European Sustainable Finance Regulations

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Over recent years we have seen the start of a tectonic shift¹ of capital towards sustainable investing with investors moving their money into sustainable investments at six times the growth rate of traditional solutions. With assets globally now totalling $4 trillion across all ESG categories² we believe the growth will continue to accelerate through 2022 and beyond. To navigate this evolving landscape, investors require new guidelines, definitions and frameworks. As bodies and governments move to regulate the market, we are seeing increasingly an increasingly complex environment with both EU-wide regulations coming into effect and local country specific announcements and rules. This is fuelling a concern that the lack of standardisation in how the regulations are implemented will hinder the efforts. It can be challenging to navigate the increasingly complex environment, but this advancing backdrop also presents investors with the opportunity to be at the forefront of the transition. Here we explore the key information to help you understand, prepare for and implement the changes.

Sources

¹ https://www.blackrock.com/corporate/insights/blackrock-investment-institute/publications/sustainability-in-portfolio-construction
² Sources: Morningstar, Simfund, Broadridge. Data includes Sustainable Mutual Fund, ETF, Institutional and Alternative AUM, as defined by third party data sources, excluding integration/engagement flags. MF and ETF data as of Oct ’21, Institutional & Alternatives data as of, June ’21.

In March 2021, the European Union SFDR regulation Level 1 came into force created to establish a European wide framework to facilitate sustainable investments, increasing transparency across financial markets and standardising the regulatory disclosures required of firms operating within the European Economic Space. This phase of the regulation was high-level and principles-based. In scope firms were required to categorise all in-scope products and mandates and provide the required disclosures depending on the classification.  Additional disclosures are required for article 8 and article 9 products.

The directive requires participants to explain their process of integrating sustainability risks into investment decisions and recommendations and clearly define renumeration risks. Sustainability risk is defined by the regulation as environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact in the value of the investment. On an individual product basis investor can expect to see explanation in pre-contractual information, enhanced prospectus reporting and additional financial report disclosure requirements.

SFDR Level 2 implementation, was postponed in December 2021 until 1 January 2023. Level 2 obligations will require companies to report on 18 mandatory principle adverse impacts statement (PAIS) alongside voluntary areas. The industry is awaiting further clarification on the requirements.

MiFID suitability requirements aim to ensure that clients’ objectives including risk tolerance and time horizons are taken into account by firms prior to investment advice and investment decisions. From 22 August 2022 these entity level suitability requirements will be updated to include consideration of client’s ESG preferences and will form the revision of the MiFID II Directive. MiFID legislation brings together SFDR and EU Taxonomy. 

The European Securities and Markets Authority (ESMA) is a European supervisory authority that brings together national financial market supervisory bodies of each EU Member State, the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA). ESMA are proposing to integrate clients’ preferences on sustainability into the profiling phase. Intermediaries will be called upon to review client profiling processes, provide advice and adequacy assessment with regard to integration of ESG factors. These and further controls will aim to verify that the investment product being advised is in line with the ESG preferences declared by the client.

A further revision will come into force 22 November 2022 to influence target market and product governance and mandates the incorporation of sustainability considerations and target market assessment into product design.

The Taxonomy Regulation or EU Taxonomy is the world’s first classification system by which to organise sustainable economic activities and came into force 12 July 2020. It establishes a list of environmentally sustainable economic activities providing companies, investors and policymakers with appropriate definitions to clarify which economic activities can qualify as sustainable.

Existing mandatory reporting applies only to the climate objectives. If the delegated act regarding the remaining objectives is issued in 2022, then from 1 January 2023 mandatory reporting will include the all other objectives.

The EU taxonomy creates security for investors protecting them from ‘greenwashing’ by distorting environmental impact data and misleading investors by presenting financial products as ‘green’ when they don’t meet standards. It also helps companies become more climate friendly, mitigates market fragmentation and will help shift investments to genuinely sustainable opportunities. Ultimately this will help support the European Green Deal: achieving carbon neutrality by 2050.

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