Ethical/SRINov 7 2019

Regulating ESG investments

Supported by
Royal London Asset Management
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Supported by
Royal London Asset Management
Regulating ESG investments

It is also starting to appear in financial services regulation.

Earlier this year, EU financial regulator the European Securities and Markets Authority put forward a series of additions to the already vast Mifid rulebook to bring in ESG and sustainability measures.

Muddying the waters

However, ESMA was deliberately vague in some of its additions, citing the immature nature of the ESG investing market.

The regulator did not want to put the EU at a competitive disadvantage to other countries and regions by being too prescriptive.

As a result, Mifid amendments include statements such as: “Where ESG considerations are relevant for the provision of investment services to clients, firms should take them into account.”

The Financial Conduct Authority’s 1,000-page implementation document for the EU rules did not do much to make things clearer.

As ESG concerns and climate change grab more of the public’s attention and become more of a concern to clients, how should advisers proceed?

Key Points

  • Mifid requires advisers to consider ESG concerns with their clients
  • The EU is working on a taxonomy for green credentials
  • The suitability of a product will trump any green credentials

Des Fitzgerald, senior policy adviser at the adviser trade body Pimfa, explains that Mifid requires financial advisers to “take sustainability into account” when going through a suitability assessment.

However, “what ‘sustainable’ is remains unclear”, he says.

Advisers should not expect the FCA’s handbook to be updated with a set of explicit ESG rules, Mr Fitzgerald adds.

He says: “It’s more likely to be an organic evolution of practice and experience, because advisers and firms need to factor in issues like the Financial Ombudsman Service and how it will interpret cases where there is a dispute about sustainable finance, in the absence of specific rules.”

Mike Barrett, consulting director at The Lang Cat, also highlights the regulator’s PROD handbook as the best guide for how to take ESG factors into consideration, especially as the wording of Mifid is “not that prescriptive” in this area.

The FCA’s handbook explains that product providers must analyse their client base and identify a specific target audience for any new product.

For distributors – which, in the FCA’s language includes financial advisers – the requirements are similar: advisers must assess their clients’ needs before identifying appropriate products. As Mr Barrett explains, failure to do this could result in a “clear breach” of FCA rules.

Pimfa’s Mr Fitzgerald says: “In practical terms, the adviser meeting a retail client will have to assess how relevant a green investment is to a consumer, based on that consumer’s circumstances. But ultimately the suitability of a product will trump any green wishes.

“So if you have £100 and you need £10 a year to pay for food, and the only investment that will replenish the £10 is in a less-than-A-rated green product, this would be okay as the need for £10 trumps the need for green.

“But the adviser would need to document this, just as they would document, for example, why they picked plan B when plan A looks perfectly suitable and has lower charges.”

Some wordings seem aimed more at avoiding doing something ‘wrong’, rather than stating how to get things ‘right’, says The Lang Cat’s Mr Barrett.

For example, one of the Mifid amendments states that companies “should have in place appropriate arrangements to ensure that the inclusion of ESG considerations in the advisory process and portfolio management does not lead to mis-selling practices”.

This means advisers should not use ESG criteria alone as an “excuse” to sell their own products or products that cost more, the amendment states. Similarly, ESG criteria should not be used to drive portfolio “churning” or misrepresent products.

Mr Barrett adds that if, after a client’s investment strategy has been set up, he or she raises objections to a product choice, “that means you haven’t done your client analysis and ensured suitability”.

“It requires a relevant and realistic level of granularity,” Mr Barrett continues. “ESG is getting more and more mainstream, particularly if you ask the questions in a certain way. If you’re not asking these questions you risk being exposed.”

While the requirements and guidance from both the FCA and ESMA may be awkwardly worded and at times unclear, at least for financial advisers the outcome may be a positive one.

ESG metrics

Alistair Cunningham, a chartered financial planner at Surrey-based Wingate Financial Planning, says the requirements placed on product providers to clearly disclose a variety of ESG metrics (as well as costs) have made it much easier for advisers to assess the products available, and select those that may be appropriate for different kinds of clients.

“Under Mifid II there’s a lot more being forced on fund managers,” Mr Cunningham says. “We can see a lot more information. They’ve been forced to make sustainability criteria more obvious, which makes it easier for us to make an assessment.”

At Wingate, taking ESG-related concerns into account has always been part of the company’s assessment process for bringing in new clients.

“We do it because it’s the right thing to do, rather than because Mifid says we have to,” Mr Cunningham says. “It’s part of our core ethos.”

However, he adds that there “has been a slight change” more recently to the way Wingate conducts its assessments, in particular the company is “more proactive in asking questions” through a more structured process.

“Ethics isn’t something you can just put on,” Mr Cunningham states. “It’s got to run through the whole business ethos.”

This is reflected in the additions to Mifid II, in which the EU states that companies’ senior management “should also consider aspects related to sustainability risk in their respective duties”.

Advisers should also take comfort from the EU’s work on a “taxonomy” for sustainable finance, according to Mr Fitzgerald.

The taxonomy is designed to define what kinds of activities are and are not sustainable for the purposes of investment strategies. The work will set out a European standard for how fund managers should assess companies, meaning there will be less scope for “greenwashing” by providers.

Mr Fitzgerald explains: “You can’t expect an adviser to carry out an environmental impact study for each client. They will probably rely on asset manager ratings – but for an asset manager to know how to rate [an investment], they will need to drill down. The taxonomy sets out 800 pages of technical details on how to test if the [investment] is environmentally sustainable.”

Wingate’s Mr Cunningham concludes: “The outcome [of Mifid II] is positive – the way we got there was not necessarily positive. [Providers] are not disclosing this stuff because they want to, it’s because they have to.”

Nick Reeve is a freelance journalist