Commerzbank warns of ‘sizeable’ Article 8 downgrades under ESMA naming guidelines

Proposed guidelines could lead to many Article 8 funds ditching the designation and changing names to avoid restructuring costs.

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Commerzbank has warned that regulatory tightening on the labelling of ESG funds could lead to a “sizeable part” of the Article 8 universe ditching the designation.

In a research note published on Friday, the bank’s head of ESG research, Stephan Kippe, said that proposed new rules by the European Securities and Markets Authority (ESMA) could lead to downgrades as asset managers dodge tightening regulatory scrutiny.

Under the proposed ESMA rules, funds with ESG terms in their names must allocate at least 80 percent of assets to investments in line with their goals, while funds with references to sustainability would have to allocate at least 40 percent of total assets to “sustainable investments” as designated under the Sustainable Finance Disclosure Regulation (SFDR).

This is a contrast with the Article 8 requirements, which simply require a fund to promote ESG characteristics.

“We believe these regulations would force asset managers to reassign a sizeable part of the funds currently classified under Article 8 to the non-ESG Article 6 category, in order to avoid potential regulatory sanctions, reduce legal exposure, and avoid the cost of major fund restructuring,” Commerzbank said in the report.

Name change

Kippe told Responsible Investor that downgraded funds would most likely have to change their names as well, and that there may be some fund closures or merging to avoid the burden of restructuring funds to meet the criteria.

Preliminary analysis from Morningstar found that only 18 percent of Article 8 funds with sustainable in their name meet the ESMA criteria.

An annex to the ESMA consultation said the regulator had found 534 Article 6 funds with ESG-related language in their names – 13 percent of all funds with ESG language – and that these funds would be particularly impacted by the guidelines as they should not promote environmental or social characteristics or have a sustainable investment objective, and should disclose against Articles 8 or 9 if they do.

Simply removing the ESG language from fund names and staying in the Article 8 category “would not be a viable path”, due to the significant reputational risk, the report continues. Article 8 funds with no ESG references may also be a focus of future regulatory tightening as the lack of language “suggests that the impact of sustainability on asset selection in these funds is low”, meaning the rename only delays regulatory scrutiny.

While the Article 9 space has seen a flood of downgrades, with more than one in 10 funds losing their status in November alone, Article 8 funds have been more resilient. At the end of November, only two funds had been downgraded by their managers – an iShares Inclusion and Diversity ETF and an NN Investment Partners US credit fund.

Excluding exclusions

The Commerzbank note also warns that proposed minimum exclusion criteria for funds with ESG language in their names could harm transition investment. The ESMA consultation suggests using the exclusion thresholds from the EU Paris-aligned Benchmarks as minimums for all assets in named funds.

However, Commerzbank warns that using these criteria – which include a 50 percent revenue threshold from gas electricity generation above a certain carbon intensity – could affect access to the capital markets for utilities, which have been one of the biggest issuers of green bonds. This would in turn prove counterproductive to achieving the transition.