Financial Services analysis: Kate Binedell, partner, and Chris Ormond, associate director—knowledge development lawyer, at Bryan Cave Leighton Paisner discuss environment, social and governance (ESG) for fund managers, including legislation, frameworks and practical issues.
Regulation on a framework to facilitate sustainable investment published in Official Journal
of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 on sustainability‐related disclosures in the financial services sector has been published in the Official Journal.
Discussions about ESG and impact investment are ubiquitous. The prevailing trend of opinion in the industry is a renewed focus on ESG issues. It is about mindset and behaviour not just law and regulation. Some investors have stringent requirements and expect specifics to be in place in terms of ESG investing, ESG reporting and ESG governance. This could include reference to their own ESG strategies, benchmarks and risk ratings, as well as requirements for an ESG officer and DD team to be in place. These requirements are often documented in side letters.
Many fund managers are developing impact processes, such as an impact thesis and screening tools that are integrated into their investment processes. Fund managers are also likely to be mapping their ESG obligations and expectations, what these mean for their business (including side letter alignment) and considering internal issues that fold into their ability to deliver (eg diversity quotas and adequate internal resource and expertise). We are also seeing funds introducing independent impact reports and external audit requirements to measure their ESG credentials and in order to facilitate the evolution and improvement of ESG practices.
This briefing sets out fund managers’ legal and regulatory obligations in terms of ESG compliance, some of the key frameworks and reporting standards in the funds sector and finishes with a handful of FAQs.
The EU has introduced a package of sustainable finance reforms that affect EU firms and those wanting to do business in the EU. We have set out in the table below the broad application and key impacts of this legislative package, including proposed delegated acts that integrate sustainability requirements into other directives, namely Alternative Investment Fund Managers Directive (Directive 2011/61/EU) (AIFMD) and Markets in Financial Instruments Directive II (Directive 2014/65/EU) (MiFID II) (as well as the Undertakings for Collective Investment in Transferable Securities Directive (Directive 2009/65/EC) (UCITS), the Insurance Distribution Directive (Directive (EU) 2016/97) (IDD) and Solvency II (Directive 2009/138/EC), and which are currently open for public feedback. There are greater disclosure and other obligations for those firms that have sustainability focus as part of their business. We have also set out the UK’s proposals on governance of climate decision-making.
EU legislation
Disclosure Regulation (Regulation (EU) 2019/2088) (as amended by on the establishment of a framework to facilitate sustainable investment)
Applies to ‘financial market participants’, including AIFMs, UCITS ManCos and MiFID investment firms providing portfolio management advice
Came into force at the end of December 2019. The main provisions will apply 15 months later (from 10 March 2021).
From 30 June 2021 asset managers with over 500 employees (or that are the parent of a group that has) will have to publish their DD policies with respect to the principal adverse impacts of investment decisions on sustainability factors.
Firms will be required to integrate sustainability risks into their operating models, provide more detailed disclosures on ESG policies and sustainability risks and increase due diligence on the ESG profile of funds.
This involves ‘comply or explain’ decisions in relation to publishing and maintaining sustainability factors/risks for DD policies and products made available.
Ensure necessary resources and expertise. Note some disclosures apply regardless of whether or not a fund has an ESG investment focus.Consider approach to be taken for ‘comply or explain’ decisions.
Prepare/update policies eg on sustainability risk and remuneration.
Consider SMCR implications (control and supervision).
Taxonomy Regulation (2018/0178(COD))
Comes into force on 12 July 2020.
Level 2 measures/technical input awaited.
Phased implementation expected (end 2021/2022).
Establishes an EU-wide classification system or taxonomy of environmentally sustainable activities. Assessment against 6 environmental objectives eg climate change mitigation. Imposes supplemental disclosure obligations on fund managers eg a statement of whether or not a financial product has an environmental-sustainable investment objective (and if so, to what extent the criteria are met). Required updates to pre-contractual documentation and periodic reports for ESG-focused products.
Main impact on firms where products made available have an environmentally sustainable investment objective, or promotes environmental characteristics. However, all managers will at least need to make a negative disclosure to confirm that all out-of-scope financial products are out of scope.Start to prepare additional disclosures/update documentation for those funds and accounts in scope.
EU proposed delegated legislation
Delegated Regulation integrating sustainability into operating conditions for MiFID investment firms
Delegated Directive integrating sustainability into product governance obligations
Draft Delegated Regulation and Directive published on 8 June 2020 and open for feedback until 6 July 2020.For the Regulation, to apply 12 months after coming into force.
For the Directive, a transitional period of 12 months will apply.
Firms to carry out a mandatory assessment of sustainability preferences of their clients and take these into account when selecting financial products to be offered.
Firms to prepare a report explaining how the recommendation meets a retail client’s investment objectives, risk profile, capacity for loss bearing and sustainability preferences.
MiFID firms are also required to integrate sustainability preferences into the product oversight and governance process.
Impacts MiFID II and IDD suitability testing.
Firms will have to assess an investor’s investment objectives, time horizon and individual circumstances before asking for their potential sustainability preferences.
Firms to distinguish between products that promote ESG characteristics and those that pursue sustainable investment objectives.
Additional Level 2 delegated acts re sustainability risks and factors to be taken into account for MiFID, AIFMD and UCITS regimes
Draft Regulations and Delegated Directive published on 8 June 2020 and open for feedback until 6 July 2020.
Timing as above for other proposed delegated legislation.
To ensure that sustainability risks and sustainability factors are integrated within a manager’s organisational, operating, risk management and product governance processes. For instance: AIFMs to take into account sustainability risks and adverse impacts of investment decisions on sustainability factors in their DD policies and processes; and AIFMs to have the necessary resources and expertise for the effective integration of sustainability risks.
See under Disclosure Regulation above.
Consider also conflicts relating to integration of sustainability risks (eg from remuneration or personal transactions of relevant staff, that could give rise to greenwashing, mis-selling or misrepresentation of investment strategies and conflicts of interest between different AIFs managed by the same AIFM).
UK proposals on governance of climate decision-makingUK proposals on governance of climate decision-making Financial Conduct Authority’s (FCA’s) work plan on climate change and green finance (as set out in its Consultation Paper on new climate-related disclosures for large asset owners and listed issuers)
To be implemented for accounting periods beginning on or after 1 January 2021 (therefore applying to reports published in 2022) on a ‘comply or explain’ basis.
These proposals are aligned with the Taskforce for Climate-related Financial Disclosures’ (TCFD) recommendations.
The FCA is separately considering how best to enhance climate-related disclosures by regulated financial services firms.
Pending further legislative outcomes in this area, the FCA encourages in-scope asset managers and life insurers to voluntarily make disclosures in line with the TCFD’s framework for asset managers, alongside their disclosure and reporting obligations in their capacity as issuers.
It is not yet clear if all of this ‘in-flight’ legislation will apply in the UK at the end of the transitional period. However, we would expect the UK to align its rules with those of the EU, at least in order to facilitate business continuity for cross-border fund operations. Also, the statement states that the UK government is committed to at least matching the ambition of the EU’s sustainable finance action plan initiatives in relation to green finance, irrespective of the outcome of Brexit.
A growing number of investors and managers are signatories to the UN Principles for Responsible Investment. This involves a manager’s commitment to six voluntary and aspirational investment principles, including: considering ESG issues when making investment decisions; seeking disclosures from ESG entities in which they invest; and reporting on ESG activities.
Another framework that is gaining global recognition in the funds industry is the UN’s Sustainable Development Goals Impact Practice Standards for Private Equity Funds, a checklist designed to integrate impact into fund design and execution.
Finally, the Impact Management Project is a forum for organisations to build consensus on how to measure, compare and report impacts on environmental and social issues. It has created a toolkit that considers impact at every stage of the investment process to aid decision-making that optimises financial and social returns. Industry voices are championing how working on this type of integrated solution has the potential to unlock investment opportunities, such as private capital partnering with local authorities/government/other investors.
We expect explicit and systematic inclusion of ESG in investment analysis and decisions to become standard; measuring impact to become equally routine. Developing best practices in the mainstream financial sector, alongside full integration of processes and stakeholder engagement, may take longer. We see this as an exciting opportunity for real estate as an asset class—that can have tangible effects on economic prosperity, health and wellbeing of stakeholders. Real estate fund managers and investors can therefore take advantage of this, by propagating best practices, unlocking investment opportunities and being able to differentiate by adding value.
Impact investing involves deliberately investing capital to create measurable social or environmental benefits. Fund managers use their expertise, skill set and investment toolkit to deliver investment returns around a bespoke, viable strategy. Impact investing adds a positive impact dimension, be it health and wellbeing, sustainable growth or clean energy.
ESG integration involves accounting for ESG factors in risk or investment management decisions. The product, asset or service itself does not necessarily have an impact thesis. SRI involves a particular strategy, for example green investment or choosing not to invest in arms.
ESG is a trend that emerged quickly, comprehensively and broadly, galvanised by the growing importance of the impact of climate change. We expect the current coronavirus (COVID-19) crisis to increase the urgency of issues that need to be addressed, and bring a renewed focus on social and governance issues—for instance, in terms of how businesses treat their employees, suppliers and interact with their communities, as well as recovery funding being linked to achieving social good. Also that any environmental gains resulting from the current travel restrictions and lockdown measures can be capitalised on as these measures are eased.
Investors will want to measure how well a fund manager executes strategies, and how it can improve. To achieve this managers will need to be able to systematically collect and report on data and information on the ground for each investment, which can then be measured on a consistent basis. GRESB is private real estate’s leading ESG benchmark. Real estate managers are encouraged to carry out GRESB assessments, although there are areas of concern reported on it as a substantive, transparent and consistent tool.
This is a challenging and important area and will help drive scrutiny of investment products and avoid potentially problematic commercial and regulatory consequences of greenwashing and misleading product labelling.
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