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The ESG regulation advisers need to know about

Guest authors

Factoring in ESG to the advice process may soon be a risk, regulatory and client necessity. We take a closer look at the ESG regulatory changes advisers should know about.

Over the past few years, regulators have been paying more and more attention to the role of Environmental, Social and Governance (ESG) factors in investment risk and performance. At the same time, there’s  been a surge in societal interest in this area which has driven a need for better  scrutiny and transparency to protect clients.

As a result, a raft of EU regulation on sustainable finance is due to come into force. And the ESG amendment to the Markets in Financial Instruments Directive (MiFID II) is the rule that would have the biggest impact on advisers. As the situation stands, from March 2021, it would be  mandatory for clients’ ESG preferences to be taken into account as part of the suitability review.

The rule focuses on improving disclosure by investment managers on sustainability risk. It means advisers would have to:

  • take sustainability risks into account when selecting financial products for clients
  • ask clients about their ESG preferences as part of the suitability review
  • explain how clients’ ESG preferences have been incorporated into the recommendation, although only after clients’ investment objectives, risk level and time horizon have been identified.

Sustainability risk would also be integrated into the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for the Collective Investment in Transferable Securities (Ucits) although these amendments largely focus on improving disclosure requirements from asset managers.

 

The EU vision on the role of finance in sustainable economic growth  

All the EU proposals which have been progressing through the legislative process are integrated into various directives in a bid to drive ESG further into the mainstream. Regulators have recognised the importance of directing capital into sustainable investments that can support healthy economic growth.

The EU Action Plan for Financing Sustainable Growth, published  in 2018, sets out the EU’s vision on the role of finance for a long-term resilient economy. It proposes these regulatory changes to enable the transition to a sustainable financial system and a low-carbon economy.

The action plan supports both the Paris Agreement target of a neutral-carbon economy by 2050, and the United Nations (UN) Sustainable Development Goals and proposes:

  • Sustainable Finance Taxonomy: this is an EU-wide classification system and performance thresholds to help investors, companies and other stakeholders measure sustainable economic activities. Companies must show that their activities make a substantive contribution to one of the taxonomy’s six environmental objectives.
  • Climate Benchmarks and Benchmarks’ ESG Disclosures: the objective here is to enhance the ESG transparency in the methodologies of benchmarks and to propose standards for low-carbon benchmarks.
  • Green Bond Standard: its goal is to enhance the effectiveness, transparency, comparability and credibility of the green bond market; it also has an objective to encourage market participants to issue and invest in EU green bonds.
  • Corporate disclosure of climate-related information: this is guidance for companies on how to report both the impact of their business on the climate and the effects of climate change on their business.
  • Sustainable Finance Disclosures: this proposal requires asset managers to publish policies on how they integrate sustainability risks into their investment decision-making processes.

In the UK, the Financial Conduct Authority has stated that it plans  to match the aims of this EU Action Plan.

 

Shareholder rights and a major change in corporate governance

In force since September  2020, The Shareholder Rights Directive II (SRD II) is an EU directive with an objective to:

  • strengthen the position of shareholders
  • prevent voting abuse
  • reduce short termism and excessive risk taking by companies.

These issues became apparent during the global financial crisis, so this directive marks a major change in corporate governance.

 

Better disclosure on how companies manage social and environmental challenges

A directive has also been introduced which requires large companies to disclose information on the way they operate and manage social and environmental challenges. The Non-Financial Reporting Directive (NFRD) aims to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies. It also encourages companies to develop a responsible approach to their business operations.

 

Dialing up the importance of stewardship

In October 2019, the Financial Reporting Council published an updated version of the Stewardship Code. The Code, first published in 2010, contains principles and guidance to enhance the quality of engagement between institutional investors and companies. The aim is to improve long-term returns to shareholders and help with the efficient execution of governance responsibilities.

The update to the Code  took effect on 1 January 2020 and requires signatories to report annually on their actions. It also contains new expectations around how investment and stewardship should be integrated, including ESG issues.

 

Supporting UK economic policy for sustainable economic growth

The UK Green Finance Strategy was launched in 2019 with a goal to support the UK’s economic policy for strong, sustainable and balanced economic growth. The strategy also aims to deliver the government’s commitments on climate change, the environment and sustainable development. It has three core elements.

  • Greening finance: to ensure financial risks and opportunities from climate and environmental factors are integrated into mainstream financial decision making; in addition, that the markets for green financial products are robust.
  • Financing green: to accelerate finance to support the UK’s carbon targets and clean growth, resilience and environmental ambitions. It also aims to support international objectives.
  • Capturing the opportunity: ensuring UK financial services capture the domestic and international commercial opportunities arising from the ‘greening of finance’, including climate-related data and analytics. It also has a goal to capture opportunities from ‘financing green’, such as new green financial products and services.

 

Improving ESG standards and practices across the globe

Regulators across the rest of the world are also looking to improve ESG standards and practices. For example, the US and Asia are likely to focus on ESG Capital Market regulations.

One other global initiative which is helping to bring greater transparency to climate risk throughout the world’s markets is the UN Principles for Responsible Investment (PRI). It’s now mandatory for PRI signatories to adopt the Taskforce on Climate-related Disclosures (TCFD). This initiative should help make markets more efficient and economies more stable and resilient.

 

Regulations that provide much needed clarity

The amount of regulation going through the  EU legislative process highlights the scale of change around responsible and sustainable investing.

Although the ESG amendment to MiFID II would have a direct impact on advisers, all these regulations will provide much needed clarity for clients who wish to understand the ESG worthiness of their investments.

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