ESG letters
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Adopting a “green” label for retail financial products that’s similar to the labeling used on other kinds of products and services involves a tricky trade-off between stringency and credibility, according to new research from the European Securities and Markets Authority (ESMA).

The regulator examined the idea of applying an EU Ecolabel — an initiative to help consumers identify green products and services — to investment vehicles and other sorts of financial products, by setting environmental standards, exclusion requirements and transparency obligations.

“A version of the label for retail financial products has been considered as an option to help retail investors make informed investment decisions on the sustainability features of investment products,” the report said.

Researchers aimed to assess the validity of the proposal by applying a set of green criteria to a sample of 3,000 sustainability-oriented equity funds, which have a combined total of €1 trillion in assets under management.

“Using fund portfolio holdings and proxy data, we find that only 16 funds (0.5% of our sample) meet the proposed minimum portfolio greenness threshold of 50% and [certain ESG] exclusion requirements,” the paper said.

Only 26 funds, less than 1%, meet the basic threshold of being 50% green, it noted.

“We find that the average portfolio greenness ratio of sustainability-oriented funds is 11%,” it said.

Layering on the exclusion requirements narrows the field of qualifying funds even more, the researchers found.

“Out of the four types of exclusion tested, we find that the most demanding requirement to meet for sustainability-oriented funds is, by a wide margin, the 5% limit on fossil fuel activities,” it said.  “Exclusions relating to pesticides, tobacco and controversial weapons seem to be much less problematic…”

Just under half (48%) of the sample funds pass all the exclusion requirements, but coupled with the portfolio greenness requirements, only 16 funds pass both sets of standards, it noted.

The researchers noted that their findings highlight the trade-off between setting strict labelling requirements, which would likely be required to build credibility with investors, and the feasibility of introducing a system that may be too strict to attract widespread participation by the fund industry in a voluntary initiative.

“A reduced investment universe can imply (with all other things being equal) increased investment concentration in a few assets and reduced diversification benefits, which can increase the volatility of a portfolio, affect returns and lead to asset overvaluation,” the paper said.

“These findings highlight the importance of carefully calibrating the Ecolabel criteria to achieve the desired balance between credibility and take-up by product managers,” the researchers concluded.