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ESG Fund Names Under Scrutiny: Morningstar Sustainalytics Analyzes New ESMA Guidelines

ESG Fund Names Under Scrutiny: Morningstar Sustainalytics Analyzes New ESMA Guidelines

The European Securities and Markets Authority (ESMA) has issued new guidelines on the naming of ESG funds to combat greenwashing and ensure investor protection. Published on May 14, 2024, these rules demand significant changes from funds using ESG or sustainability-related terms in their names.


This article, based on insights from a detailed report by Morningstar Sustainalytics, outlines the key facts, recent developments, and potential impacts of these new regulations.


 

Key Highlights


  • ESMA's new guidelines mandate that ESG funds must allocate at least 80% of investments to meet specific environmental or social characteristics or sustainable investment objectives.


  • Exclusions are based on Paris-aligned benchmarks (PABs) and climate-transition benchmarks (CTBs), particularly targeting companies with significant revenues from fossil fuels.


  • Over 4,300 funds in the EU using ESG or sustainability-related terms in their names may fall under these new guidelines.


  • More than 1,600 funds could be forced to rebrand or divest up to $40 billion in stocks to comply with the new standards.


  • Sectors most impacted include energy, industrials, and basic materials, with significant effects on companies like TotalEnergies, Tencent Holdings, and Shell.


  • The United States, France, and China are the most affected countries in terms of market value, with substantial divestments anticipated in these regions.


  • Fund managers face challenges in interpreting and applying these exclusion rules, especially concerning the depth of a company's ownership and value chain.


  • Passive funds, holding a large number of stocks, are expected to either change underlying indexes or drop ESG-related terms.


  • Funds using terms like "sustainable" must invest "meaningfully" in sustainable investments, with interpretations left to national authorities.


  • The new guidelines are designed to curb greenwashing, ensuring greater transparency and investor protection.


  • Effective from mid-2024, these regulations are set to transform the landscape of ESG investments in the EU, promoting accountability and sustainability.


 

Key Guidelines and Their Implications


The ESMA guidelines set two principal requirements for funds using ESG or sustainability-related terms:


  1. Portfolio Composition: At least 80% of a fund's investments must meet environmental or social characteristics or sustainable investment objectives.


  1. Exclusions: Funds must adhere to exclusions set by the EU for Paris-aligned benchmarks (PABs) and climate-transition benchmarks (CTBs). PAB exclusions are particularly stringent, ruling out investments in companies deriving significant revenues from fossil fuels.


Funds with the term "sustainable" in their names must invest "meaningfully" in sustainable investments, although the term "meaningful" is subject to interpretation by national authorities.



Impact on Funds and Investments


Morningstar Sustainalytics’ report highlights that approximately 4,300 funds in the EU use ESG or sustainability-related terms in their names, potentially falling under the new guidelines. Of these, more than 1,600 funds may need to rebrand or divest up to $40 billion worth of stocks to comply with the new standards.


The sectors most impacted include energy, industrials, and basic materials, with major companies like TotalEnergies, Tencent Holdings, and Shell under scrutiny.



Detailed Insights from Morningstar Sustainalytics


Affected Sectors and Companies


  • TotalEnergies: Held by 356 funds, representing $3.5 billion in stock value.

  • Tencent Holdings: Found in 167 funds, with a total value of $3.3 billion.

  • Shell: Held by 144 funds, with a stock value of $1.4 billion.


These companies, among others like Exxon Mobil and BP, face exclusions primarily due to their involvement in oil and gas production. The industrial sector, including firms like Dassault Systèmes and Union Pacific, also faces significant impacts, particularly those providing support to thermal coal operations.



Geographical Impact


  • United States: 60 companies meet the exclusion criteria, with half involved in oil and gas production.

  • France: Impacted by major companies like TotalEnergies and Dassault Systèmes.

  • China: Over 90 companies, primarily involved in coal, face exclusions.



Challenges and Adjustments for Fund Managers


Fund managers need to interpret and apply these exclusion rules, particularly regarding the depth of a company's ownership and value chain. Passive funds, which often hold many stocks, are expected to either change underlying indexes or drop ESG-related terms.



Future Outlook and Adaptations for ESG Fund Names


Due to the stringent requirements, many funds may remove ESG-related terms from their names. Some may reposition as transition funds, aligning with the less restrictive CTB exclusions, provided they demonstrate a clear transition path.


Funds using "sustainable" in their names might only retain this term if they meet a minimum threshold of 30% meaningful sustainable investments, impacting about 56% of such funds.



Detailed Analysis by Morningstar Sustainalytics


The report by Morningstar Sustainalytics provides a granular analysis of the potential impact of the ESMA guidelines:


  1. Fund Universe: Close to 4,300 mutual funds and ETFs using ESG or sustainability-related terms in their names may need to comply with the guidelines.

  2. Exclusion Rules: Over 1,600 funds, representing about two-thirds of those with stock holding data, hold stocks potentially in breach of the PAB and CTB exclusion rules.

  3. Sector Impact: Energy, industrial, and basic materials sectors will be the most affected, with potential divestments worth up to $40 billion.

  4. Country Impact: The US, France, and China are the most impacted countries in terms of market value.


Morningstar Sustainalytics' Exclusion Criteria


  • Thermal Coal: Companies providing significant support to thermal coal activities.

  • Oil & Gas: Companies involved in the exploration, extraction, and production of oil and gas.

  • Controversial Weapons: Companies involved in the production of controversial weapons.

  • UNGC Non-Compliant: Companies not adhering to the United Nations Global Compact principles.



Key Takeaways


The ESMA guidelines represent a significant regulatory shift, aimed at enhancing transparency and protecting investors from greenwashing. Fund managers must navigate these changes, balancing compliance with maintaining their investment strategies and market positioning.


As these guidelines come into effect, the landscape of ESG investments in the EU is set to undergo a major transformation, promoting greater accountability and sustainability in financial markets.


For detailed information and further updates, refer to the official ESMA guidelines and consult with regulatory experts to ensure compliance and strategic alignment.


The full report by Morningstar Sustainalytics provides an in-depth analysis and is a critical resource for understanding the implications of these new regulations.


 

We invite you to join our vibrant ESG community, a collective force driving positive change. This is your opportunity to be part of a dynamic network where knowledge, best practices, and innovative ideas are shared freely, empowering you to make impactful decisions.


Together, we can amplify our efforts to shape a sustainable future.


Join us and become a catalyst in the global movement towards a more equitable, environmentally responsible, and socially conscious business landscape.


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