EU ESG funds face $40bn divestment risk

A new Morningstar report has unveiled a significant challenge for European Union (EU) funds labelled with sustainable or ESG-related terms. The report reveals that almost two-thirds of these funds may need to divest assets or change their names to adhere to newly established anti-greenwashing regulations.

According to ESG Today, Morningstar estimates that potential stock divestments could reach up to $40 billion if all affected funds opt to retain their current names. This development follows the European Securities and Markets Authority’s (ESMA) finalised guidelines on the use of ESG and sustainability-related terms in investment fund names, aimed at curbing greenwashing practices that have proliferated with the rising popularity of sustainability terminology in the investment sector.

The new ESMA guidelines stipulate that funds using terms such as ESG, sustainability, impact, or specific environmental descriptors like “green,” “environmental,” or “climate” must meet stringent investment thresholds. Specifically, at least 80% of their assets must align with the fund’s stated sustainability characteristics. Additionally, these funds must comply with exclusion criteria based on Paris Aligned Benchmarks (PABs), which disqualify investments in companies heavily involved in oil, coal, or gas production, emissions-intensive energy generation, and controversial industries like weapons and tobacco.

New guidelines and transition categories

A notable addition is the “transition” category, encompassing funds with labels suggesting improvement or progress, such as “improving,” “progress,” “evolution,” and “transformation.” These funds are also required to meet the 80% investment threshold but adhere to the less stringent Climate Transition Benchmarks (CTBs) exclusions, permitting investments in companies deriving some revenue from fossil fuels.

Morningstar’s extensive research, conducted through its Morningstar Direct database, identified nearly 4,300 mutual funds and ETFs potentially affected by the new guidelines. Of these, approximately 2,500 had available stock-holding data. Among this subset, over 1,600 funds held at least one company that violated PAB or CTB exclusion rules, with about 30% of these funds having at least five such holdings.

The report suggests that if these funds divested from non-compliant stocks to maintain their names, the total divestments could amount to $40 billion. Morningstar anticipates that many funds might drop ESG-related terms from their names or rebrand themselves as “transition” funds to comply with the less stringent CTB exclusions.

Impact on the ESG fund landscape

“While it is impossible to predict the full impact of these guidelines, we expect their implications to be significant. They have the potential to completely reshape the ESG fund landscape in Europe, with thousands of ESG funds changing names and/or adjusting their portfolios to comply with the new rules,” stated Hortense Bioy, Head of Sustainable Investing Research at Morningstar Sustainalytics.

Additionally, Morningstar’s analysis highlighted that if the threshold for sustainable funds to invest significantly in sustainable investments were set at 30%, nearly half of these funds would need to increase allocations to sustainable investments or rebrand.

The sectors most likely to be impacted by these divestments include energy, industrials, and basic materials, with significant holdings in companies like TotalEnergies, Shell, and Tencent Holdings at risk due to violations of the UN Global Compact principles on human rights.

The new ESMA guidelines will take effect three months after their publication in all EU languages on the ESMA website, with existing funds required to comply within six months from that date. Morningstar estimates that the guidelines could impact existing funds by March 2025.

“It may be tempting to assume that the big reshuffle ahead means many ESG funds have been greenwashing. But up until now, there were no minimum standards. The guidelines have the benefit of raising the bar for ESG products and will hopefully bring greater clarity to investors on what they are investing in,” Bioy added.

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