New Regulations Spark ESG Fund Purge in Europe

The new rules that limit the freedom with which fund managers can label funds as ESG in Europe are set to trigger a widespread purge across the industry, according to a new analysis by Morningstar Sustainalytics.

Approximately 4,300 funds domiciled in the European Union that currently claim to pursue environmental, social, or governance goals, or carry similar sustainability-related labels, are potentially affected by the new guidelines released in May by the European Securities and Markets Authority, said Morningstar Sustainalytics.

«While it is impossible to predict the total impact of these guidelines, we expect their implications to be significant,» said Hortense Bioy, head of sustainable investment research at Morningstar Sustainalytics, in an email statement. «They have the potential to completely reshape the landscape of ESG funds in Europe.»

ESMA announced last month that investment funds with ESG labels or equivalent terms must have at least 80 percent of their assets under management in something that is truly related to the fund’s name.

Funds also cannot invest in companies on an exclusion list, according to EU benchmark rules aligned with Paris.

Disinvestments of $40 billion

Morningstar estimates that this requirement could affect more than 1,600 funds and lead to disinvestments in stocks of up to $40 billion if asset managers decide to adjust their portfolios to maintain their current labels.

ESMA began working on its naming requirements in 2022, after a surge in ESG investment raised concerns that some product claims were misleading.

A year earlier, the European Union had implemented its Sustainable Finance Disclosure Regulation, an investment rulebook under which around $13 trillion in assets are now registered.

According to Bloomberg Intelligence, approximately 60 percent of them are currently listed as ESG promoters or making them an absolute target.

Sectors that are most vulnerable to disinvestment as a result of ESMA’s new rules include energy, industries such as railways and defense, and basic materials, said Morningstar.

The countries whose companies are most exposed are the United States, France, and China, in terms of market value, according to the researcher.

The 3 stocks most affected by the new rules

Morningstar identified TotalEnergies, Tencent Holdings, and Shell as some of the stocks most likely to face disinvestment pressure due to the EU’s ESG fund naming rules.

«At best, only 56 percent of funds with the specific term ‘sustainable’ in their names could maintain the term if the minimum threshold for a ‘significant’ allocation to sustainable investments is set at 30 percent,» said Morningstar.

«The remaining 44 percent of funds would need to increase their allocation to sustainable investments, modify their sustainable investment methodology, or change their brand.»

The development is not necessarily evidence of widespread greenwashing, but rather a reflection of the lack of standards that have existed until now, as well as the complexity of the area, said Bioy.

The new guidelines «have the advantage of setting minimum standards for ESG products and hopefully will bring greater clarity to investors about what they are investing in,» she stated.