23/10/23

GREEN FINANCE: ESMA Warns on “Misleading” Use of ESG-related Terms by Funds

As published on: regulationasia.com, Monday 23 October, 2023.

Research by ESMA shows that ESG-related named funds attract more inflows, raising concerns about potential greenwashing.

Growing use of ESG-related language in fund names and documentation to attract higher inflows is increasing greenwashing risks, according to new research by the European Securities and Markets Authority (ESMA).

Julien Mazzacurati, Senior Economist at ESMA and co-author of the report, noted that analysis shows a “consistent influx” of capital into ‘dark green’ Article 9 funds following the introduction of the EU’s Sustainable Finance Disclosure Regulation (SFDR), highlighting the “persistent appetite” among investors for ESG products.

This strong investor demand incentivises greenwashing behaviour among asset managers to attract higher net inflows by making “misleading, confusing, or otherwise inaccurate” claims about the ESG profile of their funds, the report noted.

The risk of greenwashing, especially in the financial industry, is becoming of increasing concern to regulators both in the EU and abroad, it added.

“In light of these developments, the question of what constitutes an ESG fund becomes pertinent,” said Mazzacurati, adding that currently there is no “EU-wide ESG labels” for ESG funds, nor a universally agreed-upon definition.

“While there are national labels and methodologies provided by data providers to assist investors in identifying ESG funds, there can be disagreements and no easy answer to defining ESG funds,” he said. The disclosure rules introduced under SFDR “fall short” of establishing a clear definition of an ESG fund or providing a formal labelling regime with minimum criteria, Mazzacurati added.

In September, the European Commission published its much anticipated consultation on SFDR. Open to feedback until 15 December, the consultation kicks off the Commission’s comprehensive assessment of the disclosure regulation and spans issues such as legal certainty, usability, and how SFDR can play its part in tackling greenwashing.

The questionnaire asks for feedback on the current requirements of SFDR, its interactions with other sustainable finance legislation, and potential changes to the disclosure requirements for financial market participants.

On the latter, the consultation considers a variety of questions that have been raised by investors since Level One first came into effect in 2021, such as the merits of developing “a more precise EU-level product categorisation system based on precise criteria”, following concern that product categories Article 8 and 9 are being used as de facto labels.

“Powerful signals”

Within the current regulatory context, fund names can act as “powerful signals” to fund managers and investors, but they can also misinform, Mazzacurati said.

According to the report, there is evidence that some asset managers take advantage of ‘hot’ investment styles by changing the names of their funds, resulting in additional fund flows and despite no clear change in their financial performance or impact on ESG factors.

“This has led to the launch of numerous new investment funds featuring ESG-related words in their names, as well as existing funds incorporating such words,” said Mazzacurati, adding that this trend reached its peak towards the end of 2021 and the beginning of 2022.

The number of actively managed funds domiciled in the EU that have changed their name to include at least one ESG word peaked at over 350 during the second half of 2021 and the first half of 2022.

This followed the period of highest net inflows into funds with ESG words in their name during late 2020 and early 2021, supporting the view that funds respond to extra demand from investors by changing their names.

Mazzacurati said that there has been a substantial increase in the use of ESG-related language in fund names over the past decade. Further, the terminology used in fund names tends to be “generic and less specific”, including words like ESG and sustainable.

While this provides flexibility to fund managers in shaping investment strategies, it can be less clear to investors about a fund’s objectives and alignment with its name, he said, underscoring the importance of fund managers offering clarity to investors regarding the implementation of their ESG strategy.

Mazzacurati noted that the introduction of SFDR did lead to more extensive disclosure in investment fund documentation concerning ESG characteristics or sustainable investment objectives.

Consistency across documentation

Additionally, the report found that the language used in fund documentation varies significantly based on type. For instance, key information documents (KIDs) tend to have standardised language, allowing limited flexibility for introducing ESG-related content.

But marketing documents, which are less standardised, provide more freedom to discuss sustainable investing and potentially include additional visual elements like images or graphics for marketing purposes.

“One noteworthy observation is that funds targeting retail investors tend to use more ESG language in their KIDs,” he said. “However, this effect does not seem to extend to marketing documents.

“While this discrepancy may be explained by differences in document structure and purpose, it underscores the importance of maintaining consistent language and disclosures across various document types.”

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Tags

Green Finance ESG Greenwashing