Who should read this?
This briefing note is relevant to fund managers, portfolio managers, discretionary and advisory wealth managers, investment intermediaries, pension fund trustees and charities.
As the regulatory framework concerning environmental, social and governance (ESG) issues continues to develop, new rules will govern how impact investing is undertaken. Although the core focus of the ESG agenda has been on environmental sustainability, social matters have also been addressed and are likely to grow in importance in the coming years, particularly in light of the economic recovery from the coronavirus pandemic.
This briefing note provides an overview of regulatory initiatives applicable to impacting investing, focusing in particular on European Union (EU) and international developments. The regulatory developments touch on a range of topics including classification of sustainable economic activities, disclosures by investors and issuers, product governance, suitability and organizational requirements. It is discussed how new concepts around sustainability are being embedded in the regulatory framework, requiring firms to integrate ESG issues into their business practices. It is also considered how impact reporting will be introduced under new ESG disclosure requirements, while action is also being taken to improve the quality of disclosure among companies of information on their social impact.
The Regulation on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation) is a unified EU classification system of environmentally sustainable economic activities. The core focus of the Taxonomy Regulation is on environmental sustainability and it does not set out criteria for an economic activity to be classified based on its social credentials alone. There is however the possibility of a “social taxonomy” being developed in the coming years although the near-term policy focus remains on environmental issues.
The Taxonomy Regulation sets out performance thresholds for economic activities to determine whether an economic activity substantially contributes to one or more of the environmental objectives, does no significant harm (DNSH) to any of those objectives, and complies with technical screening criteria. An economic activity must also comply with the minimum safeguards, which address various social issues such as human rights and labor standards, but do not require any particular social objective to be pursued. The report of the Technical Expert Group on Sustainable Finance, published in March 2020, sets out further detail on how minimum safeguards will be applied.
Sustainable Finance Disclosure Regulation
The Regulation on sustainability‐related disclosures in the financial services sector (SFDR) aims to increase the attractiveness of sustainable investments by requesting the disclosure of more information on the sustainability of investment portfolios, both in terms of composition and risks. It aims to give greater consideration to ESG factors when taking decisions on investments, and improve transparency so that instances of greenwashing can be identified by investors and regulators.
- A ‘sustainable investment’ is defined as including economic activities that contribute to environmental and social objectives, including investments focused on tackling inequality or fostering social cohesion, social integration and labor relations, or in human capital or economically or socially disadvantaged communities.
- The concept of ‘sustainability factors’ is defined to include environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters.
The SFDR requires disclosure at entity-level where a firm takes into account principal adverse impact of investment decisions on sustainability factors. Principal adverse impacts are described as impacts of investment decisions and advice that result in negative effects on sustainability factors. This will require firms to produce an impact report detailing how its activities impact on sustainability factors including social issues. The SFDR also requires product-level disclosures in relation to two types of products: financial products that promote environmental or social characteristics or a combination of these characteristics (Article 8); and financial products that have sustainable investment as their objective (Article 9).
Amendments to EU financial services regulatory framework incorporating ESG
The draft delegated acts incorporate sustainability issues and considerations across the EU financial services regulatory framework, including the Markets in Financial Instruments Directive (MiFID II), UCITS Directive, the Alternative Investment Fund Managers Directive (AIFMD). The definitions of “sustainability risks” and “sustainability preferences” and “sustainability factors” from the SFDR would be introduced into the MiFID II, UCITS and AIFMD regimes.
The draft delegated act amending Delegated Directive 2017/593 introduces changes to the MiFID II product governance obligations setting out the requirement for investment firms to consider preferences for sustainable products as part of the target market assessment for financial instruments and the types of clients for whom they are compatible.
The draft delegated act amending Delegated Regulation 2017/565 on organizational requirements under MiFID II would require investment firms to consider sustainability risks in their risk management procedures.
UCITS Directive and AIFMD
The draft Commission Regulation amending the UCITS Delegated Directive (2010/43/EU) and the draft Commission Regulation amending the AIFMD Delegated Regulation ((EU) 231/2013) would require management companies and alternative investment fund managers (AIFMs) to consider sustainability risks when complying with the organizational requirements and retain the necessary resources and expertise for the effective integration of sustainability risks, and addresses senior management responsibilities, due diligence requirements and risk management policies.
Review of the Non-Financial Reporting Directive
The European Commission announced its intention to review the Non-Financial Reporting Directive 2014/95/EU (NFRD) as part of the European Green Deal, published in December 2019. The review is focusing on embedding sustainability into the corporate governance framework, as too many companies focus too much on short-term financial performance compared to long-term development and sustainability.
- In its first consultation, published on January 30, 2020, the European Commission set out an initial, high-level roadmap for consultation on possible changes to the NFRD.
- In its second consultation, published on February 20, 2020, the European Commission sought feedback on whether companies should be required to disclose information about other non-financial matters beyond environment, social and employee issues, human rights, and bribery and corruption. Of particular relevance to impact investing, the Commission asked whether companies should be required to disclose information about scenario analyses, targets, more forward-looking information or how a company aims to contribute to society through its business activities.
IOSCO ESG developments
The International Organization of Securities Commissions (IOSCO) published on January 18, 2019 a statement setting out the importance for issuers of considering the inclusion of ESG matters when disclosing information material to investors’ decisions. IOSCO advised that issuers should consider the materiality of ESG matters to their business and to assess risks and opportunities in light of their business strategy and risk assessment methodology. ESG matters that issuers may disclose include environmental factors and social factors including labor practices and diversity, and general governance-related factors that have a material impact on the issuer’s business.
IOSCO build on this theme in its Final Report: Sustainable Finance and the Role of Securities Regulators and IOSCO, published in April 2020, in which it was announced that IOSCO would establish a Sustainability Task Force, which aims inter alia to improve sustainability-related disclosures made by issuers and asset managers.
How we can help
Our financial services regulatory and government relations practices help our clients navigate the evolving and increasingly complex regulatory environment concerning ESG. As supervisors start to scrutinize the steps firms are taking to uphold high standards of transparency and investor protection, we advise our clients on how best to minimize regulatory risk in offering ESG products and solutions. We also help our clients to comply with new ESG regulations in efficient and commercial ways which enable them to take advantage of the opportunities in the green financial markets as this important sector continues to grow.