A look at the EU’s new ESG disclosure standards
ESG investing has been gaining serious traction for some time, but it has been largely un-regulated. Following the EU’s 2018 Action Plan on Sustainable Finance, a new legislative package is currently underway to change that—and investors need to be ready.
The EU has been developing its Action Plan on Sustainable Finance to redirect investments towards sustainable investing (which is needed to enable Europe to meet targets set by the Paris Agreement of 2015 and the European Green Deal) and to provide a framework for sustainability within the asset management space. We can simplify the first regulatory initiatives into three points.
First, the Disclosure regulation will clarify the duties and responsibilities of financial market participants (incl. investment managers and distributors). The Disclosure regulation targets distributors and financial advisors as well as asset managers, so no matter where you are in the value chain, you will have to disclose how you classify your products and how sustainable the underlying investments are. The Disclosure regulation additionally requires the entities to disclose how they deal with sustainability risks in areas such as the investment decision-making process and product classification.
Second, the Taxonomy regulation will provide an aligned vocabulary on environmental aspects, which is aimed at avoiding potential occurrences of greenwashing. When dealing with ESG, sometimes it feels like you do not see the entire forest because of all the different trees. Current regulatory initiatives aim to bring structure to this. The Taxonomy has taken the first steps towards a common set of environmental definitions to be used across the industry.
Finally, updates and amendments will be applied to existing legislations, such as MiFID II, UCITS or AIFMD. We are in the midst of the regulatory process, which means there will be a lot of clarification and alignment to come. That said, we know that MiFID II will require distributors to integrate sustainability preferences into the suitability assessment when providing investment advice or discretionary portfolio management. Sustainability preferences need to be assessed alongside the usual aspects of suitability.
Distributors will need to categorise their products
Providers of products or services in the areas of ESG/sustainability/responsibility will need to categorise and classify their products. While these requirements are not yet fully clear, these changes are significant for distributors, as there will be requirements to assess, document and regularly review the product selection process of a sustainability offering.
If they have not taken any action so far, distributors need to start right away to familiarise themselves with the different regulatory initiatives – especially those with a direct effect. It is crucial to understand interdependencies of the initiatives and the impact on value, change and processes.
Essentially, there are three categories of products. The first is those which follow basic ESG considerations but with the investment objective primarily focused on delivering returns. The second category is Art. 8 Sustainable Finance Disclosure Regulation (SFDR) or ESG products. These are dedicated ESG strategies, which include elements such as exclusion and measures on how to ensure governance practices. The third category, Art. 9 SFDR or Impact products, has a sustainability objective alongside delivering a financial return.
It is important to stress, investors are not sacrificing returns to move to a higher category, it simply means the sustainability requirements are higher. The main challenge for the market is how to decide what the thresholds are. In terms of distribution, the devil really is in the details – as only the Art. 8 and Art. 9 categories are likely to be considered sustainable products, although some further specifications might be needed. If a client desires a sustainable product, you cannot simply offer a basic solution.
We can compare the current situation to the process of moving. As an industry, we have lived in our house for a long time and we are now moving into something new. However, the boxes for our belongings do not fit the things we have—many have not arrived yet. Likewise, this current guidance will be elaborated on in the months and years to come. In the meantime, it is important for advisers to start thinking about their offering and internal processes in relation to sustainable investing. Sustainability offers a potentially huge opportunity to advisors who are early in recalibrating their business model to meet the ESG assessment requirements and offer a good range of sustainable funds. We will be confronted by many challenges along this journey and we at Nordea are committed to making it easier for distributors. We encourage you to reach out and continue the dialogue.
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