On May 14, 2024, the European Securities and Markets Authority (ESMA) published its final guidelines on the use of ESG terms in fund names: Guidelines on funds’ names using ESG or sustainability-related terms.

The final report is the culmination of feedback from a consultation proposing changes to an earlier draft and input from stakeholders over a two year period. ESMA launched the consultation due to concerns that a rise in the use of sustainability related terminology by asset managers in funds names – driven by investor pressure – could lead to an increase in greenwashing.

The consultation proposed a number of changes to the original guidelines including on thresholds for the use of ESG-related terms linked to the investments used to meet environmental or social characteristics or sustainability objectives in SFDR.

The changes included in the final report are:

Scope

The final guidelines have extended the scope of the rules to cover UCITS management companies, including any UCITS which has not designated a UCITS management company, Alternative Investment Fund Managers including internally managed AIFs, EuVECA, EuSEF and ELTIF and MMFs managers as well as competent authorities.

50% threshold for sustainable investments

ESMA originally proposed that funds using the term “sustainable” or any other term derived from it in its name, should allocate, within the 80% of investments meeting sustainable characteristics/objectives, at least 50% of minimum proportion of sustainable investments as defined by SFDR’s Article 2(17).

Following criticism of definition of Article 2(17) as “too open to discretion by fund managers”, the previous threshold of 50% has now been replaced by an 80% commitment to invest meaningfully in sustainable investments for the use of any sustainability-related words in funds’ names. ESMA has yet to define “meaningful” or explain how the 80% threshold should be calculated. As such the threshold will depend on how a fund manager calculates asset allocation for its SFDR pre-contractual disclosures.

The 80% threshold related to the investments used to meet environmental and/or social characteristics or sustainable investment objectives has however, been retained.

Minimum safeguards

ESMA also proposed exclusion criteria for Paris-aligned Benchmarks (PABs) for all investment funds using an ESG- or sustainability-related term in their name.

Following criticism by stakeholders of a “one-size-fits-all” approach which would effectively deny some transition-focused strategies from using terms relating to fossil fuels, ESMA has updated its exclusion criteria for the Climate Transition Benchmark (CTB) to refer to:

• companies involved in any activities related to controversial weapons;
• companies involved in the cultivation and production of tobacco; and
• companies that benchmark administrators find in violation of the United Nations Global Compact (UNGC) principles or the Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises.

In addition to the benchmark criteria, funds using terms relating to “environmental”, “impact” or “sustainability” related terms should also exclude investments in accordance with PABs:

• companies that derive 1% or more of their revenues from exploration, mining, extraction, distribution or refining of hard coal and lignite;
• companies that derive 10% or more of their revenues from the exploration, extraction, distribution or refining of oil fuels;
• companies that derive 50% or more of their revenues from the exploration, extraction, manufacturing or distribution of gaseous fuels;
• companies that derive 50% or more of their revenues from electricity generation with a GHG intensity of more than 100 g CO2 e/kWh.

Exclusions apply only to investments in companies; the criteria does not apply to other asset classes.  

Transition-related terms

Based on feedback relating to transition terminology, including to avoid penalising funds investing in companies engaged in transition-related activities, ESMA introduced a new transition-related category which requires, in addition to the 80% threshold, the application of CTB exclusions only (described above).

The transition-related terms include words such as “improving”, “progress/ion”, “evolution”, “transformation”, and any related words.

Separation of “E” from “S” and “G” terms and combination of terms

Under the updated guidance, the terms “social” and “governance” have now been separated from “environmental” to avoid funds with social or governance in their names being restricted by fossil fuel exclusions. Those with social and governance in their names are included in the same group as transition terms.

Environmental terms should only be used by those applying the PAB exclusions. And terms like “ESG” and “SRI” should be considered environmental terms.

If terms are used in combination, the requirements apply cumulatively. To avoid penalising transition strategies, funds using both environmental and transition related terms would only have to apply the transition requirements, for example the baseline but not additional requirements.

Impact and transition terms: measurability

ESMA has also defined additional guidance for funds using the terms “impact” or “transition” in their names. This will be in addition to meeting the 80% threshold and exclusion criteria.

Those using the word “impact”, should ensure that investments made under the minimum proportion are made “with the intention to generate positive, measurable social or environmental impact alongside a financial return.”

And those using “transition” should demonstrate that the investments are “on a clear and measurable path to social or environmental transition.”

This is intended to link strategies and their names to ensure a “measurable dimension” to the strategy.

Transitional period

ESMA plans to keep to its proposal for a six-month transitional period. It adds that managers of existing funds will in fact have a minimum of nine months to comply, since the guidelines will only start to apply three months after the publication of the translations. However, funds that are set up after the guidelines start to apply are expected to comply immediately.

Next steps

Given the relatively short time frame for compliance, firms need to check if they are in scope for the final rules (for example whether they are currently using sustainability related terms in their fund names), and then assess their funds against the thresholds and requirements. This may result in some adjustments to investment strategies to comply or even a change in the name of the fund.

If you would like more information on how you might be affected by the ESMA updates, please get in touch.