With the final report on the EU taxonomy for climate change mitigation and climate change adaptation (Green Taxonomy) due in the week beginning 17th June, Ethical Screening takes a look at the details of the EU Action Plan, and progress towards implementation to date. Implications for investment management in the UK, with or without Brexit, are also discussed, with a focus on proposed changes to MiFID II.
The High-Level Expert Group on Sustainable Finance
In the wake of developments highlighting the pressing need for action on sustainability, such as the 2015 Paris Agreement, the EU Commission created a High-Level Expert Group on Sustainable Finance (HLEG). To implement recommendations in the report the European Commission officially adopted an Action Plan on Sustainable Finance, in March 2018.
The Expert Group's mandate focused on supporting the EU Commission on how to:
- Steer the flow of public and private capital towards sustainable investments;
- Identify the steps that financial institutions and supervisors should take to protect the stability of the financial system from environmental risks; and
- Deploy these policies on a pan-European scale.
The HLEG report made strategic recommendations in three main subject areas:
- Reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth;
- Mainstream sustainability in risk management; and
- Foster transparency and long-termism in financial and economic activity.
Based on these recommendations, the Action Plan on Sustainable Finance key actions include:
- Establishing a clear and detailed EU classification system - or taxonomy - to identify sustainable activities, and create a common language for all actors in the financial system;
- Establishing EU labels for green financial products, to help investors identify products that comply with green or low-carbon criteria more easily;
- Introducing measures to clarify asset managers' and institutional investors' duties regarding sustainability;
- Strengthening the transparency of companies on their environmental, social and governance (ESG) policies; and
- Introducing a 'green supporting factor' in the EU prudential rules for banks and insurance companies to incorporate climate risks into their risk management policies, and support financial institutions that contribute to fund sustainable projects.
The Technical Expert Group on Sustainable Finance
In July 2018 the EU Commission appointed a Technical Expert Group (TEG) to assist in the development of the classification system; an EU green bond standard; methodologies for low-carbon indices; and metrics for climate-related disclosure. Composed of 35 members from civil society, academia, business and the finance sector, and additional members and observers from EU and international public bodies; the TEG is expected to operate until June 2019, with a possible extension until end-2019.
The Action Plan and its Connected Legislative Initiatives
Within the framework of the planned reforms, in May 2018 the EU Commission adopted 4 legislative proposals:
- Taxonomy: a new regulation to establish the framework to facilitate sustainable investment. This is the most important of the four initiatives, since all the Action Plan architecture rests on the concept of "green taxonomy";
- Disclosure and Audits: a new regulation, targeting institutional investors and asset managers, mandating a series of disclosures relating to sustainable investment and sustainability risks. As of May 2019, the European Parliament and the Council have reached a political agreement on this proposed "Disclosures Regulation", which is expected to be adopted in Q3 2019.
- Benchmark: a new regulation to create "low-carbon" and "positive carbon impact" benchmarks;
- Consultation on Sustainability Preferences: amendments to the existing MiFID II and IDD Directives, to include ESG considerations.
Currently, significant work is being undertaken with European Supervisors, and their counterparts in each Member States, to define the technical details regarding the implementation of these proposals.
CHANGES TO MIFID AND ESMA TECHNICAL ADVICE
While all these activities deserve a closer look, the following focuses on amendments to the delegated acts (instruments used to enact European legislation) adopted by the EU Commission, within the framework of MiFID II.
In July 2018 the EU Commission requested technical advice (from the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA)) regarding the integration of sustainability risks and factors under a number of legislative measures, including MiFID II. ESMA published its proposed technical advice and, following a consultation period which yielded comments from more than 60 respondents, it published the final text of the proposed changes on 30th April this year.
In its technical opinion, ESMA acknowledges that the market has not yet reached maturity, and wants to avoid the risk of putting Europe at a global competitive disadvantage by creating overly prescriptive norms that would lead to regulatory complexity or legal uncertainty. For these reasons, it suggests a high-level principle-based approach applied with a proportionality principle in mind.
Changes to General Organisational Requirements
The first proposed change involves the incorporation of sustainability risks within the requirements set for investment firms' internal organisation. This includes the firms' processes, systems and controls; their risk management functions; and the processes to eliminate conflicts of interest.
The proposed Disclosure Regulation defines sustainability risk as: "...an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment arising from an adverse sustainability impact."
In future 'Sustainable activities' will be defined by the EU Taxonomy but, in the meantime, investment firms are expected to take a broad approach to assessing potential sustainability risks and can rely on external data providers. Note that the Taxonomy will not, at least initially, cover social and governance issues (the latest suggested text explicitly does not include social issues).
- Incorporating ESG considerations within processes, systems and controls - This requirement includes ensuring that staff possess the skills, knowledge and expertise for the assessment of sustainability risks. ESMA believes that these new provisions will not require firms to hire new staff. Instead, investment firms are invited to invest more systematically in ESG expertise, also through employee and board-member training. Investments can also include buying relevant data from third-party vendors, further task specialisation and more active engagement with companies on ESG topics.
- Risk Management - ESMA specifies that both the compliance function and internal audit must consider issues related to sustainability risk. As a response to the results of the consultation, ESMA amended the suggested text, extending this responsibility to a firm's management body and senior management.
- Conflict of Interest - According to ESMA, when identifying possible conflicts of interest which may damage the interest of a client, investments firms should also consider those "stemming from the distribution of investments in companies with strong ESG practices, or financial instruments that provide exposure to sustainable, social, and/or good governance investments".
In practice, the process to assess the presence of a conflict of interest does not change, but ESMA is clarifying that references to sustainability must not provide an excuse to sell own-products or more costly ones, or allow firms to misrepresent products or strategies as fulfilling ESG preferences where they do not.
In summary, the inclusion of ESG considerations in the advisory process must not lead to mis-selling practices or misrepresentations, and must not damage the interest of the client. Firms are expected to include a clear reference in their conflict of interest policy on how these risks are identify and managed.
Changes to Product Governance
The goal of the proposed amendments in this area are to ensure that, when considering ESG factors and sustainability risks, firms act in the clients' best interests throughout the life-cycle of products or services (applying to manufacturers and distributors).
The procedure mirrors that set out in ESMA's "other target market assessment requirements, which cover not only the manufacturing of the product, but also its distribution and review.
Manufacturers and distributors are expected to specify, with a meaningful level of granularity, which ESG preferences the investment product fulfils. This is aimed at avoiding general descriptions of target markets, such as "clients who are interested in environmentally sustainable, social and good governance investments".
Some respondents to the public consultation expressed reservations about this approach, stating that it would unduly increase the complexity of the suitability assessment. ESMA took note of the criticism, but decided not to change the text of its advice, stating that the principle-based approach adopted does not impose a specific approach to firms. However, it also committed to providing further guidance on this topic in future.
Changes to the Suitability Assessment
According to the new regulation firms will have to:
- take into account their clients' ESG preferences in assessing the investment objectives; and
- consider ESG factors in the context of product classification
While the requirements to take into account certain factors is not new, the integration of ESG preferences is a potentially ground-breaking change. Indeed, while the current ESMA guidelines note that it would be a "good practice" for firms to consider non-financial elements, the new text suggests that firms "should" collect such information, thereby creating a much more stringent requirement.
In response to worries raised during the drafting of its technical advice, ESMA clarified that ESG preferences do not take precedence over other suitability criteria. They just contribute to the assessment, after suitability has been addressed in accordance with the criteria of knowledge and experience, financial situation and investment objectives.
In line with the high-level approach underlying the whole system, firms will be allowed to take a range of approaches to achieve compliance, without there being a prescribed one.
Regarding their entry into force, the new delegated acts are expected to be introduced after the adoption of the Disclosures Regulation, and in all likelihood by the end of 2020. This is based on the consideration that the adoption of the updated MiFID II delegated acts by the Commission has to be followed by a 3 to 6 months objection period by the European Parliament and the Council, and then a 12 months delay for their entry into application.
It is also worth noting that ESMA acknowledge that some further changes to the delegated acts implementing MiFID II might be needed in light of the new requirements introduced in the proposed Disclosure Regulation.
As of yet, it is uncertain what effect Brexit will have on the application of the legislation. However, it is expected that, unless there is a hard Brexit on 31st October 2019, the transition period for Brexit (originally to end on 01/12/2020), together with the option to extend it by 1 or 2 years, will mean that the updated legislation will have time to enter into force in the UK.