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What has happened?

In the not too distant past, environment, social and governance (ESG) and sustainability were little more than investment buzzwords, but they are fast becoming business as usual. The increasing popularity of sustainable and responsible investing, as well as the growing economic argument in its favour, have resulted in regulatory and policy change across the world, with the UK often taking a pioneering role.

ESG investing – what are the regulatory options?

Last year, European regulator ESMA proposed changes to MiFID II requiring advisers to incorporate clients’ ESG or sustainability preferences as part of the existing suitability process. Following Brexit, similar proposals are likely to be introduced in the UK, but the details and timing for this are still unknown.

The proposed requirement to take clients’ ESG or sustainability preferences into account when giving advice is likely to be significant for investment advisers. For the first time, firms will have to consider specific, non-financial factors when carrying out a client suitability assessment and when demonstrating ongoing suitability. The requirement will be applicable whether giving advice on a specific product or service or when managing a portfolio.

The impetus for financial services markets to help combat climate change has come from a series of global, European and UK initiatives. The UN kicked it off and the Paris Agreement added crucial definitions, with requirements for regulators, wealth managers, credit rating agencies and benchmark providers to ensure proper conduct. The EU has produced a sustainable finance action plan requiring companies to consider sustainability risks and to disclose how ESG is integrated into the investment process. The plan will also introduce new benchmarks and a European-wide taxonomy. The taxonomy already exists in draft and although it is not mandatory yet, its existence means that financial institutions can start evaluating their portfolios from an ESG perspective, and individual companies can see how they measure up.

In the very near future, the European Commission plans to clarify how the industry should integrate sustainability risks and factors into its governance and investment processes. This will be done either by amending delegated acts under, for instance, the UCITS, AIFMD, MiFID II, Solvency II and IDD Directives, or by introducing new delegated acts under these Directives. The UK government has stated that it will comply with or exceed the new requirements. ESG is being treated as part of the government’s Clean Growth Strategy and relevant initiatives are underway from the FCA and PRA. For financial advisers, COBS 9 suitability rules will be amended with the requirement to consider a client’s ESG preferences in due course.

In addition, the European Union’s Sustainable Finance Disclosure Regulation (SFDR) – also known as the Disclosure Regulation – came into effect in March 2021. SFDR, which does not apply in the UK, imposes new transparency obligations and periodic reporting requirements on investment management firms at both a product and manager level. For the largest investment firms, this means extremely onerous new ESG disclosure requirements. However, some degree of additional disclosure will be required from all firms that market funds into the EU, while firms that incorporate ESG considerations into their investment process will be required to make detailed product level ESG disclosures.

All firms in scope of the SFDR (that is, non-UK firms), including those that do not purport to make sustainable investments, must include on their websites a description of their policies with respect to how sustainability risks are integrated into their investment process and remuneration practices. Here, “sustainability risk” means an environmental, social or governance event or condition – for example, widespread flooding across parts of the UK or high workforce turnover as a result of poor employment practices– that could cause a material negative impact on the value of an investment.

All products in scope of the SFDR, including products that do not purport to promote any ESG factors, must be accompanied with a pre-contractual disclosure that sets out the manner in which sustainability risks are integrated into investment decisions and the likely impacts of sustainability risks, such as environmental events, on the returns of the product. Even where sustainability risks have been deemed to be irrelevant, a brief explanation of the reasoning must be provided.

Though Brexit and the end of the transition period on 31 December 2020 meant that there was no comprehensive onshoring of the SFDR, the UK Government has committed to at least matching the key objectives of the EU sustainable finance action plan. The framework of the EU Taxonomy Regulation, including the environmental objectives, will form part of UK domestic law as retained EU law, but not the disclosure obligations and technical screening criteria. Rishi Sunak announced on 9 November 2020 that the UK will implement a green taxonomy that takes the scientific metrics in the EU taxonomy as its basis and a UK Green Technical Advisory Group will be established to review these metrics to ensure they are right for the UK market. The Low Carbon Benchmarks Regulation forms part of domestic UK law as ‘retained EU law’, including the delegated acts underlying the Regulation, which became applicable from 23 December 2020.

Moreover, the EU’s Capital Markets Union project includes a package of reforms on sustainable finance intended to define a harmonised ESG framework for European financial services firms in order to prevent ‘greenwashing’ – marketing products as having an ESG component when in fact ESG considerations are not substantively taken into account in the investment process.

Rishi Sunak also announced on 9 November 2020 that the UK will become the first country in the world to make Task Force for Climate-related Financial Disclosures (TCFD) -aligned disclosures fully mandatory across the economy by 2025, going beyond the ‘comply or explain’ approach. The cross-regulator taskforce published its interim report with a roadmap for implementing mandatory disclosures, many of which will come into force by 2023. The future rules and regulations will capture a significant portion of the economy including listed commercial companies, UK-registered large private companies, banks, building societies, insurance companies, UK-authorised asset managers, life insurers, FCA-regulated pension schemes and occupational pension schemes.

Moreover, the revised EU Shareholder Rights Directive (SRD II) requires asset managers to develop and disclose an engagement policy that describes how they combine shareholder engagement in their investment strategy. ESG issues are central to SRD II, with the engagement policy needing to describe how they monitor investee companies on relevant matters. These include strategy, financial and non-financial performance and risk, capital structure, social and environmental impact and corporate governance, conduct of dialogues, the exercise of voting rights and other rights attached to shares, communicating and cooperating with relevant stakeholders of the investee companies, and managing conflicts of interests.

The revised UK Stewardship Code took effect on 1 January 2020 and it places ESG factors at the heart of effective stewardship. Within its twelve principles for asset owners and managers, signatories are required to integrate stewardship with investment, including on material ESG issues. Furthermore, signatories are required to explain how this integration has differed for funds, asset classes and geographies.

How can we help you?

We can assist firms, including investment advisers and managers and Alternative Investment Fund Managers, with advice projects, ongoing compliance support arrangements and FCA authorisation applications in the ESG and sustainability sphere.

Alternatively, through Resolution Compliance, its wholly-owned FCA-regulated subsidiary, it can offer Appointed Representative hosting services to a range of business models including investment advisers and intermediaries and fund intermediaries and promoters.

If you’d like to know more about how we can help you with your ESG and related arrangements, or any other regulatory compliance issues, our expert team is here to help.

Contact us today on 0207 436 0630 or email info@thistleinitiatives.co.uk.