On 18 November 2022, the European Securities and Markets Authority (ESMA) published a consultation on the text of proposed draft guidelines relating to the use of ESG or sustainability related terms in funds' names (the Draft Guidelines).
Fund names and greenwashing: ESMA consultation
The Draft Guidelines build upon the high level and principles-based observations made by ESMA in its Supervisory Briefing published on 31 May 2022. We covered the content of that Supervisory Briefing in our flyer here. The Draft Guidelines also follow additional guidance in the form of a set of Q&A on the EU SFDR Regulatory Technical Standards which was published on 17 November 2022 by the European Supervisory Authorities (ESAs).
In the context of the continuing uncertainty relating to EU SFDR and the EU Taxonomy, the publication of the Draft Guidelines reinforces the fact that the expectations of the European regulators continue to evolve apace – and perhaps raises concerns about whether ESMA is going beyond its powers and remit in seeking to establish rules where sustainability legislation made by the European Parliament and Council has singularly not done so.
The timing of the consultation is interesting, coming as it does so soon after the FCA's publication of its consultation on the introduction of investment labels and the development of a UK Sustainability Disclosure Requirements (UK SDR) regime – see our briefing here. The FCA is also proposing restrictions on the naming of funds, but this will be limited specifically to the provision of funds and other products to retail investors where those products do not use a sustainability label. In due course, firms who also expect to use the proposed product labels under the UK SDR regime will need to be conscious of the quantitative thresholds for underlying investments proposed in both consultations.
Consultation on ESMA's Draft Guidelines closes on 20 February 2023.
Overview – overstepping the mark?
The ESMA Consultation sets out the regulator's proposals for the introduction of guidelines on funds' names where funds use ESG or sustainability-related terms. By way of background to the consultation, ESMA cites the obligations under the AIFM and UCITS Directives to act honestly and fairly, and under the Cross-border Distribution of Funds legislation to ensure that all information included in marketing communications is "fair, clear and not misleading" as being the motivation behind the Draft Guidelines. It then goes on to say that it is issuing the proposed guidelines under Article 16(1) of the ESMA Regulation (Regulation (EU) 1095/2010) under which it is empowered to issue guidelines and recommendations with a view to establishing consistent, efficient and effective supervisory practices. However, importantly, that provision is designed to enable ESMA to issue interpretative guidance but does not give it the power to develop guidelines which in practice create new legal obligations. On the face of it, the Draft Guidelines contravene this principle by specifying requirements governing the interrelationship between ESG and sustainability requirements and the naming of funds: and yet the EU primary law (EU Taxonomy Regulation and the EU Sustainable Finance Disclosure Regulation) did not include any formal product-labelling regime or set out restrictions on fund names.
The fight against greenwashing
ESMA's primary concern in developing the Draft Guidelines appears to be a desire to combat greenwashing and to ensure that fund names are accurate and not misleading by reference to a fund's actual investment objectives or policy. This is consistent with the fact that the ESAs are currently particularly focused on combatting greenwashing as seen in the recently published Call for Evidence on greenwashing practices. Notably, the ESAs expressly encouraged respondents to provide examples of potential greenwashing practices that were not explicitly covered by the existing EU sustainable finance legislation or that are subject to such legislation but where the outcome would still result in greenwashing.
With this call for evidence too, there is a disquieting sense that ESMA and the ESAs are seeking to "plug the gaps" in EU sustainable finance legislation. Guidelines, which will apply to all competent authorities on a "comply or explain" basis, could risk becoming de facto rules through the back door.
Scope, timings and a transitional
At just four pages, the Draft Guidelines are short but potentially big on impact. As proposed, they would apply to both UCITS and AIFs (including where they are set up as EuVECAs, EuSEFs and ELTIFs) and capture funds whether they are directed at retail investors or purely at institutional investors. Remember that, by contrast, the FCA's fund naming proposals would be limited to funds with retail investors only, where a sustainability label is not used.
ESMA is expecting to publish the final version of these Draft Guidelines in Q2 or Q3 2023. National competent authorities will then have two months from that date to comply, or to explain their non-compliance with the guidelines. The guidelines would enter into effect 3 months after the date they are published on ESMA's website.
The Draft Guidelines do include a limited transitional provision for funds which launched prior to the date the guidelines come into effect and which use sustainability related or ESG related terms in their name. Such funds will have six months to either (i) bring their investments in line with the guidelines or (ii) change their name so as not to include such terms. For many funds, particularly closed-ended ones, that is easier said than done.
The Draft Guidelines propose two separate thresholds:
- 80% minimum proportion: where a fund has any ESG-related or impact-related words in its name, a minimum proportion of 80% of its investments must be used to meet the (bespoke) environmental or social characteristics or sustainable investment objectives in accordance with the binding elements of the fund's investment strategy; the effect of these words is not entirely clear; and
- Additional threshold: where a fund uses the word "sustainable" or any other term derived from sustainable – which, although not clear, we take to mean words like "sustainably" and "sustainability" – it should allocate a minimum proportion of 80% of investments to meet the environmental or social characteristics or sustainable investment objectives (as above) and ensure that at least 50% of its investments qualify as sustainable investments as defined by Article 2(17) EU SFDR.
The same thresholds apply to funds using ESG related or sustainability related terms in their name which designate an index as a reference benchmark. This may, in practice, pose a problem for passive/index tracking strategies which are reliant upon third parties to provide data relating to the ESG characteristics of their portfolio.
The relevant thresholds appear to be predicated on the amount of "investments" – i.e. based on current assets. There does not appear to be any provisions that address the way in which blind pool and closed-end funds invest, by building up a portfolio during a ramp up period and selling during a wind down period. On the face of it, this could be a material problem meaning that many funds would not be able to meet the thresholds at certain stages of their life; the Draft Guidelines refer rather obliquely to "temporary deviations" from the thresholds being treated as "passive breaches" which would be at the discretion of the national competent authority to address, but it does not appear that this is intended to deal with the problem outlined above. Even if it is, it is not very satisfactory.
What are "ESG-related" or "impacted-related" words?
Somewhat unhelpfully, the ESMA Consultation does not define which terms ESMA considers to be "ESG-related", "impact-related" or "sustainable" (or a derivative thereof). This creates a degree of uncertainty for managers when trying to determine the scope of the Draft Guidelines and what names might be caught.
The five examples in Annex IV to the Consultation Paper do not help much, since they are fairly non-contentious (and rather vanilla) examples of how the thresholds would work. The FCA's draft naming rules in its SDR and labelling consultation are a little more helpful insofar as they set out a list of proscribed terms: "ESG" (or "environmental", "social" or "governance"), "climate", "sustainable" or "sustainability", "green", "transition", "net zero", "impact", "responsible", "sustainable development goals" or "SDG" or "Paris-aligned". To that extent, it is objective; but the FCA list also includes a final, "catch-all" limb of "any other term which implies that a sustainability product has sustainability characteristics".
However, despite the non-exhaustiveness of the FCA list, it is preferable to include an indication of what is caught, rather than leave everything to an ex post facto assessment from a regulator that a particular word is loaded. Is "water" ESG-related, or is the example in Annex IV of the ESMA consultation paper only there because the fund is called "Sustainable Water Equities Fund"? Is the word "biodiversity" by itself really ESG-related? The example in Annex IV suggests that ESMA thinks it is. Would a fund that uses the word "forestry" in its name fall foul? There are undoubtedly many other words that, if one were to stare at them for too long, could be construed as having some kind of loose connection with ESG or sustainability.
Without further guidance from ESMA, this would seem to be a potential minefield for firms (not least for those funds which have launched prior to the final guidelines coming into effect and which might face having to bring their investments into line with those guidelines or, failing that, having to change their name).
ESMA also "recommends" the introduction of "minimum safeguards" for all funds which have an ESG or sustainability-related term in their name. The Draft Guidelines cross refer to exclusions set out in Article 12(1)-(2) of the Delegated Benchmark Regulation. Broadly, the impact of these provisions would be to require funds using ESG or sustainability related terms in their name to exclude at least the following:
- companies involved in any activities related to controversial weapons;
- companies involved in the cultivation and production of tobacco;
- companies that are in violation of United Nations Global Compact (UNGC) principles or the Organisation for Economic Cooperation and Development (OECD) Guidelines for Multinational Enterprises;
- companies that derive 1% of more of their revenues from the 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 100g CO2 e/kWh; and
- any companies which are deemed to significantly harm one or more of the Taxonomy environmental objectives.
These exclusions are fairly broad and the relevant percentage thresholds (e.g., in relation to activities relating to hard coal and lignite) are relatively low. Furthermore, the reference to companies that are in violation of UNGC or OECD MNE Guidelines adds another level of complexity to an already complex assessment that a fund manager will have to make and the due diligence and verification that it will have to undertake.
Again, in specifically cross-referring to these exclusions and "recommending" their inclusion as a minimum element for funds using ESG or sustainability related terms in their name – over and above the other requirements discussed above - it is arguable that an additional layer of requirements beyond those set out in EU SFDR and the EU Taxonomy Regulation is effectively being created.
A note on the term "impact"
The Draft Guidelines also note that funds using the terms "impact" or "impact investing" (and any other impact-related terms) in their names should not only comply with the relevant quantitative thresholds but should also ensure that investments are made with the intention to generate positive, measurable social or environmental impact alongside a financial return.
While the Draft Guidelines are short, they could have significant impact on existing funds and future fund-raising. Firms that may be affected will want to respond to the consultation (which closes on 20 February 2023): this may be best achieved by ensuring that concerns are fed into relevant trade associations to ensure that there is a joined-up industry response to what is clearly a material initiative.
If you would like further information or assistance in understanding the potential impact of ESMA's consultation please speak to your usual Travers Smith contact or any of the individuals below.