(Bloomberg) -- Asset managers are being advised by their lawyers not to adapt portfolios to planned ESG rules that would force many to abandon the label.

A proposal by the European Securities and Markets Authority, for which an industry consultation ended last month, has been met with alarm and dismay by investment managers. ESMA, which wants to set minimum thresholds for what funds must do before marketing a product as ESG or sustainable, is now plowing through the feedback and plans to move forward with its proposal in the second and third quarters.

“The industry feedback to ESMA’s proposed approach has been forceful and fierce, and we hope ESMA will take these views on board,” said Sonali Siriwardena, partner and global head of ESG at Simmons & Simmons in London. In the meantime, asset managers should sit tight rather than assume the proposal will go through in its current form, she said. 

“We aren’t advising clients to make any drastic revisions to their approach pending ESMA’s response to the industry feedback, which has been loud and clear in requesting ESMA to reconsider its approach,” Siriwardena said. “Given the force of the industry response, I suspect they may well reconsider but hard to say for sure.”

ESMA has said it’s trying to fight greenwashing risks in Europe’s fund management industry amid signs that ESG designations have been applied too liberally. Europe’s highest ESG fund class, known as Article 9, was the focus of a mass purge late last year after stricter EU guidance led investment managers to strip the tag from 40% of the market. 

ESMA’s current proposal has the potential to cause serious upheaval to Europe’s other ESG fund class. Known as Article 8, the designation is weaker than Article 9 and covers a much bigger market. More than $5 trillion of client assets are managed under the Article 8 tag, according to data compiled by Bloomberg, which includes funds of funds and money market funds.

The Details...

  • ESMA has proposed that fund managers marketing themselves as ESG prove that at least 80% of their investments promote ESG
  • ESMA wants to set a tougher investment requirement for managers claiming their funds promote sustainability, so that 50% of the 80% meets the new bar
  • The Securities and Markets Stakeholder Group estimates that more than 80% of Article 8 funds marketing themselves as sustainable would have to abandon that label, if ESMA moves ahead
  • ESMA has said it expects to finalize its guidance by the second or third quarter, after considering feedback

Investment firms marketing funds as Article 8 are supposed to “promote” environmental, social and governance goals under Europe’s Sustainable Finance Disclosure Regulation. But if ESMA’s proposal goes through, less than a fifth of Article 8 funds will be able to claim they’re sustainable, according to the watchdog’s advisory body, the Securities and Markets Stakeholder Group.

Julia Vergauwen, an attorney at Linklaters who advises the fund industry, said ESMA’s plan to impose a minimum requirement for ESG labels “would have a huge impact” on the industry.

The proposed 80% threshold for ESG labels “is a very, very high percentage,” she said in an interview. “Especially as we know for certain types of funds in the liquid space, specifically for retail investors, around 20% of the assets must be kept as cash for liquidity purposes.”

Yet some in the investment industry are already choosing to adjust their business, in anticipation of new labeling guidelines from ESMA, according to Vergauwen.

“Certain managers take the consultation into account when choosing a name for their new funds,” she said.

Any adjustments remain risky, though, in part as it’s far from clear how national regulators within the EU will respond to whatever ESMA ends up pushing through. 

“Different supervisors in the EU have different views on this,” Vergauwen said. “From the market, there will be a lot of pushback.”

Asset Manager Feedback...

  • State Street Global Advisors said ESMA didn’t explain how to calculate the 80% threshold, which “would lead to investment managers and national competent authorities adopting different approaches, thereby having the direct opposite effect of enhancing comparability between investment funds.”
  • BlackRock said it’s “premature” to set investment thresholds before providing an adequate definition of a “sustainable investment.” It also foresaw “challenges in applying the proposed thresholds to fixed income, multi-asset funds, or those active in private markets.”
  • Amundi said the ESMA plan overlooks strategies, asset classes or geographies that may be critical to transitioning the economy.

Siriwardena also pointed out that a key stumbling block for the industry remains the European Commission’s failure to date to provide a usable definition for sustainable investment. “It is rather premature to set out minimum percentages for sustainable investments in the absence of definitional clarity,” she said.

The European Commission has acknowledged such concerns and says it’s looking into how to address these.

“We are currently in contact with different stakeholders, including the European Parliament and Member States,” a spokesperson for the EU Commission said in an emailed reply to questions. “We will also plan a public consultation” for SFDR.

Meanwhile, the fund industry is facing a separate wave of disruptions after MSCI ESG Research said it was conducting a major review that would result in “more downgrades than upgrades.” The changes in funds’ ESG ratings are due to take effect by the end of next month, according to MSCI. 

The next 12 to 18 months “will be challenging as we navigate the churn and chop of these ESG regulatory waves,” Siriwardena said. And for asset managers, that’s likely to mean a lot more work.

(Adds reference to planned fund downgrades from MSCI ESG Research in penultimate paragraph.)

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