Investors in European ESG funds could be in for a rude awakening as new guidelines from the European Securities and Markets Authority (Esma) threaten to upend the industry, according to Morningstar. As many as 1,600 funds could be affected.
According to a report by Morningstar Sustainalytics, a staggering number of funds may be forced to rebrand or divest billions of euro worth of holdings to comply with new exclusion criteria set forth by Esma.
The new rules prohibit funds using ESG or sustainability-related terms in their names from investing in companies deriving significant revenue from fossil fuels. These Paris-Aligned Benchmark (PAB) exclusions are particularly stringent, effectively ruling out investments in major energy giants like TotalEnergies and Shell.
Massive rebranding exercise coming up
In the 20-page research report named EU Guidelines on ESG Funds› Names: A Great Reshuffle Ahead, Morningstar Sustainalytics identified around 4,300 European funds with ESG or sustainability-related terms in their names that fall under the purview of the new guidelines. Of the 2,500 funds with available stock holding data, a staggering 1,600 funds – approximately two-thirds – hold at least one stock that potentially breaches the PAB or climate-transition benchmark (CTB) exclusion rules.
To comply, these funds face two stark choices: either divest from the offending stocks or remove the ESG-related terms from their names, effectively rebranding. If all 1,600 funds opt to keep their names, it could trigger stock divestments worth up to 40 billion dollars, with sectors like energy, industrials, and basic materials bearing the brunt.
The most commonly held stocks potentially in breach of the PAB/CTB exclusion rules include TotalEnergies, Tencent Holdings, and Shell. Other prominent names on the list include Exxon Mobil, Chevron, and BP.
Most affected by exclusion rules
The most affected countries in terms of market value would be the United States, France, and China, but China, the United States, and India would be the most affected in terms of the number of companies.
Transition funds and sutainable investments
Due to the stringent nature of the PAB exclusions, researchers at Morningstar Sustainalytics expects many funds to drop “ESG” and related terms from their names, while some may reposition as transition funds, to which the less restrictive CTB exclusions apply, provided they can demonstrate a clear and measurable transition path.
Additionally, funds with the specific term “sustainable” in their names will need to invest “meaningfully” in sustainable investments as per the Sustainable Finance Disclosure Regulation (SFDR). At best, only 56 percent of such funds would be able to keep the term if the minimum threshold for a “meaningful” allocation is set at 30 percent.
Esma has specified that once published, the guidelines will apply to new funds three months after the publication date and to existing funds nine months after the publication date. Therefore, assuming a publication date of June 15, 2024, the guidelines could apply to new funds from September 15, 2024, and to existing funds from March 15, 2025, according to Morningstar.