Focus on ESG
Sustainability preferences and climate targets: ESG investments enter a new phase
Investors are taking the financing of the transformation of the economy to a sustainable and thus stable system in the long term very seriously: at the end of March 2022, mutual funds with sustainability characteristics managed 563 billion euros for German investors. This represents 40 percent of the total money invested in mutual funds. Within a year, assets under management in sustainable products have risen by 80 percent, according to the German fund association BVI. A further boost is expected when the MiFID amendment comes into force on 2 August, when financial advisors will be obliged to ask about sustainability preferences.
Institutional investors are also taking sustainability criteria very seriously, as shown by a global survey of pension funds conducted by CREATE-Research and sponsored by the investment company DWS. More than half the pension funds reported that they have already implemented net-zero strategies in their portfolios or are planning to do so. In other words, their investment decisions are designed to help reduce CO2 emissions in a very specific way, in line with the goals of the Paris Climate Accords. The EU reference value Paris Aligned Benchmark (PAB) is playing an increasingly important role in this context. Funds and ETFs that track these indices thus fulfill environmental objectives in line with the EU taxonomy of limiting climate change and adapting to its consequences.
In any case, it is becoming apparent that a lot will depend in the future on having access to the correct ESG data to be able to comply with the different sets of rules in the advisory process.
Infront has already laid the foundation with its comprehensive integration of ESG data. ESG scores from Clarity AI, one of the world's leading providers of sustainability and impact reporting, cover 30,000 companies and 20,000 funds. Infront helps clients adapt to ESG demand, the changing investment landscape, and regulatory requirements.
These two recent announcements highlight the fact that investing in stocks and funds on the basis of environmental and social criteria as well as good corporate governance (Environment, Social, Governance - ESG) can now be considered standard. It is no longer a question of ESG or not, but of access to the latest, relevant ESG data and regulatory ratings. Which products meet which sustainability criteria? Does the product comply with EU taxonomy goals? What is the current status under the Disclosure Regulation?
1. EU Sustainable Financial Disclosure Regulation (SFDR)
In force since March 2021. Only funds classified under Article 8 or Article 9 of the EU Disclosure Regulation may be described as "sustainable" or directly impacting sustainability. Article 7 of the SFDR should not be overlooked as, from 30 December 2022 at the latest, the adverse impact on sustainability must be disclosed for all products. Planning is currently underway for Level II, the introduction of which was recently postponed from July 2022 to January 2023 . This stipulates that fund providers must also report on the impact of their investment strategy in relation to ESG criteria. In other words, asset managers will have to provide so-called qualitative reports on their individual products. In the final stage, which is scheduled to come into force in March 2023, regular ESG reports on asset managers and individual products with quantitative information must be made available.
This is also intended to make the actual sustainability impact of a fund investment transparent. However, the specifications for the published details and reporting sizes are currently still being finalized. From mid-2022, however, the SFDR classification will combine the classification of investment processes with documentation of their impact on the portfolio. In the past, this was only possible individually through ESG seals on the one hand and ESG fund ratings on the other.
At the same time, further EU standards are taking shape. The CSDR (Triolog) is currently being finalized and is expected to be adopted in mid-2022. Consequently, the first application will be delayed until the 2024 reporting year instead of the proposed 2023 deadline.
2. EU taxonomy
The EU taxonomy still lags far behind its own aspirations. Up to now, corresponding sustainable activities and technical criteria have only been defined for two of the taxonomy's six environmental goals. When the taxonomy is published in full, asset managers will have to prove their investments are sustainable in the sense of the EU taxonomy. The roadmap for the application of the taxonomy to date is as follows:
- For climate targets (limiting climate change and adapting to its consequences): since 1 Jan 2022
- For other environmental goals: (3) sustainable use and protection of water and marine resources, (4) transition to a circular economy, waste prevention and recycling, (5) prevention and reduction of pollution, (6) protection of healthy ecosystems and biodiversity: from 1 January 2023 (unlikely)
- For other ESG targets for social and governance criteria: open
3. MiFID II amendment with definition of sustainability preferences from 2 August 2022 onwards
Querying investors' sustainability preferences has been mandatorily redefined and will come into force on 2 August 2022:
- Consideration of Principal Adverse Impacts (PAI)
Investors can and ought to define the extent to which companies should be considered for sustainable investment that considers the adverse effects of their business activities (Principle Adverse Impacts) on sustainability goals.
- Positive contribution to environmental or social goals
Investments should primarily be considered sustainable if they contribute to achieving environmental or social goals while avoiding governance violations. Important: investors should also be able to expect from a sustainable investment product that a certain share of the portfolio achieves the intended effects.
- Positive contribution to the taxonomy
Here, the client should specify a minimum proportion of economic activities at the fund or portfolio level that is taxonomy compliant. However, the details are only defined for two of the six environmental objectives of the taxonomy, i.e., climate change mitigation and adapting to its consequences. The taxonomy has not yet conclusively addressed the four other topics. In addition, companies are not required to report on them until 2022. For consultants, this means that comprehensive data for EU companies will not be available before 2023. As a result, compliance with the taxonomy will be difficult to measure until then.
A major challenge for consultants is to moderate their clients' expectations. Due to the many aspects that an advisor must inquire about and document accordingly, investors' sustainability preferences are severely limited. However, with the current product classification according to the Disclosure Regulation - i.e., particularly Articles 8 and 9 SFDR - it is hardly possible to prove whether an investment solution is suitable for the elevated preferences stipulated by MiFID.
The consideration of sustainability aspects in the delegated acts relating to MiFID II is associated with a considerable implementation effort for all advisory services. This includes enhancements to investment advisory and portfolio management systems, comprehensive training for employees, or revisions to sales strategies: in order to properly prepare for the requirements, those affected must take action at an early stage.
It is important to note that any delays in applying the regulatory standards will not impact the disclosure obligations extended by the taxonomy. Accordingly, financial service providers must disclose the extent to which the investments underlying the financial product are taxonomy compliant. If this information is not available from publicly available company data, though, it is not permissible to use estimates. Equivalent information obtained from companies or third parties may, however, be used.
In concrete terms, it is advisable not only to analyze the existing regulations to identify a possible need for adaptation but also to anticipate possible implications for the next technical implementations. Because as soon as the SFDR Level II Regulatory Technical Standards (RTS) come into force, fund companies and other product providers will not only have to disclose which of the Principal Adverse Impacts (PAI) on sustainability of their investments they take into account. They will also have to justify the way they do so and how they deal with negative consequences if they fail to disclose this information. In addition, asset managers will have to complete comprehensive disclosure templates or reports, quantitatively and qualitatively, for all funds with environmental and social characteristics (Article 8 funds) and for funds with sustainable investment objectives (Article 9 funds).
Recommendations for action:
For consulting services, taking into account sustainability factors contained in the MiFID II-related delegated legislation entails a considerable implementation effort and a risk that should not be underestimated. Among other things, it means extensions to investment advisory and portfolio management systems, comprehensive staff training and revised sales strategies. It is, therefore, essential for affected stakeholders to take action at an early stage to prepare adequately for the requirements.
Specifically, it is advisable not only to analyze the existing regulations concerning governance and processes to identify a possible need for adaptation but also to anticipate possible implications for the next technical implementations. This is because, once the SFDR Level II Regulatory Technical Standards (RTS) come into force, fund companies and asset manager will not only have to disclose which of the key negative sustainability impacts (PAIs) of their investments they take into account, but also how they intend to do so and deal with the negative impacts (or justify non-disclosure, if applicable). In addition, they will have to complete comprehensive pre-contractual and periodic disclosure templates or reports, quantitatively and qualitatively, for all funds with environmental and social characteristics (Article 8 funds) and funds with sustainable investment objectives (Article 9 funds).
"In the meantime, we have implemented disclosure regulation reports for Article 8 products in particular for our clients and will also provide a standard template as a basis for specific individualisation from mid-May. Due to the lack of clear options for assigning Article 8 products in particular to MIFID sustainability categories, we are currently assuming that we will make adjustments to profiling as well as target market and suitability checks in the first step and then focus on the core regulatory aspects using the German association target market concept. Of course, we will also watch the further interpretations of the associations, such as the VuV and DSGV, and incorporate these into our planned development. We can already support further requirements of individual customers at any time using the individualisation layer of our systems," says Torsten Reischmann, Executive Director Product Management Portfolio & Advisory Solutions.