EU markets regulator the European Securities and Markets Authority (ESMA) announced the release of an update of its proposed guidance for the use of ESG and sustainability-related terms in investment fund names, including the introduction of a new “transition” category enabling the use of labels to identify funds that include investments not currently classified as green, but are focused on transition strategies.

The update follows the launch of a consultation on the guidelines in November 2022, which the regulator said was aimed at protecting investors from greenwashing risk, by ensuring that fund names that include terms such as “ESG” or “sustainability” fairly reflect funds’ actual investment policies and objectives.

In a recent study released by ESMA, the regulator found that there has been a sharp increase in the use of sustainability-related terms in fund names in Europe over the past several years, with the proportion of funds using ESG terms up more than 4x in 10 years, as fund managers launched new ESG-related products, and changed the names of funds to incorporate sustainability-related terms. The study also found a preference by fund providers for more generic ESG terms, which could make it difficult for investors to verify that investments align with the funds’ names.

One of the proposals included in the initial consultation included introducing a threshold of the minimum proportion of investments required to support an ESG-related fund name, including an 80% threshold for the use of ESG-related words, and a 50% threshold for the use of “sustainable” or any sustainability-related term.

The inclusion of different thresholds for ESG and for sustainability-related terms was met by criticism from investor groups, who suggested that the system may cause confusion for investors who often do not distinguish between the terms. Following the consultation, ESMA removed the 50% sustainability-related threshold, replacing it with new guidelines, including a requirement for an 80% minimum proportion of investments used to meet the sustainability characteristics, the application of Paris-aligned benchmark (PAB) exclusions – such as exclusions of companies involved in controversial weapons or tobacco production, and of companies deriving more than 10% of revenues from exploration, production or refining of oil fuels – and investing “meaningfully” in sustainable investments in alignment with the SFDR definition.

Another significant change in the guidelines is the introduction of a new category for transition-related terms, which would not apply the fossil-fuel related PAB exclusions, while retaining the 80% investment threshold. The regulator also noted that funds with “social” or “governance” terms in their names could be too restricted by the fossil fuel exclusions.

In its statement announcing the updated guidelines, ESMA said:

“Funds’ names are a powerful marketing tool. In order not to mislead investors, ESMA believes that ESG- and sustainability-related terms in funds’ names should be supported in a material way by evidence of sustainability characteristics or objectives that are reflected fairly and consistently in the fund’s investment objectives and policy.”