By Ryan Medlock, Royal London’s Senior investment development and technical manager.
The surge in momentum behind responsible investing continues to accelerate with record flows continuing to be pumped into Sustainable funds. In addition to this client demand and many prominent societal shifts taking place, the finishing touches are being made to a number of regulatory proposals that are likely to have a fundamental impact on the financial advice process. This is predominantly being driven at a European Union (EU) level and central to this is the European Commission’s (EC) Sustainable Finance Action Plan.
A little piece of context
In recent years, the EU has publicly backed its commitment to international accords such as the Paris Agreement and the UN’s Sustainable Development Goals. Sustainable finance is one mechanism being used towards meeting the 2050 carbon-neutrality goal and this is where the Sustainable Finance Action Plan comes into play.
There are a number of recommendations within this plan such as the creation of an EU taxonomy, the Sustainable-Finance Disclosure Regulations (SFDR) and development of Sustainability Benchmarks.
But that’s not all because in addition to these proposals, the EC made a formal request to the European Securities and Markets Authority (ESMA) to integrate sustainability risk into a number of delegated acts including MiFID II. This is undoubtedly the big one for the financial planning community because it injects ESG considerations into the heart of the advice process.
Although this package of proposals are been driven at an EU level, it is likely that these measures will be transcribed into UK Law over similar timescales. Let’s explore the main legislative proposals within this package:
- EU Taxonomy: a framework to label green activities
- Disclosure: a common way to inform investors of sustainable risk & investment types
- Benchmarks: two new categories plus additional disclosure requirements
- MiFID II: integrating sustainability risk and amendments to Article 25
The number one recommendation in the action plan is the creation of an EU taxonomy which is a classification system to help investors determine which financial products are ‘sustainable’.
To meet taxonomy eligible criteria, investments must meet one of six environmental objectives including climate change mitigation and pollution prevention. In addition, investments must also fulfil certain obligations such as substantially contributing to one of the environmental objectives and also comply with minimum social safeguards.
The taxonomy is due to be fully put into application by 2022 and advisers will be able to identify how much a particular investment product invests in taxonomy-eligible activities, for example. The taxonomy will also be aligned with the goals of both the Paris Agreement and the UN SDG framework.
Sustainable-Finance Disclosure Regulations (SFDR)
The SFDR is the EU’s primary mechanism for promoting the integration of sustainability risks (the risk of investment fluctuation due to ESG factors) into the investment process as well as disclosing these risks and sustainability targets to investors. The regulations take a different direction from other recent pieces of EU legislation in moving towards a more mandated and prescribed feel by setting strict disclosure standards to combat the threat of greenwashing.
The regulations cover pre-contractual disclosures, disclosures in reports as well as website disclosures and marketing communications. The regulations also distinguish between two types of investment products:
- Article 8 investments: products promoting environmental or social characteristics, and
- Article 9 investments: products which have a sustainable investment objective.
There are a number of implications for advisers. This includes publishing information, such as a policy statement, on adviser websites highlighting how sustainability risk is integrated into the advice process as well as detailing this information in pre-contractual disclosures.
In addition, if an adviser promotes the ESG characteristics of either an Article 8 or Article 9 investment, the disclosures must include reference to how these characteristics are achieved. In reality, advisers should be able to satisfy the various requirements by passing-through the relevant disclosures from product manufacturers. However, firms will need to ensure they have a robust process in place to satisfy these regulations.