ESMA: Guidelines on ESG Fund Naming

Alessandro Micagni

On August 28th, 2024

ESMA’s 2024 guidelines on ESG fund naming enforce stricter regulations, introducing quantitative thresholds to prevent greenwashing and ensure transparency across EU markets.

Introduction

In May 2024, the European Securities and Markets Authority (ESMA) published its eagerly anticipated final guidelines on the use of environmental, social, and governance (ESG) or sustainability-related terms in fund names. These guidelines represent a significant regulatory advancement aimed at curbing greenwashing and ensuring transparency and integrity within the financial markets. The guidelines were developed under Article 16 of the ESMA Regulation (EU) No 1095/2010, which gives ESMA the authority to issue guidelines and recommendations with the purpose of establishing consistent, efficient, and effective supervisory practices across the EU. In August 2024, ESMA released the official translations of these guidelines in all EU official languages, with a clear enforcement date set for November 21, 2024. Asset managers are now under considerable pressure to take immediate and comprehensive steps to align with these guidelines to avoid potential regulatory repercussions, including scrutiny from National Competent Authorities (NCAs).

ESG Regulations Background

The demand for investment funds incorporating ESG factors has seen a sharp increase, driven by both regulatory pressures and growing investor awareness of sustainability issues. This trend is expected to continue its upward trajectory, reflecting a broader shift towards sustainable finance across global markets. The name of a fund plays a critical role in shaping investor perceptions and decisions, as it is often the first attribute that potential investors encounter. Recognizing the risks associated with misleading fund names—particularly in terms of greenwashing, where funds are falsely marketed as more sustainable or ESG-compliant than they are—financial services regulators like ESMA have taken proactive steps to establish more stringent oversight and ensure that ESG-related terms are used appropriately.

On May 31, 2022, ESMA issued a supervisory briefing addressing sustainability risks and disclosures within investment management. This briefing, while non-binding, provided principles-based guidance on the use of ESG and sustainability-related terms in fund names. Issued under Article 29(2) of the ESMA Regulation, the briefing aimed to promote common supervisory approaches among Member State competent authorities (NCAs) but did not impose a mandatory comply-or-explain mechanism. Consequently, while it set out important guidelines, its impact was somewhat limited, as NCAs were not required to enforce compliance in a uniform manner.

Six months later, ESMA launched a consultation on draft guidelines for the use of ESG or sustainability-related terms in fund names. These draft guidelines offered more detailed and prescriptive guidance compared to the initial supervisory briefing. The consultation, which closed on February 23, 2023, was expected to quickly lead to the finalization of the guidelines by Q2/Q3 2023. However, the extensive feedback from the market, reflecting the complexity and significance of the issues at stake, delayed the final publication until May 14, 2024. Unlike the earlier briefing, these final guidelines are binding under Article 16 of the ESMA Regulation, which means NCAs are required to implement them through a comply-or-explain mechanism. This mechanism obliges NCAs to either comply with the guidelines or explain their reasons for not doing so, thereby enhancing the binding nature and enforceability of these guidelines across the EU.

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One of the most critical aspects of the ESMA guidelines is the introduction of quantitative thresholds that funds must meet to use ESG or sustainability-related terms in their names. These thresholds are meticulously designed to ensure that funds genuinely align with the ESG principles they claim to represent, thereby providing greater transparency and protecting investors from potential greenwashing.

Specifically, the guidelines stipulate that a minimum of 80% of a fund’s investments must be directed towards meeting environmental or social characteristics or sustainable investment objectives. This requirement is grounded in the binding elements of the investment strategy as disclosed in Annexes II and III of Commission Delegated Regulation (EU) 2022/1288, which supplements the Sustainable Finance Disclosure Regulation (SFDR) Level 2. This regulation provides detailed requirements for sustainability-related disclosures in the financial services sector, ensuring that investment products marketed as promoting environmental or social characteristics or sustainable investments meet rigorous standards.

Additionally, the guidelines establish minimum safeguards, including exclusion criteria derived from the Commission Delegated Regulation (EU) 2020/1818 of July 17, 2020. These exclusion criteria are based on established benchmarks, such as the Climate Transition Benchmark (CTB) and the Paris-aligned Benchmark (PAB), which set minimum standards for ESG-aligned investments. Funds using terms like "transition," "impact," "green," or any ESG-related abbreviations must adhere to these exclusion criteria to ensure that their investment portfolios do not include companies or sectors that are incompatible with the advertised ESG goals. This requirement ensures that only funds with substantial ESG-related investments can leverage these terms in their names, thereby upholding the integrity of ESG-focused investment strategies and protecting investors from misleading marketing practices.

By setting these rigorous quantitative thresholds and exclusion criteria, the ESMA guidelines significantly raise the bar for what can be legitimately marketed as an ESG or sustainability-focused fund, aligning market practices with investor expectations and regulatory standards.

Scope

The ESMA guidelines extend to a comprehensive array of entities within the investment management sector, with specific applicability to various regulatory and operational frameworks. These guidelines are crucial for ensuring that the marketing and management of investment funds align with the principles of environmental, social, and governance (ESG) criteria. Specifically, they apply to:

Management Companies of Undertakings for Collective Investment in Transferable Securities (UCITS): The guidelines are pertinent to all UCITS management companies, including those that have designated a management company under the UCITS Directive (Directive 2009/65/EC) and those that are internally managed (i.e., UCITS that have not appointed an external management company). These entities are required to adhere to the guidelines to ensure that ESG-related terms in fund names accurately reflect the underlying investment strategies and objectives.
Alternative Investment Fund Managers (AIFMs): The guidelines also cover both external and internal AIFMs as defined under the Alternative Investment Fund Managers Directive (AIFMD, Directive 2011/61/EU). This includes managers of alternative investment funds (AIFs) who are responsible for ensuring that the use of ESG or sustainability-related terms in fund names meets the specific thresholds and exclusions outlined by ESMA. The directive’s wide-reaching scope means that both EU-based AIFMs and non-EU AIFMs managing or marketing AIFs within the EU may fall under these regulations, though the application to non-EU entities remains partially ambiguous.
Managers of European Venture Capital Funds (EuVECA), European Social Entrepreneurship Funds (EuSEF), European Long-Term Investment Funds (ELTIF), and Money Market Funds (MMFs): These specialized funds are also within the purview of the guidelines. Managers of these funds must ensure compliance with ESG-related terminology requirements, particularly concerning the accurate representation of sustainability goals and adherence to relevant benchmarks such as the Climate Transition Benchmark (CTB) and the Paris-aligned Benchmark (PAB).
National Competent Authorities (NCAs): As the primary enforcement bodies, NCAs are tasked with implementing and supervising compliance with the guidelines within their respective jurisdictions. They are also responsible for determining whether fund names conform to the ESG and sustainability-related criteria set forth by ESMA, and for addressing any discrepancies or breaches.

While the scope of the guidelines is broad, covering a wide range of financial entities and products, certain areas of ambiguity remain. For instance, the guidelines do not explicitly clarify their applicability to non-EU AIFMs and non-EU AIFs. Although non-EU AIFs managed by EU-based AIFMs are generally included if marketed within the EU, the situation is less clear for non-EU AIFMs marketing AIFs in the EU under Article 42 of the AIFMD. This lack of clarity may lead to inconsistencies in application across different jurisdictions. Additionally, the guidelines do not fully encompass all financial products covered by the Sustainable Finance Disclosure Regulation (SFDR), particularly those that might not fall neatly within the categories specified, thereby creating a potential regulatory gap between the two frameworks.

Three Categories on ESG Requirements

The ESMA guidelines delineate funds into three specific categories based on the nature of the terms used in their names. This categorization is critical for ensuring that fund names accurately reflect the investment strategies and ESG commitments underlying each fund, thereby enhancing transparency and investor protection:

Category 1: Transition, Social, and Governance-Related Terms: This category encompasses funds that utilize terms associated with transition (e.g., "transition," "transitioning," "transitional"), social (e.g., "social," "equality"), and governance (e.g., "governance," "controversies"). To use these terms, funds must ensure that at least 80% of their investments are dedicated to meeting environmental or social characteristics or sustainable investment objectives, as specified in the SFDR Level 2 regulations. Additionally, funds in this category must adhere to Climate Transition Benchmark (CTB) exclusions, which set forth specific criteria for excluding investments that do not align with a climate transition pathway.
Category 2: Environmental and Impact-Related Terms: Funds that employ terms indicative of environmental characteristics (e.g., "green," "environmental," "climate") or impact-related objectives (e.g., "impact," "impacting," "impactful") fall under this category. These funds are required to meet the 80% investment threshold, ensuring that a significant portion of their portfolios is aligned with environmental or social objectives. Furthermore, they must apply Paris-aligned Benchmark (PAB) exclusions, which are designed to align investment portfolios with the goals of the Paris Agreement, particularly in terms of reducing carbon emissions and promoting sustainable development.
Category 3: Sustainability-Related Terms: This category includes funds that use terms related to sustainability (e.g., "sustainability," "sustainably"). In addition to the 80% investment threshold applicable to the other categories, funds in this category have an additional requirement: they must "invest meaningfully" in sustainable investments as defined by Article 2(17) of the SFDR. This provision ensures that funds labeled as "sustainable" are genuinely contributing to sustainable development through their investment choices, beyond merely meeting basic ESG criteria.

The guidelines further specify that if a fund name combines terms from both Category 1 and Category 2, the requirements from each category must be met cumulatively. However, when transition-related terms are combined with other terms, only the specific requirements for Category 1 and Category 2 are applicable. This cumulative approach is designed to prevent funds from using multiple ESG-related terms in a misleading way, ensuring that the use of such terms is backed by substantive, measurable investment commitments.

a painting of a snowy landscape with trees — Supervisory Expectations and Breach Handling

ESG Compliance: Supervisory Expectations and Breach Handling

The ESMA guidelines emphasize the importance of continuous oversight by National Competent Authorities (NCAs) to ensure that funds remain in compliance with the established ESG and sustainability-related terms throughout their lifecycle. This supervisory role is integral to maintaining the integrity of the environmental, social, and governance (ESG) standards that investors increasingly rely upon.

To facilitate this, the guidelines mandate that NCAs regularly monitor compliance through periodic disclosures as required under the SFDR Level 2 framework. These disclosures provide detailed information on the extent to which funds adhere to their stated ESG objectives, offering transparency and accountability. If a fund temporarily deviates from the established quantitative thresholds or other conditions—such as those related to investment in sustainable activities or exclusion criteria defined under Commission Delegated Regulation (EU) 2020/1818—NCAs should classify such instances as passive breaches, provided they result from market conditions or other factors beyond the control of the asset manager, rather than from a deliberate decision. These passive breaches must be promptly corrected, with the asset manager taking steps to realign the fund’s investments in the best interests of the investors. The Guidelines require that such corrections are made with minimal disruption to the fund’s overall strategy and without compromising its ESG commitments.

NCAs are also instructed to engage in more proactive supervisory dialogues with fund managers when discrepancies arise that cannot be classified as passive breaches. For example, if a fund fails to maintain the 80% investment threshold required for using ESG, transition, impact, or sustainability-related terms in its name, or if there is a notable inconsistency between the fund’s stated objectives and its actual portfolio composition, NCAs are expected to intervene. This could involve conducting a thorough investigation to determine whether the fund’s naming practices are misleading investors. Such scrutiny is crucial in preventing the misuse of ESG-related terms, ensuring that funds marketed under the ESG banner genuinely reflect the sustainability and governance commitments they claim to uphold. This supervisory vigilance is essential in preserving the credibility of ESG-focused investment strategies and protecting investors from greenwashing.

Date of Application

On August 21, 2024, ESMA officially published the final Guidelines on its website, making them available in all EU official languages. This publication initiated the formal timeline for compliance with the Guidelines, which are critical in aligning fund naming practices with the broader regulatory framework governing ESG disclosures and investments.

NCA Notifications: By October 21, 2024, NCAs are required to notify ESMA of their intentions regarding the Guidelines. Specifically, NCAs must state whether they will comply with the Guidelines, do not comply but intend to comply, or do not comply and do not intend to comply. This notification process is designed to ensure transparency and accountability across Member States, enabling ESMA to monitor the adoption and enforcement of the Guidelines throughout the EU.
Application Date: The Guidelines will officially come into effect on November 21, 2024. From this date forward, all new funds must be fully compliant with the Guidelines before they can be marketed within the EU. This includes adhering to the specified quantitative thresholds for ESG-related investments and ensuring that fund names accurately reflect their underlying strategies and objectives.
Compliance for Existing Funds: For funds that were established before November 21, 2024, the Guidelines allow a transition period, requiring full compliance by May 21, 2025. This six-month window provides fund managers with the necessary time to review and adjust their fund names, investment strategies, and legal documentation to meet the new regulatory requirements. It is during this period that NCAs will play a crucial role in guiding fund managers through the compliance process, ensuring that all adjustments are made in accordance with the Guidelines.

ESMA has emphasized that these Guidelines were developed within the context of the current legislative framework, reflecting the evolving standards in sustainable finance. However, ESMA remains prepared to review and update the Guidelines as necessary to respond to any future changes in legislation or market practices. This adaptive approach ensures that the Guidelines remain relevant and effective in promoting transparency and accountability in the use of ESG and sustainability-related terms in fund names.

Next Steps and Assistance for Fund Managers

As the compliance deadlines approach, it is imperative for fund managers to take proactive measures to align their practices with the ESMA Guidelines. The first step involves closely monitoring the notifications made by Member States to ESMA by October 21, 2024. These notifications will provide critical insights into how each Member State plans to enforce the Guidelines, offering fund managers a clearer understanding of local compliance expectations and potential areas of focus for regulatory scrutiny.

Fund managers should also undertake a comprehensive assessment to determine whether their funds fall within the scope of the Guidelines. This assessment should include a detailed review of all fund names to identify those that contain ESG or sustainability-related terms. It is essential to recognize that the Guidelines apply not only to explicit terms listed within the documentation but also to any terms that could give investors the impression of having environmental, transition, social, or governance implications. This broader interpretation ensures that all potentially misleading fund names are brought into compliance.

Once the relevant funds have been identified, fund managers have two primary options for ensuring compliance:

Renaming the Fund: If a fund name falls within the scope of the Guidelines and does not meet the required thresholds or criteria, managers may opt to rename the fund. This action might necessitate obtaining investor consent, depending on the fund’s legal structure and the terms of its governing documents. Renaming the fund could help avoid potential regulatory breaches but must be approached carefully to maintain investor trust and clarity.
Review and Compliance: Alternatively, fund managers may choose to review and adjust the fund’s investment strategy and legal documentation to align with the Guidelines. This process involves ensuring that the fund meets the 80% investment threshold for ESG-related investments and adheres to any applicable exclusion criteria. It may also require updating SFDR disclosures to reflect the fund’s compliance with the Guidelines accurately.

Given the complexity and potential challenges associated with these compliance tasks, seeking professional assistance is highly recommended. Expert advisors with experience in working with NCAs and a deep understanding of ESG regulations can provide invaluable guidance to fund managers. This support is crucial in accurately interpreting the Guidelines, making informed decisions, and ensuring full compliance without compromising the strategic objectives of the fund.