ESMA’s New ESG guidelines: The Road to Compliance Will Be Complicated

In May 2024, the European Securities and Markets Authority (ESMA) finalised its long-awaited guidelines on the use of fund names that use ESG or sustainability-related terms. Following the translation of these guidelines this week, funds now have three months to comply, with an additional six months for funds already authorised in the EU.

Investors support the spirit of these guidelines, which seek to ensure that funds actually “walk the talk” and promote transparency towards retail investors by aligning fund names with the companies in which they invest.

However, companies are aware that some market segments are considering delaying implementation pending further clarification from ESMA on how these guidelines will be applied in practice. Teething problems may arise when these guidelines come into force, as many funds will have to divest from certain companies or sectors, rebrand their products, or risk not meeting the expectations set by the guidelines.

For example, on exclusions, funds that use sustainability, environmental and impact-related terminology in their names can find it challenging to meet the exclusion criteria of the Paris-aligned benchmark (PaB), according to the guidelines.

About half of these funds are invested in companies that do not meet these exclusions, including those exposed to fossil fuels, tobacco, controversial weapons or in breach of the UN Global Compact and the OECD Guidelines for Multinational Enterprises. Ensuring that funds are not exposed to such breaches requires rigorous data collection and ongoing monitoring , which will result in many market participants demanding additional resources.

The situation is further complicated when asset managers invest in fixed-income instruments, such as green bonds, rather than general equities, as ESMA confirmed

ESMA has confirmed that these investments are not exempt from the requirement that the issuing company meets the exclusion criteria of the Paris-aligned benchmark. This could pose a problem for funds that have invested in instruments intended for sustainability purposes , but whose issuers are still in the early stages of their transition and may have legacy business lines that do not meet the PaB exclusion criteria.

Even after applying the exclusion criteria, some asset managers may be unsure of how to demonstrate that they meet the 80% threshold relating to the fund’s sustainability objective or the promotion of environmental or social characteristics. Many may need to seek new sources of data to ensure that their sustainability disclosures withstand the additional scrutiny that ESMA guidelines will require.

Other challenges are anticipated, such as oversight of the ESMA guidelines, as different supervisors may have different interpretations of whether certain terms are included, and ensuring interoperability, particularly in relation to the FCA’s rules on Sustainability Disclosure Requirements (SDR) on naming and marketing.

In summary, while these guidelines set a solid foundation for ensuring that the EU asset management sector substantiates any claims about the sustainability of products offered to retail investors, we anticipate that the path to compliance will be a complicated one. Funds will likely need to change their name, divest assets or face the risk that their investment strategy will not meet supervisory expectations.

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(Featured image by Alexey Larionov via Unsplash)

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First published in Funds Society. A third-party contributor translated and adapted the article from the original. In case of discrepancy, the original will prevail.

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