Navigating ESMA's New ESG Guidelines: What Investors Need to Know

In collaboration with Kalinka Dyankova , Senior Fund Analyst at SG Kleinwort Hambros .

In May 2024, the European Securities and Markets Authority (ESMA) introduced a new set of guidelines to standardize and enhance transparency in Environmental, Social, and Governance (ESG) investing. These guidelines aim to protect investors from misleading or exaggerated sustainable claims—often referred to as "greenwashing"—in fund names. Until now, ESG investment criteria have lacked clear standards, making it a complex area often clouded by subjectivity.

The new ESMA guidelines establish that, to use specific ESG-related terms, funds must invest at least 80% of their assets to meet environmental, social, or sustainable objectives. They also outline exclusion criteria for particular terms in fund names:

·??????? Terms like "Environmental," "Impact," and "Sustainability" must align with the Paris-aligned Benchmarks (PAB).

·??????? Terms such as "Transition," "Social," and "Governance" must adhere to the Climate Transition Benchmarks (CTB).

Additionally, funds using "impact" or "transition" terminology must demonstrate that at least 80% of their investments either contribute positively and measurably to social or environmental outcomes alongside financial returns or are committed to a defined social or environmental transition.

Does This Help Investors?

These minimum standards are a step toward providing greater clarity for investors. However, some gray areas remain. For example, some funds may need to drop certain ESG-related names or reposition to meet the CTB’s less stringent requirements. Additionally, the guidelines require funds to "invest meaningfully" in sustainable assets, but the term "meaningfully" is open to interpretation. Ultimately, the impact will depend on how fund managers communicate and adhere to these new standards by:

·??????? Periodically disclosing how their funds meet the 80% investment threshold.

·??????? Demonstrating compliance with ESG-related returns in both quantitative and qualitative terms.

What Does This Mean for Fund Selectors?

The guidelines, set to take effect on November 21, 2024, will apply immediately to new funds and provide a transition period for existing funds. Although fund names are intended to set initial expectations, the actual ESG selection process goes far beyond labels. A thorough ESG assessment process, using multiple key performance indicators (KPIs) and portfolio analysis tools, will be critical to ensure strategies align with their claimed ESG commitments. Effective fund evaluation includes discussions with portfolio managers and ESG teams, challenging portfolio composition to verify its alignment with stated ESG goals. The Sustainable Finance Disclosure Regulation (SFDR) has not provided a consistent framework for these assessments, as strategies classified as Article 8 vary widely in their ESG focus. Consequently, ESMA aims to phase out SFDR reliance, shifting towards the EU Taxonomy as a more unified standard.

Comparison to the UK Market

The UK’s Sustainable Disclosure Requirements (SDR) and the EU’s SFDR both seek to create consistent standards for sustainable investing and reduce greenwashing, though they differ in specifics. Asset managers operating in both the UK and EU markets may find it challenging to apply both regulations simultaneously. Unlike the ESMA’s 80% threshold, the UK’s SDR mandates that 70% of SDR-labeled funds align with sustainable objectives but applies only to UK products.

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