Following the recent publication of European Securities and Markets Authority (ESMA)’s final guidelines on ESG fund names, investors should brace themselves for a potential reshaping of the ESG fund landscape in Europe.
In our preliminary impact assessment, we reported that as many as two thirds of EU funds using ESG or other sustainability-related terms in their names may need to consider either rebranding or making some portfolio adjustments.
In the study, we focused on the potential impact of the new exclusion rules on funds with stock holding data only. We found more than 1,600 funds were exposed to at least one stock potentially in breach of the Paris-aligned and climate transition exclusion rules.
It is important to understand that different data sources could have led to different results in terms of the universe of companies to be excluded. Using Morningstar Sustainalytics research, we captured quite a large number of companies, including many which, through their products and services, enable other businesses to continue their coal, oil and gas operations.
So now, what’s next?
Impact assessment and exclusion lists
In the coming months, ESG fund managers will be busy assessing the impact of the guidelines on their portfolios to decide whether to divest from the companies that don’t meet the requirements or to change the name of their funds.
The first step will be to identify the companies in breach of the Paris-aligned and climate transition benchmark criteria. And this task won’t be easy as it requires interpreting the rules and finding the data.
Product involvement and controversies data tend to vary from data provider to data provider due to differences in data sources, methodologies, estimations, coverage, and timeliness. Different approaches can also be taken when considering company ownership and value chain. The stricter the interpretation of the rules, the broader the universe of exclusions, and potentially the bigger the portfolio adjustments.
With that in mind, investors shouldn’t be surprised to see different managers use different exclusion lists. Some will be more conservative than others. Some will even use different lists internally to accommodate different investment styles.
When doing due diligence, investors will therefore need to understand these aspects to avoid any bad surprises. It will be equally important that investors understand the implications of the exclusion rules. The larger the number of exclusions, the more constrained the investment strategies, which in turn, could have significant implications on the risk-return profile of a strategy.
More transition funds
Managers of strategies that will require too many adjustments may simply choose to drop key ESG terms from the fund names. We therefore expect many funds to drop “ESG”, “SRI”, “sustainable”, “climate”, and “clean” from their names, while some will reposition as transition funds. This will make sense especially for those funds that focus on environmental solutions as these often invest in companies in the energy and utilities sectors that offer products and services that help other businesses to decarbonize, alongside their legacy fossil fuel businesses.
More transition funds may turn out to be a positive outcome of these guidelines given the broad consensus that companies need to be supported in their transition journey. This rebranding exercise, however, will have to be done in a thoughtful manner. ESMA specified in its guidelines that when using any “transition”-related word fund managers will need to demonstrate that the investments are on a clear and measurable path to social or environmental transition. This is expected to be done by setting credible KPIs and through engagements. Engagement reports will need to show how actors are actively accompanying the companies in portfolios.
A smaller ESG fund universe to invest into
The ESMA guidelines have the benefit of setting minimum standards and providing greater clarity to investors on what they’re investing in. This, however, will probably result in a smaller universe of ESG funds. By how much this universe will shrink is hard to predict at this point, especially as each national competent authority in the EU has yet to decide on the implementation of the guidelines. Some countries, like France, have existing rules in place, such as the ISR label, that currently differ from the ESMA guidelines.
There will therefore need to be coordinated efforts among regulatory bodies to ensure consistent practices across the EU and the best outcome for investors.
