Two-thirds of funds in the EU labelled with sustainable or ESG-related terms may need to sell assets or change their names to align with new anti-greenwashing rules, with stock divestments of as much as $40 billion if all were to keep their names, according to a new report released by investment research firm Morningstar.

The new report follows the release last month by EU markets regulator the European Securities and Markets Authority (ESMA) of its finalized guidelines for the use of ESG and sustainability-related terms in investment fund names. ESMA launched the new rules after noting a sharp increase in the use of sustainability-related terms in fund names in Europe over the past several years, leading to an increased risk of greenwashing.

Under the new guidelines, funds using ESG, sustainability, or impact terms, or environmental terms such as “green,” “environmental,” or “climate,” will be required to meet investment thresholds including having at least 80% of assets in investments used to meet the sustainability characteristics of the fund, and to follow the exclusion criteria for Paris Aligned Benchmarks (PABs). PAB exclusions include companies with more than 10% of revenue from oil production or refining, 1% from coal, or 50% from gas fuels production, those with most revenues coming from emissions-intensive energy generation, as well as those involved in controversial weapons, production of tobacco.

The new guidelines also introduced a “transition” category, which includes funds labeled with terms such as “improving,” “progress,” “evolution,” and “transformation.” The transition category also includes an 80% investment threshold, while applying exclusions from the EU’s rules for Climate Transition Benchmarks (CTBs), instead of the more stringent PABs, in order to enable investment in companies deriving part of their revenues from fossil fuels.

ESMA also removed a proposed 50% threshold for the use of “sustainable” or any sustainability-related term, following feedback from investor groups, but added instead a requirement for such funds “to invest meaningfully in sustainable investments.”

For the study, Morningstar searched its Morningstar Direct database for funds that could fall in the scope of the new guidelines, identifying nearly 4,300 mutual funds and ETFs, including approximately 2,500 with available stock-holding data.

Of the latter group, more than 1,600 were found to be holding at least one company breaching the PAB or CTB exclusion rules, according to Morningstar, including around 30% with at least 5 such holdings.

If the funds were to sell the stocks in breach in order to keep their names, Morningstar’s analysis estimated that divestments would reach up to $40 billion. Morningstar anticipated that many of the funds will drop the ESG and related terms from their names, while predicting that some may choose to reposition to “transition” funds, which are exposed to the less stringent CTB exclusions.

Hortense Bioy, Head of Sustainable Investing Research, Morningstar Sustainalytics, said:

“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.”

The findings were similar to a recent analysis performed by sustainability technology platform Clarity AI, which found that more than 40% of ESG or sustainability-labelled funds could be required to change names due to the new ESMA guidelines.

The Morningstar analysis also found that if the threshold for “sustainable” funds “to invest meaningfully in sustainable investments” were to be set at 30%, nearly half (44%) of these funds would be required to increase allocations to sustainable investments or rebrand.

The report also examined the holdings potentially most affected by divestments motivated by the new rules, finding that the energy sector was the most exposed, representing approximately 40% of the holding value of the stocks held by funds that were in breach of the exclusion rules, followed by the industrials sector at 26%, and basic materials at 12%. By holding value, the most exposed individual stocks included oil and gas companies TotalEnergies, and Shell, as well as Taiwanese communication services company Tencent Holdings, due to its inclusion on Morningstar Sustainalytics’ list of violators of the UN Global Compact principles on human rights.

ESMA’s new guidelines will begin applying three months after publication in all EUB languages on the ESMA website, with existing funds given six months from then to comply. Morningstar estimates that the guidelines could apply to existing funds in March 2025.

Bioy added:

“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.”

Click here to access the Morningstar report.