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All is not rosy as ESMA clamps down on greenwashing and introduces ESG fund name restrictions

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    ESMA has published a consultation paper on proposals for guidelines around funds' names using ESG or sustainability-related terms (the "Guidelines"). The proposal includes setting quantitative thresholds for funds which use sustainability-related terms in their names, with the thresholds linked to their categorisation under SFDR.

    These proposed changes – along with Natasha Cazenave's recent speech – potentially lay the groundwork for a more aggressive European enforcement approach in the ESG fund space. ESMA states that "As the EU legislative framework for sustainable finance gradually kicks in, the focus will increasingly turn to supervising and enforcing the rules".

    As such, the proposed Guidelines are likely to have a significant impact on EU funds which use such terminology in their names, and we expect to see an increased supervisory focus once these Guidelines take effect. Asset managers looking to launch new funds beware – these naming rules will fundamentally influence your strategy if you are looking to market a fund as having as ESG focus.

    Why has this consultation paper been published?

    ESMA points out that the increasing tendency for investors to allocate significant proportions of their portfolios towards ESG strategies has led to market pressure on asset managers to include ESG-related terminology in their funds' names. This has, in turn, led to greenwashing in certain cases, according to the regulator. It goes on to state that the proposed Guidelines set out in the paper will complement the principle-based guidance on fund names published in ESMA's previous supervisory briefing by providing quantitative thresholds to reduce the risk of greenwashing. ESMA states that the choice to use quantitative thresholds was discussed at length and was partly made in response to the similar approaches adopted in the US and the UK, as well as national requirements implemented in France and Germany within the EU.

    Reading between the lines, the EU was first out the starting blocks when it came to ESG regulation, but as the SFDR has been implemented it has morphed into a labelling regime – which does not really work, based on the underlying Level 1 test. The result has been a headlong rush by asset managers to categorise their funds as Article 8, given the broad range of strategies and approaches that can fit under this category.

    Consequently, the European regulators have been trying to tighten up the regime via backchannels: through the issuance of Q&As, supervisory and clarificatory statements. Yet, without revamping the SFDR itself, it has been difficult to impose any real restrictions on that Article 8 classification. By issuing additional Guidelines on naming which are attached to existing requirements under EU legislation, ESMA avoid the need for new regulation or a potentially embarrassing overhaul of SFDR. Make no mistake though, these proposed Guidelines are fundamentally designed to make it harder for firms to fit into that Article 8 category – after all, for most firms there is no advantage to being an Article 8 fund if you cannot make your ESG credentials known to investors.

    What are the requirements of the proposed Guidelines?

    There are three requirements under the proposal:

    1. Where a fund has any ESG-related words in its name, a minimum proportion of at least 80% of its investments should be used to meet the environmental or social characteristics, or sustainable investment objective of the fund. The corollary of this is that funds disclosing under Article 6 SFDR only cannot use ESG-related terminology in their names.
    2. Where a fund uses the term "sustainable" (including any derivations) it should comply with the 80% requirement above but also ensure that at least 50% of the investments used to meet the environmental or social characteristics, or sustainable investment objective of the fund qualify as "sustainable investments" under Article 2(17) SFDR.
    3. In addition to these two requirements, ESMA proposes that in order to use the term "sustainability" or other ESG-related terms in the fund name, a fund must also comply with the exclusions for Paris-aligned Benchmarks set out in the Benchmark Regulation Delegated Regulation (Commission Delegated Regulation (EU) 2020/1818) Article 12.

    These exclusions include:

    • companies that "are found or estimated by them or by external data providers to significantly harm one or more of the environmental objectives referred to in Article 9 of Regulation (EU) 2020/852 of the European Parliament and of the Council [the EU Taxonomy]";
    • companies involved in any activities related to controversial weapons (as referred to in international treaties and conventions, UN principles and national legislation);
    • companies involved in the cultivation and production of tobacco;
    • 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;
    • 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; and
    • companies that derive 50 % or more of their revenues from electricity generation with a GHG intensity of more than 100 g CO2 e/kWh.

    What are the key impacts for firms?

    This imposes a significant additional impact on firms, by effectively requiring funds which use the term "sustainable" or other ESG-related terminology in their names to comply with an extensive set of exclusionary criteria.

    It may also require them to carry out a partial EU Taxonomy assessment on all assets to ensure they do not do significant harm to any environmental objectives, in order to meet the exclusion criteria set out above. This is significant for Article 8 SFDR funds which do not commit to making any sustainable investments as these are not currently required to disclose EU Taxonomy alignment, and therefore do not currently need to undertake an EU Taxonomy assessment. That may change when these new Guidelines come into force.

    A number of funds in the market currently categorise themselves as Article 8 primarily on the basis of negative screening strategies. Therefore, a related impact is that the exclusionary criteria outlined above will undermine the defensibility of any categorisation as Article 8 on the basis of negative screening strategies which are less stringent that those outlined by ESMA. Firms in this position should consider whether they can mitigate this risk by reclassifying as Article 6 or upgrading their ESG strategy.

    It remains to be seen how these Guidelines will be interpreted by the national regulators – however, under the existing SFDR disclosures Article 8 and Article 9 funds are required to disclose what safeguards are applied to any investments which do promote environmental or social characteristics or the sustainable investment objective. It is feasible that national regulators may adopt these requirements as minimum standards applicable to all Article 8 and Article 9 funds regardless of their names, given the lack of clarity to date as to what these safeguards should be.

    How are the thresholds assessed over time?

    The proposed Guidelines do not give any indication as to how the 80% and 50% thresholds should be assessed over time. It is unclear whether a fund will be in breach if at any point it falls below the relevant threshold or whether there is a grace period where it can remediate.

    However, given the thresholds are tied to the definition of "sustainable investment" or investments which "promote environmental or social characteristics" under SFDR, we consider that a fund's compliance with the thresholds could only feasibly be assessed on an annual basis by using its SFDR periodic disclosures. The concepts of "sustainable investment" or investments which "promote environmental or social characteristics" are subjective and so even if the relevant data was available to regulators, they would be unable to determine (for a particular fund) whether it was in breach of the relevant threshold at a particular point in time.

    Who do the proposed Guidelines apply to?

    ESMA do not intend for the proposed Guidelines to interfere with firms' obligations under the SFDR or EU Taxonomy. Instead, the guidelines will apply to the existing requirements under the UCITS Directive (Article 14(1)(a)), AIFMD (Article 12(1)(a)) and the cross-border distribution of funds directive (Article 4(1)). This means that the proposed Guidelines will apply to all firms in scope of one of these three existing regulatory provisions. There is currently no relief for funds which are already closed and no longer marketing – so the proposed Guidelines will apply to both new and existing funds. However, there is a six month transitional period for funds launched prior to the publication of the finalised Guidelines.

    How does the ESMA proposal interact with other international regimes?

    The ESMA proposals pose a headache to any cross-jurisdictional asset managers. This is because both the SEC and the FCA are looking to impose similar restrictions, but the requirements between the three regulators are not aligned.

    The easiest way to understand this issue is to use an example: let's say that the Ashurst Sustainable Energy Fund looks to invest in renewable energy companies. The FCA does not intend to incorporate the "do no significant harm" principle and so it is likely that virtually all of the Ashurst Sustainable Energy Fund's assets will be "sustainable" under the FCA regime (as they contribute to a sustainable objective), meaning it will easily meet the 70% sustainable investment threshold to sit within the FCA's Sustainable Focus category. However, it is possible that the Ashurst Sustainable Energy Fund will not invest more than 50% of its relevant assets in "sustainable investments" under the SFDR as they may not meet the "do no significant harm principle", which is a core requirement of the SFDR sustainable investment definition.

    Under the FCA's proposals, the Ashurst Sustainable Energy Fund will be entitled to use the term "sustainable" in its name, as it qualifies for the Sustainable Focus label. However, it will be prohibited from using that term by the proposed ESMA Guidelines. Similarly, the SEC is suggesting an 80% threshold but with a different standard as to what amounts to sustainable.

    Therefore, cross-jurisdictional asset managers will need to take a "highest-standard" approach once these various regimes come into force, opt not to use sustainability-related terms in their funds' names, or ultimately choose not to distribute in the most challenging jurisdictions – which at the moment appears to be the EU.

    To make matters worse, there is an additional question as to how to square these proposed Guidelines with the FCA distributor requirements – it is feasible that we will end up in the bizarre situation where a fund is not permitted under the EU rules to use the word "sustainable" in its name, but its distributors will be required under FCA rules to ensure that a nice big "Sustainable Focus" label is displayed next to it for all potential investors to see.

    What is the timing?

    Responses to this consultation paper are due 20 February 2023.

    Author: Henry Glasford

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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