(Bloomberg) -- The investment unit of Deutsche Bank AG will have to divest more than 5% of holdings in some ESG funds in response to new European Union rules set to be implemented this year.

The European Securities and Markets Authority will start enforcing new requirements in the coming months, targeting funds that reference ESG, sustainability, transition and impact in their names to ensure those terms really reflect what the portfolio holds. Though not yet finalized, the rules are already forcing asset managers to review portfolio holdings and make any necessary adjustments.

“The biggest impact that we currently observe for an existing strategy through the new binding elements in ESG-labeled funds is more than 5% of the investment universe,” Dennis Haensel, head of ESG advisory at DWS Group, said in an interview. He declined to name the specific funds that will be affected, but said that DWS is getting in touch with portfolio managers and clients regarding the adjustments.

“It’s a big impact because it mainly relates to a few sectors,” Haensel said. “This is definitely a situation” in which portfolio managers will sit down “with all the involved stakeholders, also with sales and distribution partners” to figure out how to proceed, he said.

ESMA proposed the changes back in November 2022, after asset managers flooded the market with funds claiming to advance environmental and social goals. Regulatory scrutiny of those claims revealed that some fund managers weren’t doing enough to justify their ESG marketing materials. In many cases, funds had done little more than exclude tobacco or controversial weapons.

In a January note to clients, Debevoise & Plimpton advised asset managers to consider new exclusion screens, amendments to strategies or name changes, “each of which may require investor consent.” The law firm said managers “should consider carefully which of their funds may be within scope.”

Haensel said that most funds affected by the ESMA rule will face divestments of as much as 3%. Funds that are tilted toward Europe will be less vulnerable than those more exposed to emerging markets, he said.

ESMA’s proposed mandatory exclusion criteria cover companies selling controversial weapons and tobacco; companies exceeding specified levels of coal, oil and gas sales; and those found to be in violation of guidelines set by the United Nations Global Compact or the Organisation for Economic Cooperation and Development.

As recently as last week, ESMA issued a sharply worded report on funds that claim to advance the UN Sustainable Development goals after finding portfolios weren’t significantly different from other investment products. Misleading claims threaten to undermine investor confidence and choke much needed funding, the watchdog warned.

Qualms about greenwashing coupled with financial underperformance coincided with the first-ever global quarterly outflows for ESG funds in the final three months of 2023. Even in Europe, which dominates the ESG market, top-ranked funds — known as Article 9 — suffered outflows, according to a January report by Morningstar Inc. 

DWS has felt the impact of greenwashing allegations first-hand. In September, the asset manager paid $19 million to settle with the US Securities and Exchange Commission following an investigation into its alleged misstatement of its ESG business. And DWS has been visited by prosecutors in Germany in connection with the same case. 

Elements of ESMA’s Proposed Fund Naming Rules

  • 80% of portfolio assets need to be aligned with the fund name
  • Impact funds must ensure investments generate — or are on track to generate — positive, measurable benefits
  • Transition funds need to apply exclusions set forth in the Climate Transition Benchmark criteria
  • Sustainability funds must apply exclusions set forth in the Paris-aligned Benchmark criteria and invest “meaningfully in sustainable investments”

DWS and other asset managers say they welcome regulatory efforts to introduce clarity to the ESG investing market. But the lack of definitions for key terms needed to make minimum thresholds meaningful remains an issue.

Clemence Humeau, head of sustainability coordination and governance at Paris-based Axa Investment Managers, said that because the EU hasn’t adequately defined what it means by a sustainable investment, there’s “the possibility for all market participants to define their own methodology” and that creates “a risk of lack of comparability.”

ESMA updated its fund-name proposal in December, but hasn’t yet published the final wording. EU regulators, meanwhile, have put forward new requirements to the bloc’s overarching ESG investing rulebook, while the European Commission has launched a review of the Sustainable Finance Disclosure Requirement.

The EU’s largest industry organizations for banks, insurers and asset managers issued a statement Monday, saying the wave of rulemaking is creating legal risks and bewildering investors.

What SFDR Says About Sustainable Investments:

Such an investment should contribute to environmental or social objectives. It should do no significant harm to other environmental or social objectives. It should also follow good governance practices.

Laurence Caron-Habib, head of public affairs at BNP Paribas Asset Management, said she’s skeptical as to whether ESMA’s naming rule will make fund strategies any clearer to investors. BNP will probably have to make some adjustments to its portfolios to comply, though these are likely to be insignificant, she said.

“We think that using some absolute ratios isn’t a good approach, especially because we don’t have common definitions,” Caron-Habib said. “When you’re talking about ESG, what are you talking about exactly? And when you look at this 80% ratio, what does it mean exactly?”

ESMA said in December that it plans to publish final guidelines, pending the release of related legislation for investment funds. The ESMA rules will apply three months after their publication, and managers of new funds will have to comply immediately. Managers of existing funds will have six months to adjust.

France’s financial regulator was alone in objecting to ESMA’s plan, while Sweden, Austria and the Czech Republic abstained, citing conflicting national laws according to minutes of the meeting. Austria supports the initiative, but had to abstain for legal reasons, said Klaus Grubelnik, a spokesman at the Austrian Financial Market Authority. An amendment to Austrian laws is in the works to pave the way for the requirements’ adoption, he said.

Haensel said the downside to DWS’s efforts to adjust to the new requirements is “we may have less dedicated ESG funds in the future” than the asset manager currently offers.

(Adds response from industry trade groups in 15th paragraph.)

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