Sustainable finance

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rules, rules and more rules

18 months ago we alerted readers that, as a result of the Paris treaty on climate action, policy makers were beginning to turn their attention to how they can encourage or require institutional investors and asset managers to adopt strategies that will support countries in meeting their new commitments. We predicted that new regulation would ensue. After a consultation and a report by the High-Level Expert Group, the European Commission has now released a package of legislative proposals and further consultation.

The largest part of the package is a Regulation to establish the criteria for determining whether an economic activity is “environmentally-sustainable” – the taxonomy. It will apply to the following types of financial market participants:

portfolio managers
management companies of UCITS, AIFs, EuSEFs¹ and EuVECAs²
insurance companies offering insurance-based investment products
occupational pension funds
pension product providers

This focus on the first factor of ESG (environmental, social, governance) is very marked. In contrast, the 'social' and 'governance' factors receive only short references in the separate Regulation on disclosures. Moreover, the text on 'social' investment is not the same as and does not refer to the definition in the EuSEF Regulation.

Extract from the draft Regulation on disclosures, Article 2:

“(o) ‘sustainable investments’ mean any of the following or a combination of any of the following:

investments in an economic activity that contributes to an environmental objective, including an environmentally sustainable investment as defined in Article 2 of [the Taxonomy Regulation];
investments in an economic activity that contributes to a social objective, and in particular an investment that contributes to tackling inequality, an investment fostering social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities;
investments in companies following good governance practices, and in particular companies with sound management structures, employee relations, remuneration of relevant staff and tax compliance”

The Taxonomy Regulation sets out six environmental objectives:

climate change mitigation
climate change adaptation
sustainable use and protection of water and marine resources
transition to a circular economy, waste prevention and recycling
pollution prevention and control
protection of healthy ecosystems

For an activity to be environmentally-sustainable, it must contribute substantially to one or more of these objectives, not significantly harm any of them, and comply with minimum safeguards and technical screening criteria, which will be set out in a Delegated Act.

It is notable that the main body of the rules (Articles 3-12) will not apply until six months after the relevant Delegated Acts have entered into force – that is, between July 2020 and December 2022. Given the considerable amount of work still to be undertaken by the Commission and the European Supervisory Authorities (ESAs) on the taxonomy, there is an overarching question whether it is too soon to begin discussing the various other requirements – set out in four further Regulations.

One of the additional Regulations covers disclosures by the financial market participants listed above. It is to be underpinned by various Delegated Acts and Regulatory Technical Standards.

The disclosures cover:

publication on the website of the firm’s written policy on the integration of sustainability risks in their investment decision-making process;
pre-contractual information on the procedures and conditions for integrating such risks in investment decision, the extent to which these risks are expected to have a relevant impact on the returns of the financial products available, and how the firm’s remuneration policy is consistent with the integration policy and, where relevant, with the sustainable investment target of the financial product;
for financial products that target sustainable investments or that have similar characteristics (it is unclear what this means): information on any designated index or how the investment target will be reached; and reference, where appropriate, to reduction in carbon emissions;
for each such product, publication on the website of a description of the sustainable investment target, the methodologies used to assess, measure and monitor the impacts, etc; and
periodic reports describing the overall sustainability-related impact by the financial product judged against relevant factors and, where relevant, its impact relative to any designated index.

Readers will note that the articles frequently refer to “financial products”, which will likely cause interpretation and implementation issues in the context of portfolio management (a service).

Another Regulation amends the Benchmarks Regulation to include references to “low-carbon benchmarks” (one which has less carbon emissions compared to a standard capital-weighted benchmark) and “positive carbon impact benchmarks” (for which the underlying assets are selected on the basis that their carbon emissions savings exceed the assets’ carbon footprints). Again, this Regulation will be underpinned by Delegated Acts.

The last two – short – Regulations insert into the MiFID II and IDD Delegated Regulations requirements for intermediaries to seek information about and to have regard to clients’ ESG preferences.

This is a substantial package of proposals, with very many more pages to come in the form of Delegated Acts and Regulatory Technical Standards. The specific reference to the Taxonomy Regulation not taking effect until the various Delegated Acts are in place may be welcome by national regulators and the industry, but there is much work to be done in articulating what all these requirements actually mean in practice. Overall, the package constitutes a major set of new regulatory requirements that will impact many types of institution. It seems that a legislative pause for the industry to embed “business as usual” is unlikely to be granted in the short term.

It is important that asset managers, fund managers and institutional investors engage in the European debate, to have a regular dialogue with their clients and beneficiaries on sustainability issues, and to evolve their investment strategies, product options and disclosures for a world in which sustainable finance is the regulatory norm, not a “nice to have”.

Questions for CEOs

How embedded in our investment offerings and processes is the consideration of sustainability? Do we have skill gaps?

Do we know what best practice looks like? Do we want to be in the lead or lag behind?

Do we need to undertake a review of our current investment governance and decision-making processes? What assurance does the Board receive and from whom?

How well-prepared is our second line of defence (e.g. Risk) to challenge the first line in the identification, management and monitoring of these risks?