SUSTAINABILITY IN FOCUS
The Holy Trinity Supporting ESG Investing
SFDR, amended MiFID II and ESG labels
Measures introduced under the EU Action Plan on Financing Sustainable Growth include the requirement to disclose sustainability risks and to clarify clients’ sustainability preferences. Although they are complimentary, these measures still need to be supported by ESG labels for external validation.
While sustainable investing has been around for decades, it has seen explosive growth in recent years, together with more widespread acceptance that the climate transition would require massive capital spending. And so, regulators became involved. The European Union has passed a package of measures in the form of an Action Plan on Financing Sustainable Growth. This plan is probably one of the fastest-adopted and most-efficient reforms the EU has seen, mainly because it begins with the highly regulated financial sector. As such, instead of regulating every single sub-industry, it introduces only a few paragraphs into the regulations governing the financial sector – a highly effective lever that can be deployed to convince companies to report and consider ESG risks.
This has two far-reaching consequences: First, the time of “free-style” approaches to sustainable investments is over. Self-assessment and the obligation to clarify client preferences will automatically increase demand for external verification and ESG labels. A general market standard will therefore soon be established. The second consequence is the emergence of a new product class. With the introduction of a category of investment products with clear sustainability objectives, customers will at last have more transparency and clarity on what they are getting. Instead of nebulous ESG ratings, for instance, information is now provided on what percentage of portfolio companies’ earnings support the energy transition, and how long it will take to reduce the portfolio’s carbon footprint to net zero.
The EU Action Plan creates a new sustainability governance
The purpose of the Action Plan on Financing Sustainable Growth published by the EU Commission in March 2018 is to reorient capital flows towards a sustainable economy, place greater emphasis on sustainability risks in financial analysis and improve the transparency of sustainable financial products. Two key components include the Sustainable Finance Disclosure Regulation (SFDR), which recently came into force, and the amended Markets in Financial Instruments Directive II (MiFID II), which introduces the obligation to clarify clients’ sustainability preferences.
SFDR – disclosure is not the same as rating
Obligations regarding the reporting of sustainability risks came into force in March 2021. They require financial institutions to disclose and explain – both at the company and product level – whether, and how, sustainability criteria are considered in investment decisions and how the incentive structures are set. The goal is to ensure investors have access to transparent information.
Source: Bank J. Safra Sarasin, 15.6.2021 based on BNP Paribas AM, 2021
At the product level, SFDR proposes three possible variants, based on the relevant articles in the regulation:
Article 6: Products without a sustainability promise do not have to include any sustainability criteria. In this case, an explanation must be provided on why sustainability risks are not considered.
Article 8: Products with a sustainability commitment must disclose exactly how the sustainability risks and characteristics are included and how they compare to the benchmark (if relevant).
Article 9: Products must explicitly pursue a sustainability goal. In addition to the integration of sustainability risks, the objective and the adaptation path must also be presented (if relevant, also compared to a benchmark).
Both the fulfilment of the sustainability criteria in Article 8 products and the fulfilment of the sustainability objectives of Article 9 products must be reported regularly. It is important to understand that the distinction made in the SFDR only provides a limited explanation of the sustainability quality of the underlying products. This is not the objective of the regulation. Rather, its sole purpose is to create greater transparency by introducing the obligation of disclosure. Article 8 financial products, for example, may have very different sustainability qualities and risks. Neither is there any guarantee that an Article 9 product has more of a sustainability impact in the real world than an Article 8 product.
MiFID II – client’s sustainability preferences are paramount
The amendments to MiFID II proposed by the European Commission focus on the clients’ sustainability preferences and how they can be accommodated. The aim is to extend the high standard of investor protection to sustainability in investment strategies and to encourage demand for sustainable investments. In concrete terms, the amendment requires financial service providers to ask customers about their sustainability preferences and to recommend suitable products on this basis. Although they will most likely still be able to recommend products with no sustainability promise, it must be clear that these do not satisfy the client’s sustainability preferences.
However, the regulations do not specify exactly what the phrase “suitable from a sustainability perspective” means. Although the amendments to MiFID II refer to the EU taxonomy and SFDR, they are only references to suitable instruments, not to how the result is to be interpreted. Scope for interpretation is therefore deliberately left open for national players. This is also known as “target market compatibility”, which needs to be defined. This requires the involvement of national regulatory authorities and associations that define target market compatibility, therefore providing a framework for sustainability quality. We expect this in turn to increase the importance of sustainability labels, which are presumably the simplest way for financial service providers to meet the different national standards for sustainability quality. Because they allow the investor straightforward comparability, we think sustainability regulations will significantly boost demand for ESG labels.