The ESG Labelling Method: A Structural Failure.

A remarkable paradox lies at the heart of sustainable investing in 2026. The asset class has never attracted more capital; global ESG-labelled assets under management now exceed $40 trillion. Yet the label has never been less informative. The regulatory ground has shifted dramatically. But the stakes have not. While reporting requirements have been simplified in some jurisdictions, the legal and commercial consequences of ESG failures are, if anything, expanding. Greenwashing is no longer a reputational risk. It is a legal liability.

SUSTAINABLE INVESTING INSIGHT SERIES  |  PART I  |  SEPTEMBER 2026

When everything claims to be sustainable, nothing is. ESG ratings from major agencies do not correlate. Two agencies can simultaneously give the same company a top-decile and bottom-decile sustainability score. Both are technically correct within their own methodologies. 880 funds changed their ESG names in one year without changing their portfolios. Not their investments. Not their processes. Just their names. And the EU's regulatory simplification has created a data vacuum at precisely the moment when ESG scrutiny is at its highest. The ESG labelling method is not a work in progress. It is a structural failure. This article explores why and what investors should do about it.

ESG AUM Global	Funds Renamed 2024-25	Rating Correlation	Greenwashing Cases EU
$40+ trillion	880 funds	0.54 vs 0.99	247 investigations

The Regulatory Ground Has Shifted. The Stakes Have Not

For years, the trajectory of ESG regulation pointed in one direction: more mandatory disclosure, stricter standards, and greater accountability. That consensus has fractured.

In February 2025, the European Commission adopted its so-called Omnibus I package, a sweeping set of simplifications to its landmark sustainability frameworks. The Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CSDDD) were both substantially narrowed. Most companies in EU supply chains will now produce no mandatory sustainability disclosures at all, creating a significant data vacuum at precisely the moment when supply chain ESG risk is under its highest-ever level of regulatory and public scrutiny.

Across the Atlantic, the Trump administration withdrew the SEC's proposed climate disclosure rule in March 2025. Some US states, however, are pushing in the opposite direction: a New York court ordered climate regulations to be issued in 2026, and California's climate disclosure laws remain in force for large businesses. The result is a regulatory patchwork that creates genuine complexity for organisations operating across borders.

⚠️  The regulatory simplification has not reduced exposure; it has increased ambiguity.

When fewer companies must disclose, investors have less data but the same legal and reputational risk if they get it wrong.;

Why Do ESG Ratings Diverge So Dramatically?

When MSCI, Sustainalytics, ISS ESG, FTSE Russell and Bloomberg all rate the same company, they frequently disagree not by a small margin, but fundamentally. The correlation between major ESG rating agencies has been measured at about 0.54, compared to 0.99 for credit ratings from Moody's and S&P. Two agencies can simultaneously give the same company a top-decile and bottom-decile sustainability score. Both are technically correct within their own methodologies. This is not a minor inconsistency. It is a structural failure with profound consequences for investors, allocators, and the credibility of sustainable investing as an asset class.

1. Scope Divergence: What Is Measured

Different agencies measure fundamentally different things. Some focus on environmental impact: carbon emissions, water usage, biodiversity. Others weight governance heavily. Others prioritise social factors. As a result, a mining company with excellent governance but poor environmental practices can receive radically different scores depending on which agency weights which dimension more heavily.

2. Measurement Divergence: How It Is Measured

Even when agencies agree on what to measure, they disagree on how to measure it. Carbon emissions can be measured on a Scope 1, Scope 2 or Scope 3 basis, and the choice makes an enormous difference. A technology company that outsources its manufacturing appears carbon-light on Scope 1 and 2, but its Scope 3 supply chain emissions may dwarf those of a vertically integrated manufacturer.

3. Data Source Divergence: Where Information Comes From

Most ESG data is self-reported. Companies disclose what they choose to disclose, in the format they choose. An agency that relies primarily on company disclosures rates the quality of a company's sustainability communication, not its sustainability performance. With the Omnibus simplification reducing mandatory disclosures, this self-reporting problem is about to get significantly worse.

"The ESG rating problem is not that agencies disagree. It is that investors treat their ratings as if they agreed. A label that means different things to different people is not a standard. It is a spectrum of convenient fictions."

880 Funds Changed Their Names: Not Their Portfolios

The scale of the labelling problem became impossible to ignore when ESMA introduced its new naming guidelines in 2024. Under the rules, fund names using terms such as 'climate', 'impact' and 'sustainability' must align with Paris Agreement benchmarks, with at least 80% of investments meeting stated ESG characteristics.

The industry's response was revealing. Research by Morningstar Sustainalytics found that at least 880 alternative investment funds changed their names between May 2024 and May 2025, but all retained their approach to ESG issues.

880 funds changed their ESG names in one year.

Not their portfolios. Not their investment processes. Not their ESG methodology. Just their names.

If that does not illustrate the structural failure of ESG labelling nothing will.,

The SFDR Paradox: Regulation That Created More Confusion

The European Union's Sustainable Finance Disclosure Regulation (SFDR) was designed to create a clear taxonomy. Article 8 (environmental or social characteristics) or Article 9 (sustainable investment objective) were meant to give investors reliable signals.

The result has been the opposite. Article 8 now encompasses over €5.2 trillion of assets, including funds that hold tobacco companies, defence contractors and fossil fuel producers. The European Commission has proposed a reform introducing new categories: transition finance, ESG basic, and sustainable, but the European Parliament and Council are not expected to finalise a text until late 2026. Until then, the confusion persists.

"SFDR attempted to solve the ESG definition problem through regulation. Instead, it created a new layer of complexity without resolving the underlying issue. Article 8 is now so broad that it has lost all informational value."

Greenwashing Is Now a Legal Liability

For investors and compliance teams, the most important development of the past two years is the emergence of greenwashing as a credible, high-stakes legal liability one that is evolving faster than most organisations' risk frameworks.

United Kingdom

The Advertising Standards Authority has deployed an AI tool that proactively scans more than 500,000 advertisements per month to identify misleading green claims. The Competition and Markets Authority has acquired significant new enforcement powers, allowing it to impose fines of up to 10% of global annual turnover for consumer law breaches including greenwashing.

European Union

Litigation against banks and corporates for alleged misrepresentation of climate commitments is active in multiple jurisdictions, including the Milieudefensie v. ING Bank case, expected to be argued in the Dutch courts in 2026. The Green Claims Directive is advancing through the EU legislative process, which will further tighten requirements on environmental marketing claims.

United States

While the federal regulatory direction has shifted, the legal risk has not disappeared. State-level action, particularly in New York and California, continues to impose disclosure obligations. And institutional investors, despite a public retreat from ESG coalitions, still factor sustainability risk into capital allocation decisions. Japan's $1.7 trillion Government Pension Investment Fund increased its ESG-linked equity holdings in 2025, even as others retreated.

The regulatory ground has shifted. The stakes have not.

Companies are still being taken to court for greenwashing.

Institutional investors controlling 50% of listed equity in the US, UK and Ireland are still demanding sustainability-related disclosures.

The commercial and legal consequences of ESG failures are, if anything, expanding.

What Is Coming: The Regulatory Horizon

While the near-term direction of ESG regulation has shifted toward simplification, several developments over the next 12-18 months will directly affect investors and compliance programmes.

UK ESG Ratings Regulation

The UK government has laid the Financial Services and Markets Act 2000 (ESG Ratings) Order 2025 before Parliament, subjecting ESG ratings providers to formal FCA oversight for the first time. The FCA is expected to publish final rules in Q4 2026, with provisions taking effect from June 2028. This will significantly change how institutional investors can rely on and evidence third-party ESG assessments.

CSRD Assurance Standards

In February 2026, the Dutch Authority for the Financial Markets published guidelines on the independent auditing of sustainability reports under CSRD. the first year, audit firms were required to verify those reports under the directive. As these standards develop, the bar for credible sustainability reporting will rise materially.

ESG Litigation Pipeline

With the Green Claims Directive advancing through the EU legislative process and UK regulators deploying automated tools to identify non-compliant marketing claims, ESG-related enforcement and litigation is set to increase. Investors, corporates, financial institutions and their advisers need robust processes and a clear paper trail to prepare for regulatory scrutiny.

"Those that will navigate the ongoing changes most effectively are teams that treat ESG risk with the same seriousness they apply to financial or legal risk as a material factor requiring genuine investigation, documented evidence, and independent verification."

What Should Investors Do? 1. Look Through the Label

The starting point for rigorous ESG analysis is to treat the label as a starting point, not a conclusion. An Article 8 designation or a top-decile MSCI ESG score tells you that the fund or company has met a particular agency's criteria within a particular methodology. It tells you nothing about the underlying sustainability reality. Read the methodology. Understand what is being measured and what is not.

2. Focus on Materiality

Not all ESG factors are equally relevant to all companies. Carbon emissions are material for energy companies, airlines and cement manufacturers but less so for software businesses. The most rigorous sustainable investing frameworks focus on the ESG factors that are financially material to each specific business, not on a comprehensive but undifferentiated list of criteria.

3. Demand Independent Verification

Self-reported ESG data is, by definition, unverified. The gold standard is still rare, but growing under CSRD, is third-party assurance of sustainability claims, conducted by independent auditors to recognised standards. The analogy with financial auditing is direct: we would not accept a company's financial statements without independent audit. There is no principled reason to accept its sustainability statements without the same standard of verification. 4. Engage: Don't Just Screen

Negative screening, which excludes companies that fail ESG criteria,is the bluntest and least effective tool in the sustainable investor's toolkit. Engagement, using ownership rights to push companies toward better practices, is more effective and more consistent with fiduciary duty. The investors who will drive genuine sustainability outcomes are those who engage with the companies they own, not those who simply relabel their portfolios and call it sustainable investing.

"Without a common standard. ESG scores are narratives, not measurements. The solution is not more labels. It is more rigour. Independent verification. Materiality-focused analysis. Engagement over exclusion."

In Part II of this series, we turn to carbon assets, one of the few areas of sustainable investing where market prices, rather than ratings agencies, provide the most reliable signal of environmental value.

📖 Read next: Part II : Carbon Assets as Portfolio Diversifiers

📄 This article is Part I of the Alfinas Sustainable Investing & Green Finance Insight Series, September 2026. Download the full series: www.alfinas.com/insights

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Sources: Morningstar Sustainalytics, How ESMA's New EU Rules are Impacting ESG Portfolios, 2025; European Commission Omnibus I Package, February 2025; ESMA Greenwashing Report; FCA ESG Ratings Consultation 2026; Travers Smith ESG Litigation Tracker 2026; Bloomberg ESG Data; OECD Institutional Investor Engagement Report 2025.

This article is published by Alfinas Alternative Investment Advisers for informational and educational purposes only. It does not constitute investment advice. © Alfinas Alternative Investment Advisers, September 2026.

Marie-Laure Mikkelsen PhD., C.A.I.A  |  Founding Partner, Alfinas Alternative Investment Advisers  |  info@alfinas.com  |  www.alfinas.com