"We are our choices"
- John Paul Sartre
In June, I joined Simo Liu in BBH Investor Services’ Beijing office for a video discussion on environmental, social and governance (ESG) themes that continue to occupy the minds of many global asset managers. A key area we flagged relates to “point of sale” regulation, which is trending towards more detailed requirements across different investor priorities.
In the context of ESG, an EU product manufacturer, a distributor of a fund product or other investment firm regulated by the Markets in Financial Instruments Directive II (MiFID II) will be required to ensure that customers and prospective investors have clear information on the social and environmental risks and opportunities attached to their investments.1 Manufacturers and distributors are expected to disclose sustainability factors in a transparent way that allows investment firms to engage in dialogue with clients and investors so that they have a sufficiently granular understanding of individual sustainability preferences in line with MiFID II suitability requirements.
The new amendments take effect on August 2, 2022.
Meanwhile, the new European ESG Template (EET) is intended to facilitate the necessary exchange of data between a product manufacturer and distributor to fulfill ESG-related regulatory requirements contained in the Sustainable Finance Disclosures Regulation (SFDR), relevant provisions of the Taxonomy Regulation,2 and relevant delegated acts in connection with MiFID II and the Insurance Distribution Directive (IDD).3
To put these initiatives into context, let’s first focus on the broader MiFID requirements.
Moving Beyond Sustainability Preferences
There are three types of sustainability preferences set out under the new requirements that can be described broadly as (i) EU Taxonomy alignment, (ii) percentage of investments deemed sustainable by SFDR, or (iii) consideration of principle adverse impact (PAIs).4
A complicating factor is that an investor might express a preference for a mixture of the three preferences or want all three considered. The preference expressed by the investor must be matched to a product satisfying the preference and should be consistent with a fund’s EET.
If a fund manufacturer or distributor does not have an existing product to match the preference expressed, a discussion with the investor may take place so that the preference is adjusted to match existing funds. There is some explaining by the manufacturer or distributor required to square this circle and it carries with it a risk of claims of mis-selling or greenwashing. It will therefore be important to document the basis of any adaptation.
All other existing MiFID suitability considerations, such as financial circumstances, risk tolerance, knowledge, and experience, will continue to apply. Sustainability preferences layered on top of all of this will further complicate the point of sale interaction. Investors may choose more rather than less ESG, putting more pressure on a manufacturer or distributor to match a suitable product with a correctly-calibrated level of ESG conviction. This level of investor engagement will require more consideration supported by data that goes beyond the current focus on categorizing funds under Article 6, 8 or 9 of SFDR.
Where an investor opts for a fund which measures itself by its percentage of sustainable investments defined under SFDR, the fund manufacturer must decide on what minimum percentage they are willing to commit to and how any explicit number might be perceived by prospective investors. Questions to consider include: is 80% alignment “good” and is the correct data available to support it – both at the level of the individual portfolio holding and the portfolio composition as a whole?
The Timeline Challenge
Like many other EU ESG policy rollouts this one is challenging from a timeline perspective. There are several challenges evident as we traverse through an undulating EU ESG landscape, including:
- The final guidelines for conducting sustainability preference assessments under MiFID II are not expected until late 2022;
- The EU Taxonomy remains a work in progress and currently lies in limbo after a major political disagreement about inclusion or exclusion of gas and nuclear within the green taxonomy;
- The detailed disclosures under SFDR for Article 8 and 9 funds will greatly help these assessments. However, the Level 2 detailed SFDR disclosure templates only come into effect in 2023 – again sometime after the August 2, 2022, imposition deadline;
- The underpinning data for the assessments and the EET remains far from complete and the main policy to reduce this data scarcity issue comes in the form of the Corporate Sustainability Reporting Directive (CSRD)5. While this directive does not actually kick-off until 2024, “equivalent information” may be used in the interim. However, there is no assurance regarding whether and how much additional Taxonomy data will come online from issuers in advance of CSRD going live.
ESG is Everywhere, But it’s All About the Manager’s Story
So, as I continue to believe ESG is everywhere, it will now form the basis of a mandatory point of sale conversation for most or all fund sales in Europe. This will increase the focus on how well asset managers and their distributor network can speak to a fund’s ESG story. There will be success stories, and fund sales will increase, but there will also be risk. The risk of being accused of greenwashing—and the need to avoid this—will be on the minds of everyone in the industry.
The requirements are yet another case of ESG presenting managers and distributors with great opportunity but also great challenge.
1 Amendments of 22nd April 2022 amending Delegated Directive (EU) 2017/593 as regards the integration of the integration of sustainability factors into the product governance obligations. Available at: https://ec.europa.eu/info/law/better-regulation/have-your-say/initiatives/12067-Sustainable-finance-obligation-on-investment-funds-to-advise-clients-on-social-environmental-aspects_en
2 The Taxonomy Regulation establishes a classification system (or taxonomy) which provides businesses with a common language to identify whether or not a given economic activity should be considered "environmentally sustainable"
3 The IDD regulates how insurance products are designed and distributed in the EU
4 MiFID II Delegated Regulation, Article 2 (7).
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