Nathan Griffiths: It's all in the name (after all)

December 17, 2024

By Nathan Griffiths, Sustainable Finance, EY Netherlands

‘What’s in a name? That which we call a rose by any other name would smell as sweet.’ So said Romeo to his teenage love Juliet. As Romeo believed, so it seems did the European Council when it drafted the Sustainable Finance Disclosure Regulation (SFDR). The name of an investment fund was not as important as what the fund disclosed. But investors were left somewhat confused and dissatisfied with the regulation.

However, whilst in search of a saviour from greenwashing risks, the three wise men (or regulators) of the European financial sector (the Joint ESAs) determined that the name of a fund does matter after all. Indeed, it is perhaps the single most important marketing tool for fund providers.

Whether by design or not, the existing rules implicitly assumed that investors have the inclination to read fund documents in detail and then compare with the other funds on offer. In reality, even many of those of us with a career spent in the asset management industry rarely look too far beyond the name and performance of a fund (guilty as charged). The authors of the SFDR disclosures could hardly be accused of a lyrical way with words. Good for Rudolph with his bright nose, but perhaps not so good for Dasher, Dancer and Prancer.

New minimum requirements

In short, the regulators belatedly realised that if a fund has a sustainability- or ESG-related label, a large number of retail investors (and some institutional investors) will assume that the fund has a meaningful level of sustainability. In fact, the regulations may have inadvertently increased the risk of greenwashing by providing an implicit minimum expectation of the sustainability profile of funds disclosing under articles 8 or 9 of the SFDR.

Taking their direction from the Greenwashing Progress Report in 2023, and the overwhelming feedback that market participants wanted labels, not just disclosures, the European Securities and Markets Authority (ESMA) has now introduced minimum thresholds for sustainability- and ESG- labelled funds. In time for the Christmas stocking, from November 21 all new funds with such labels must meet minimum requirements relating to exclusion criteria, negative impacts, linkage of holdings to the fund name and the carbon intensity of the portfolio. The same requirements will apply to existing funds from May 21, 2025.

The most stringent requirement is to follow the exclusion criteria of EU Paris-Aligned or EU Climate-Transition benchmarks. The impact of these new guidelines will be significant. Morningstar estimates that 64% of funds with stock level data available will need to either make divestments or change the fund name to remove ESG or sustainability related labels.

One particular requirement that will perhaps resonate with retail investors is that investments with an environmental, ESG or impact label can no longer hold fossil fuel companies. These were never explicitly excluded under the SFDR rules. Whilst article 9 (‘dark green’) funds tend not to hold such companies, many article 8 (‘light green’) funds are low tracking error products which more closely follow benchmarks and as a result will have holdings in, for instance, the oil and gas sector.

More differentiation

There are other consequences for investors to consider. The MSCI World Climate Paris Aligned index for instance had 543 holdings as of November 29, 2024. This compares to 1,397 for the standard MSCI World index. The result is a higher tracking error and higher volatility than the standard benchmark, which is likely to translate to greater deviation in performance for a typical ESG or sustainability labelled fund when the new requirements are applied.

The exclusion of fossil fuels means other sectors will have higher weightings. For example, IT makes up 28.5% of the Paris Aligned benchmark compared to 26.3% in the MSCI World index. Moreover, the need for a 7% per annum reduction in carbon intensity should see sector allocation and performance differentials increase over time. The trade-off for more sustainability will be (some) more volatility. In a world that is currently not on track to meet climate objectives, this would appear intuitively correct.

As with all new regulatory changes, the proof is in the pudding. There will be implications for fund managers and investors which only become apparent during the implementation. Keeping to the festive theme, the sustainability regulations so far have tended to be of a more traditional heavy British-style Christmas pudding rather than a light Italian panettone. But it is clearly a step in the right direction in providing investors with more clarity on how aligned investment products are with climate targets in particular. On May 22 2025, you should have a lot more understanding of what is in the funds you are invested in simply from the name. Take note Mr. Shakespeare!