EU rule change highlights difficulty of defining ‘green’

There has been a lot of talk about ESG funds going out of favour, but in Europe, they continue to have inflows. Sustainable funds attracted more than $10bn of new cash on the continent in the third quarter of 2024, in contrast with outflows in the US, according to Morningstar.

But there is continuing controversy about what should be allowed into these funds, as I report in today’s story.

After today, we’re taking a festive break, and we’ll be back on January 3. Happy holidays!

ESG funds

What we can learn from the resistance to the ‘transition’ label

Can green financial instruments only be issued by green companies?

That’s the question at the core of a controversy in Europe that sheds light on the evolution of the sustainable investing agenda.

In October, the European Securities and Markets Authority drew backlash from investors over rules that would have blocked ESG funds with names such as “green” and “environmental” from investing in big polluters.

Green funds holding companies that derive more than 1 per cent of revenue from coal, 10 per cent from oil, or 50 per cent from gas would have needed to either sell those assets or rename, using terms such as “transition,” “transformation” or “net zero.” It was part of a bigger regulatory effort to root out greenwashing.

Esma’s rules had rattled ESG departments at banks across Europe. So sustainability specialists breathed a sigh of relief last week, when Esma announced that it would, after all, allow “green”-labelled funds to include green bonds from polluting businesses.

The U-turn applied only to bonds, meaning equity funds advertised as green will still need to exclude stocks based on issuers’ emissions. In a June analysis, Morningstar predicted that more than 1,600 mutual funds and exchange traded funds in the EU, which use ESG or sustainability-related terms in their names, could hold stocks falling within the scope of Esma’s guidelines, and could therefore be forced to rebrand or divest.

“By mid-year next year, the ESG fund landscape will look significantly different. A large number of funds will have changed names as well as investment objectives and portfolios. Many others will close,” Hortense Bioy, Morningstar’s global director of sustainability research, told me.

The picture in bonds, meanwhile, looks different. Transition investing — through which investors channel capital to help high-emitting companies decarbonise — has been having a moment. But asset managers didn’t much like the idea of trading in the “green” label for “transition.”

The International Capital Market Association led the opposition to the Esma rules, and investors protested that “green bonds” should be narrowly focused on the activity underlying the bond — the so-called use of proceeds — not the broader behaviour of the issuer.

“The pure players of this world — the 100 per cent green companies — they don’t really need green bonds to channel capital to their activities,” Agnes Gourc, BNP Paribas’ head of sustainable capital markets, told me. If the green bond market were to be restricted to environmentally friendly companies, she argued, “what it can deliver is going to be fairly limited”.

Instead, she said, the green bond market’s purpose has always been for investors “to be able to identify the green projects that are going to deliver the changes we want to see with companies and sovereigns”.

That sounds a lot like transition investing, I pointed out. But Gourc maintained that the green bond market was always focused on use of proceeds, so it would be destabilising to introduce a new focus on the firm’s other activities.

If Esma’s rules rooting out bonds issued by heavy polluters had moved ahead, about half of European funds using environmental and impact terms in their names would have had to divest or rebrand, according to research firm Clarity AI. These funds held bonds issued by at least one company that breached the rules, such as power groups.

The discussion raises deeper questions about ESG’s theory of change — and whether, when push comes to shove, the label can be more than a marketing gimmick.

Issuers such as major utilities that derive significant revenue from fossil fuels want their use of proceeds bonds to be eligible for ESG funds. But why? There’s scant evidence that issuing green bonds reliably makes it easier for companies to access cash, compared with issuing ordinary debt.

“You can absolutely finance sustainability without sustainable finance. That’s not the point. There has never been a lack of money to finance this stuff. The question is, what’s the level of transparency and accountability,” Nicholas Pfaff, Icma’s head of sustainable finance, told me.

“The tension,” he added, “is when you have a very good project-level green bond, but you may not be happy with the overall trajectory of the issuer.”

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