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Investors ESG demand drive regulation

Investors’ ESG demands drive regulation

May 2019

Voices clamouring for ESG (environmental, social and governance) investing and carbon controls are increasing. Demand for responsible treatment of employees, customers and other stakeholders is also growing, as is indignation about poorly-managed companies. The investor voice is directly influencing the European regulatory agenda and sustainable finance has now moved onto the global regulatory agenda too.

Two elements of the European Commission’s May 2018 package of legislative proposals have been adopted by the European Parliament and the Council (see below). Finalisation of the “taxonomy” (which includes key definitions – see Asset Management Regulatory Insights May 2018) now awaits the appointment of the new Parliament and Commissioners in the autumn. However, work has already begun in fleshing out the rules at “Level 2”, amendments to the current “suitability” Level 2 rules have been issued, and the Commission is considering the introduction of an eco-label to encourage retail savers to buy green investments. Also, the European Securities and Markets Authority (ESMA) has established a Coordination Network on Sustainability, which will work with national regulators on policy development and integration of sustainability considerations in financial regulation.

Reaction to the original Commission proposals was mixed. A pan-European survey by the Chartered Financial Analyst Institute sums up the investor viewpoint: “Most, but by no means all, institutional investors believe sustainability should be incorporated into portfolios. However most, but not all, investors believe that ESG measures should not be mandated.”

Implications for firms

The new requirements apply to asset managers, investment funds, investing institutions (including insurance companies and pension funds) and intermediaries. By the end of 2020, firms will have to publish their policies on the integration of sustainability risks (SRs) in their investment decision-making process and whether they consider adverse impacts of investment decisions on sustainability factors. They will have to disclose to investors the integration of SRs and the consideration of adverse sustainability impacts in their processes, and provide related information for funds. Importantly, if they do not consider such matters, they will have to state that they do not so, their reasons for not doing so, and whether and when they intend to do so.

In particular, asset and fund managers will have to set up new controls and have sufficient human and technical resources for the assessment of SRs. Remuneration policies will have to be linked to SRs and targets, and all other policies and documentation will need to be reviewed and amended.

It is clear that investor demands coupled with regulatory imperatives mean that consideration of ESG factors is now a must for all asset managers and investment funds.

Further details on the finalised European requirements are provided below. For further details on the global and national regulatory agendas and investor sentiment, look out for this years’ Evolving Asset Management Regulation report, to be launched in June, and please visit KPMG’s Sustainability webpage.

Questions for CEOs:

  1. Could we lose market edge if we choose not to offer ESG services or products (given that we will have to declare that we do not)?
  2. How embedded in our investment offerings and processes is the consideration of sustainability risks? 
  3. Do we currently consider adverse impacts on sustainability factors or only positive indicators?
  4. Do we have skill gaps? 
  5. Do we have gaps in our product or service offerings? 
  6. How well and how regularly are we engaging with clients on this issue? 

A bit more detail…

Two elements of the Commission’s May 2018 package have been adopted by the European Parliament and the Council:

  • Disclosure requirements for institutional investors and intermediaries (implementation by autumn 2020, with later deadlines in certain areas)
  • The creation of new categories of low-carbon benchmarks (implementation by April 2020)

Also issued are amendments to the Level 2 regulations under MiFID II and the Insurance Distribution Directive (IDD) to integrate ESG considerations into firms’ suitability tests. These cannot formally be adopted until the Disclosure Regulation has been published in the Official Journal.

Disclosures to investors

  • Financial market participants (including asset managers, fund managers and pension funds) and financial advisers must make disclosures on the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of related information on financial products (including funds and pension products). 
  • Sustainable investments are defined as investments in an economic activity that contribute to:
    • An environmental objective, such as measured by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste and greenhouse gas emissions, and on the impact on biodiversity and the circular economy
    • A social objective, in particular that contributes to tackling inequality, or that fosters social cohesion, social integration and labour relations, or that invest in human capital or economically or socially disadvantaged communities

      provided that the investments do not significantly harm any of those objectives and the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of relevant staff and tax compliance.
  • A SR is defined as an ESG event or condition that could cause an actual or potential negative impact on the value of the investment arising from an adverse sustainability impact.
  • Financial market participants must publish on their websites their policies on the integration of SRs in their investment decision-making process.
  • They must also publish whether they consider adverse impacts of investment decisions on sustainability factors and, if they do, their due diligence policies, including the identification, prioritisation and description of principal adverse sustainability impacts, and action taken or planned.
  • If they do not perform such considerations, they must state that they do not do so, their reasons for not doing so, and whether and when they intend to do so. 
  • All firms must include in their remuneration policies information on how they are consistent with the integration of SRs.
  • Pre-contractual disclosures (e.g. fund prospectuses) must include descriptions of the manner in which SRs are integrated into their investment decisions and assessment of the likely impacts of SRs on the returns of financial products, or a clear and concise explanation of why SRs are not relevant.
  • Financial products that have sustainable investment objectives must disclose methodologies used to assess, measure and monitor the E or S characteristics, or the impact of the sustainable investments. If a product has designated an index, it must disclose how the index is aligned to the objective and why it differs from a broad market index.
  • By 2022, each financial product shall also disclose a clear and reasoned explanation of whether, and if so how, it considers principal adverse impacts of sustainability factors, or why it does not do so. 
  • Further Level 2 measures will be drawn up in most areas. It is likely, therefore, that firms will need to come into compliance with the requirements before all details are known or face a very rushed implementation.

Low-carbon benchmarks

Two new benchmarks have been created: the EU Climate Transition Benchmark (CTB) and the EU Paris-aligned Benchmark (PAB):

  • CTB: the underlying assets are “selected, weighted and excluded in such a manner that the resulting portfolio is on a decarbonisation trajectory”:
  1. Companies disclose measurable and time-based carbon emission reduction objectives
  2. Companies disclose a carbon emission reduction which is disaggregated down to the level of relevant operating subsidiaries
  3. Companies disclose annual information on progress made towards those objectives
  4. The activities of the underlying assets shall not significantly harm other ESG objectives

A decarbonisation trajectory means a “measurable, science-based and time-bound trajectory to reduce scope 1, 2 and 3 and carbon emissions towards the alignment with the long-term warming target of the Paris Climate Agreement”.

  • PAB: the underlying assets are “selected in such a manner that the resulting benchmark portfolio’s carbon emissions are aligned with the long-term global warming target of the Paris Climate Agreement.”

An explanation must be given of how the key elements of the methodology reflect ESG factors for each benchmark or family of benchmarks (excluding currency and interest rate benchmarks). Exclusions will include, for example, companies that are associated with a level of carbon footprint or fossil fuel reserves that is incompatible with inclusion in the benchmark. If a benchmark does not pursue ESG objectives, this must be clearly stated.

Further Level 2 measures will specify:

  • The criteria for the choice of underlying assets, including, where applicable, any exclusion criteria
  • The criteria and method for weighting of the underlying asset.
  • For CTBs, the determination of the decarbonisation trajectory 
  • The standard format to be used for references to ESG factors.

Suitability tests

The amendments to the MiFID II and IDD Level 2 rules that have already been issued are short. It is the further Level 2 changes under consideration that merit close attention by firms. They will impact fund managers and distributors.

In May 2019, ESMA issued its final advice to the Commission on these further Level 2 amendments, which include:

  • Taking ESG preferences into account when assessing clients’ investment objectives and in product classification
  • Requiring UCITS managers and AIFMs to incorporate SRs into their internal procedures and investment processes, and to identify and manage conflicts of interest
  • Minimum disclosure requirements on whether and how ESG factors were included in credit ratings

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