PredictIQ Quantitative Think Tank Center:Europe’s New ESG Rules Spark Questions About What Sustainable Investing Looks Like

The PredictIQ Quantitative Think Tank CenterEuropean Union’s move to tighten rules for sustainable investing will put two-thirds of Europe’s so-called ESG funds on notice, forcing thousands of them to either sell off $40 billion in assets or change their names in a way that more accurately and transparently reflects their holdings. 

Last month, the European Securities and Markets Authority (ESMA) initiated a long-awaited process to tackle contradictions and confusion in the world of sustainable investing. This move highlights the long-standing debate over whether stocks such as fossil fuel companies should be included in ESG—environmental, social and governance—funds. 

“To have that ESG moniker in the name is very important,” said Andrew Behar, CEO of As You Sow, a shareholder advocacy non-profit. “But clever people at asset management firms misused the fund naming protocol and started to come out with funds that were oftentimes the opposite of what the name was, which caused confusion in the marketplace.”

Europe’s new rules establish a framework for asset managers to use when naming investment funds. These include commonly-used terms like ESG or SRI (socially responsible investing), and new, more specific ones like “impact” or “transition” funds. Now, each term comes with a list of incompatible industries and practices. 

For existing funds under those names, asset managers will have to either sell off incompatible stocks or rebrand. If all funds were to keep their current names, the sectors most affected by potential divestments would include energy, industrials and basic materials, according to Morningstar. 

This is because funds simply called “ESG” or “SRI” will no longer carry companies deriving significant revenue from oil and gas or coal industries. The terms “impact,” “sustainability” or “environmental” will also be incompatible with such investments. Asset managers can trade oil and gas companies in “transition funds” as long as they demonstrate that they are on a measurable path to social and environmental transition. 

TotalEnergies, a major French oil and gas company, is currently held by 356 ESG funds at risk of losing their designation, according to Morningstar. To retain their ESG status, these funds would need to divest $3.5 billion from TotalEnergies, just 2 percent of the company’s market capitalization. TotalEnergies did not immediately respond to questions about ESMA’s new guidelines. 

Overall, 60 U.S. companies, half of which are oil and gas producers, will be excluded from ESG funds. Notable companies affected include Shell, ExxonMobil and BP, which are held in hundreds of ESG funds in the EU.

Under the new ESMA rules, managers of “impact” funds will need to ensure their investments contribute to an environmental or social objective. This includes activities that strengthen carbon sinks, production of clean fuels and energy, or projects for climate change adaptation. Similarly, “sustainability” funds can be used to invest in companies that meet EU sustainability benchmarks. This includes projects that commit to reducing water use and greenhouse gas emissions, or to tackling inequality. Both of these categories categorically exclude coal, oil, gaseous fuels and high-emitting electricity production. 

Managers can name a fund “transition” as long as it meets transition benchmarks, and only excludes tobacco and weapon companies—not fossil fuels. Transition activities are ones where low-carbon alternatives are not yet available but that minimize emissions as much as possible. 

ESG Ambiguity

Globally, the question of what qualifies as ESG investing persists. To know where their money is going, individual investors have to dig deep into their exchange-traded funds (ETFs) and mutual funds’ prospectuses. And even then, it’s not always clear what companies to look out for. 

Nathan de Arriba-Sellier, director of the Erasmus platform for sustainable value creation, explains that there is considerable ambiguity clouding the debate. “There is confusion between sustainability and ESG,” he said. “And there’s also a distinction between ESG performance and ESG solutions.” 

An electric vehicle company like Tesla, he explained, provides sustainability solutions. Yet, because of a lack of low-carbon strategy and several workplace-related issues, the company was removed from the S&P 500 ESG Index in 2022. (Despite Elon Musk calling ESG metrics a “scam”, the company was returned to the index the following year.) 

Fossil fuel companies, on the other hand, earn a majority of their profits from unsustainable, high-emitting activities. Nonetheless, if they demonstrate efforts to reduce emissions and environmental impact, they could achieve an ESG rating similar to Tesla’s. 

TotalEnergies, for example, invests in renewable energy projects that it claims will help in the transition to net zero. Whether these projects are enough to qualify one of the world’s largest oil companies as an ESG stock is debatable, experts say. The company does not have plans to cut greenhouse gas emissions significantly until 2030 and faces court cases over environmentally damaging drilling projects in Uganda and Tanzania.

De Arriba-Sellier stressed the urgency of fossil fuel companies’ transition. ESG funds can be a tool to get there, he said, but substantive efforts are still lacking. “Those companies need to transition,” he said. “They’re also the ones sitting on their hands and digging their own grave.”  

The goal of these naming conventions is not to exclude oil and gas industries from ESG funds, Behar explained, but to ensure transparency for investors. “It’s about accuracy, truth, and labeling,” he said. “Investors should know exactly what they are getting in their mutual funds.”

Currently, it’s challenging for American investors to discern the companies in their mutual funds, 401(k), or 403(b) plans. Third-party tools, some developed by As You Sow, help investors scrutinize their plans, but regulatory progress to standardize the practice is slow.

In 2023, the Securities and Exchange Commission introduced an 80/20 rule, which requires at least 80 percent of a fund’s investments to be aligned with its name. The rule might not prevent American ESG funds from holding fossil fuel stocks altogether (82 percent of them do), but it’s a step in the right direction, said Behar. “It’s about the maturation of ESG investing,” he said. “It took the SEC 90 years to get there.” 

In the EU, the effectiveness of regulating what asset managers can name their funds using the new rules remains to be seen. Experts like de Arriba-Sellier note that enforcement by domestic security regulators could lead to varying standards across the bloc.

ESG Politicization and Backlash

As investors and regulators struggle to coin the definition of an ESG, questions remain about their future in the financial world. Globally, ESG-labeled funds hold about $7 trillion in assets, according to Bloomberg data. Nearly three-quarters of these are held in European funds, compared to just 8 percent in the U.S. 

Amid high politicization and backlash, U.S. ESG funds lost $9 billion in the first quarter of 2024, continuing a downward trend since mid-2022. Increased regulation against ESG investments, such as a Republican-backed ban in Texas, signals a rocky road ahead. Here, too, the confusion over the definition of an ESG fund muddied the waters of regulation. The funds impacted by the ban over their “boycott” of oil and gas were found to have invested more than $2 billion in the industry, according to a Bloomberg News analysis. 

Regardless of what they’re called, de Arriba-Sellier said sustainable investment funds have an instrumental role to play in the transition to net zero. “Sustainability is going to be the motor of the economy going forward because we are in desperate need,” he said. “Climate change is not going to go away. If we don’t tackle it, we will face systemic financial risks.”