a six-month transitional period until 21 May 2025. Fund managers will need to review their portfolios and ensure that their fund names meet the new criteria, or they may face the possibility of rebranding or restructuring their portfolio allocation.

This period will be crucial for the industry to adjust and for regulators to monitor compliance closely. The transitional provisions are designed to give fund managers adequate time to adjust their strategies and marketing materials. However, the timeline is tight, and those who manage multiple funds or have complex portfolios may face significant challenges in aligning their funds with the new requirements.

Funds that are newly created after the application of the guidelines should apply them immediately.

The guidelines appreciate that there will be temporary deviations from the 80% threshold or the applicable exclusion requirement. Where such deviation is not intentional, it will be treated as a passive breach and should be corrected in the best interest of the investors. Regulators shall seek supervisory dialogue with fund managers not “sufficiently” meeting the minimum requirements, or where the use of transition-, ESG-, impact- or sustainability-related terms in the fund name would result in investors receiving unfair or unclear information or in a failure of the fund manager to act honestly or fairly and thus mislead investors.

This will become particularly relevant for funds that are unable to fulfil a specific asset allocation disclosed in their SFDR pre-contractual information. ESG-focused venture capital or private equity funds, for example, will need some time until they have built up a respective portfolio allocation.

Osborne Clarke comment

We anticipate that these new ESMA guidelines will have a significant impact on the marketing and structuring of investment funds across Europe. Fund managers should start preparing for these changes now, ensuring that their investment strategies and fund names are fully aligned with the new requirements. This is not just a regulatory compliance issue but an opportunity to build greater trust with investors.

The clear categorisation of terms such as ESG, sustainability, impact and transition underscores the need for precise language in fund naming, which can enhance credibility and investor confidence. We expect to see a wave of fund rebranding and potential restructuring as managers adapt to these new rules. Additionally, the introduction of minimum safeguards and specific exclusions means that fund managers will need to scrutinise their investment portfolios more closely to ensure they are not inadvertently breaching the guidelines.

This could lead to a shift in the types of assets held by funds and potentially in the broader market as well.

However, important interpretation and application questions remain following the publication of the ESMA guidelines.

If you would like help navigating the ESMA guidelines and their impact on your business, please contact our experts.