There is still quite a bit of confusion about what constitutes ESG, sustainable, and impact investing - and regulators are now stepping in to try and address the definition. Regulators in the US, EU and UK are taking a stab a how to label funds.
EU sustainable fund labelling
As outlined in an earlier blog, the European Commission published their sustainability‐related disclosures for the financial services sector, which asks investors to categorize their funds as Article 6 (no ESG integration or objective), Article 8 (promoting E and / or S characteristics) or Article 9 (having an objective to invest a minimum of the fund in susainable investments). A sustainable investment means an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly harm any environmental or social objective and that the investee companies follow good governance practices.
ESMA's fund name and labels
The European Securities and Markets Authority (ESMA) is an independent EU authority whose purpose is to improve investor protection and promote stable, orderly financial markets. ESMA recently issued guidelines to complement the European Commission’s SFDR Regulation, aimed at helping make Fund names and labels more consistent, comparable, and subject to regulated thresholds of what is and isn’t sustainable. ESMA proposed that a threshold of 80% of the minimum proportion of investments for the use of any ESG-, or impact-related words in the fund name.
UK sustainable fund labelling
In an earlier blog, we looked at the UK's Sustainable Disclosure Requirements, specifically the proposal for a three tiered labelling system for sustainable products. The FCA’s proposed system establishes three sustainable investment labels: sustainable focus; sustainable improvers; and sustainable impact.
The FCA proposed a minimum threshold of 70% of the minimum proportion of investments for the use of any ESG-, or impact-related words in the name.
US sustainable fund labelling
The Securities and Exchange Commission has taken another step towards heightened climate transparency with two new proposals covering how US investment firms label and market funds for environmental, social, and governance (ESG)—asking that stronger ESG claims be matched with emissions data to prove that high-carbon assets aren’t being greenwashed.
The first proposal covers fund categorization. The core idea: the more central that ESG is to the objectives of the fund, the stronger the disclosure requirements should be. To make this explicit for investors, the SEC wants funds to identify as one of three distinct tiers:
ESG-integrated funds, where ESG qualities are a routine selection factor, but only as one factor among many.
If ESG is a consideration, the fund needs to disclose its methodologies and data sources used in their evaluation. Funds will then be accountable to either consistently evaluate accordingly or remove the ESG labeling.
ESG-focused funds, where ESG qualities are a “significant” or “main” consideration.
Funds that don’t consider greenhouse gas emissions will need to say so explicitly in a prominent place in their disclosures.
Funds that do consider emissions will need to disclose both their total carbon footprints (mostly Scopes 1 and 2; see later section on Scope 3) and weighted average carbon intensities (emissions divided by a business metric like revenue) across their portfolios, with any offsets left out. They’ll also need to outline their methodologies for including and excluding assets, along with any relevant information on how they’ve voted on ESG-related proxies.
A summary of all this information will also need to be published in a standardized table to allow for easy comparison, with links in that table to fuller explanations, e.g.:
Impact-focused funds, where specific ESG outcomes are the explicit intent of the funds. They’ll need to disclose how they measure qualitative and quantitative progress towards those objectives—including relevant emissions data for any environmental goals.
The second proposal covers fund naming. The SEC wants to extend the 1940 “Names Rule” to cover ESG labeling, where any fund that includes a specific type of investment in its name (like ESG) would need to allocate at least 80% of the fund’s value accordingly—which for ESG would also require a clear definition of the criteria used.
Under both proposals, these disclosures would need to be included in all fund prospectuses, annual reports, and advisor brochures.
Key reference: https://watershed.com/blog/sec-esg-fund-labeling
French sustainable fund labelling
It is worth noting that there are other regions that are developing guidelines and regulation around fund labels, namely France and Germany, which need to be considered. The Autorité des Marchés Financiers (AMF) in France regulates participants and products in France's financial markets. It regulates, authorizes, monitors, and, where necessary conducts investigations and issues sanctions. Recently it has started work on a sustainable fund labelling as well.
Concluding thoughts
We think that regulatory conversion on definitions and thresholds is a positive step and will help minimize the reporting burden on investors operating across jurisdictions, and the risk that a fund is called sustainable in one market (the UK) but not in others (the EU and US).
There is a small discrepancy currently between the ESMA proposed threshold of 80% of the minimum proportion of investments for the use of any ESG-, or impact-related words in the name, which aligns with thresholds proposed by the SEC but is higher than the 70% proposed by the FCA SDR.
We also think that there is a need for greater clarity on words that are ESG- or impact-related, the mechanisms through which sustainable percentage figures should be calculated.
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