Sustainable Funds Face Dilemma as ESMA Rules Clash with Green Bond Investments

The financial industry is grappling with the implications of the European Securities and Markets Authority's (ESMA) new guidelines on sustainable fund-naming, which have revealed a surprising conflict with investments in use-of-proceeds and sustainability-linked bonds. As Clarity AI's research has uncovered, over 70 funds are now in breach of these rules, highlighting the complex challenges facing the sustainable investing landscape.

Navigating the Evolving Sustainable Investing Landscape

ESMA's Sustainable Fund-Naming Rules: A Double-Edged Sword

The ESMA guidelines require funds with ESG or sustainability-related terms in their name to implement exclusion screens in line with the EU's Paris-aligned Benchmark (PAB) regulation. This means that funds must exclude companies that violate certain norms, as well as those with significant exposure to coal, oil, and gas production. However, the most concerning aspect for green bond investors is the exclusion of companies that derive more than 50 percent of their revenue from electricity generation with an intensity of more than 100 grams of CO2 equivalent per kWh.

The Unintended Consequences: Funds Caught in the Crossfire

Clarity AI's research has revealed that more than half of the 3,200 funds with environmental and impact-related terms in their name would need to either divest at least one holding or change their name to comply with the ESMA rules. This is because many of these funds have invested in a small subset of commonly held companies that are now in breach of the exclusion criteria.

The Green Bond Dilemma: Caught in the Regulatory Crosshairs

The analysis provided to Responsible Investor shows that 70 funds will be in breach of the ESMA rules solely due to their investments in use-of-proceeds or sustainability-linked bonds (SLBs). These funds will now have to either divest these holdings or change their names, creating a significant challenge for the green bond market.

Pushback from the Industry: Calls for Issuer-Level Exceptions

The market has seen wider pushback against the ESMA rules, with a particular focus on the impact on the green bond market. The International Capital Markets Association has called for issuer-level exceptions when investing in credible green and sustainability-linked bonds. Analysts have also noted that utilities, many of which will breach the PAB limits, are likely to be among the early adopters of the EU green bond standard.

MSCI's Methodology Refinements: Potential Overestimation of Affected Companies

Meanwhile, Barclays analysts have warned that MSCI's new methodology for aligning with PAB exclusions may overestimate the number of companies affected by ESMA's fund-naming rules. MSCI's approach, which combines oil and gas revenue and changes its methodology for emissions-intensive generation, has increased the number of issuers flagged by the screen by around a quarter, adding an additional $7.5 billion of assets to the divestment list.

The Way Forward: Navigating the Regulatory Landscape and Preserving the Green Bond Market

As the industry grapples with the implications of the ESMA rules, it is clear that a balanced and nuanced approach is needed to ensure that sustainable investing can continue to thrive while preserving the integrity of the green bond market. Regulators, industry associations, and data providers must work together to find solutions that address the unintended consequences and allow for the continued growth of sustainable finance.