_We sit at a fascinating time for the development of environmental, social and governance (ESG) investing. Since evolving from social impact investing, ESG investments have enjoyed rapid growth. It is estimated that funds with an ESG component now amount to approximately one quarter of assets managed globally, and it continues to grow rapidly, with ESG factors being leading considerations for young investors, who are themselves a growing market.
The rate of change, and breadth and complexity of legal and commercial issues has meant that regulators have been challenged to keep apace. But at the European level, the huge undertaking of regulating this space has begun in earnest, with initiatives underway that impact the entire value chain.
The European Commission adopted its Action plan on Financing Sustainable Growth in May 2018, targeting all financial market participants, and cutting across every aspect of financial services and beyond. It aims to introduce measures to clarify asset managers’ duties in integrating ESG factors and risks into investment, as well as to clarify and standardise transparency duties and ESG reporting requirements.
“Sustainable finance is about making sure our money works for our planet as well as our bottom line. There is no greater return on investment.” Jean-Claude Junker
While the resulting proposals initially appeared to apply to the ESG/sustainable finance space, it is important to understand that the intended reach is far more significant and should not be underestimated. The Commission’s greater objective being to re-orientate capital flows towards sustainable investment (and so, one should assume, away from investments that are not considered sustainable). This should not simply be considered a series of green measures, but also a wider consideration of sustainability in corporate governance and risk management, increased transparency and a drive away from short-termism in capital markets.
There are now a series of initiatives at an EU level that are at varying stages of progress to implement of the EU’s Action plan on Financing Sustainable Growth. We have seen the introduction two climate benchmarks (the ‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks), and a proposal for an ESG taxonomy, with rules to come later, but the next initiative to come to market relates to sustainability-related disclosures in the financial services sector.
Regulation (EU) 2019/2088 on Sustainability-related disclosures in the financial services sector (the “Disclosure Regulation”)
The Disclosure Regulation was published on 9 December 2019 and entered into force on 29 December 2019, and will have a staggered application. Its provisions relating to applicable firms will apply from 10 March 2021 and its product-level provisions will apply from 30 December 2022 (though it should be noted that its firm-level rules will have impacts on product disclosures from 10 March 2021).
It is important because it applies to a wide range of financial market participants and financial advisers, but its breadth of application is such that it will cause those firms to make enquiries to investee companies. In its objective of reorientation of capital flows towards sustainable investment, the Commission places the onus on the firms who are subject to the Disclosure Regulation to ensure that they themselves are compliant (or explain why they are not) by causing them to perform sufficient due diligence on – and obtain sufficient transparency from – investee companies.
As a Regulation, it has direct effect, and the majority of its provisions apply from 10 March 2021. However, it is relatively light on detail and only runs to 16 pages (including six pages of preamble), so firms will have to wait for the Regulatory Technical Standards (RTS) that will be drafted by the Joint Committee of the ESAs (which includes ESMA).
One potential point of concern is that the Joint Committee has until the end of December 2020 to provide the Commission with its draft RTS, which means there could be a very short window for firms to become compliant.
The key question for firms will be to assess what constitutes a sustainability risk. This is a broad definition, and a “sustainability risk” means an environmental, social or governance event or condition that, if it occurs, could cause a negative material impact on the value of the investment. As such, firms will need to consider this term in its broadest possible sense.
The Disclosure Regulation’s top-down approach of harmonised sustainable investment aims for investee companies to follow good governance practices and that the precautionary principle of do no significant harm is ensured. This is achieved by working on the basis that financial market participants (allocators of capital) must effectively discharge their sustainability‐related stewardship responsibilities.
The Disclosure Regulation applies to financial market participants, which is a broad term that captures UCITS/AIFs, their managers, VC funds, insurance-based investment products, manufacturers of pension products and credit institutions; and additional provisions capture financial advisers, which is also a very broad definition.
The Disclosure Regulation is ambiguous in places and suffers from Byzantine drafting, so what follows is an attempt to reduce it to sensible prose. We’ll start by looking at the rules that apply to financial services firms that do not consider sustainability factors in the products or services that they offer
Rules applying to firms that do not consider sustainability risks or factors*
All financial market participants, whether promoting or managing funds or advising on investments or insurance, will have to publish information on their websites about their policies on the integration of sustainability risks, whether into their investment decision‐making process or their advice, as the case may be (Article 3).
A comply-or-explain approach applies to the requirement for website disclosures, such that where firms do not consider adverse impacts of investment decisions on sustainability factors (meaning environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters), they must give clear reasons for why they do not do so, including, where relevant, information as to whether and when they intend to consider such adverse impacts (Article 4).
*Note, however, that this limited derogation will not apply to larger (>500 employee) firms or groups from June 2021, and these larger firms will have to publish and maintain a statement on their websites on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors (see below). Furthermore, from 30 December 2022 they will also have to make mandatory product-level disclosures (Article 7).
Furthermore, where financial market participants deem sustainability risks not to be relevant, there is a requirement to clearly and concisely explain the reasons why in their pre-contractual disclosures with clients (Article 6), and an explanation as to why the firm does not consider the principal adverse impacts on sustainability factors should also be provided in their financial statements.
Finally, where a firm’s products do not include the consideration of adverse impacts of investment decisions on sustainability factors, the firm will have to include additional product-level pre-contractual (prospectus) disclosures from 30 December 2022, stating the fact and the reasons therefor (Article 7).
Rules applying to firms that consider sustainability risks and factors in their offering of products and services
As above, these firms must include information on their websites about their policies on the integration of sustainability risks, whether into their investment decision‐making process or their advice, as the case may be (Article 3).
Where such firms consider principal adverse impacts of investment decisions on sustainability factors, this must include a statement on due diligence policies with respect to those impacts, taking due account of their size, the nature and scale of their activities and the types of financial products they make available (Article 4).
What does this mean in practice? The recitals describe these as impacts of investment decisions and advice that result in negative effects on sustainability factors (environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters). Clearly there will be cases where there may be competing impacts, such as environmental and social impacts of cobalt mining for battery production. As such, the information should include information on how these impacts are prioritised.
Article 4 goes on to make more prescriptive requirements around what should be included in this statement as a minimum:
- information about their policies on the identification and prioritisation of principal adverse sustainability impacts and indicators;
- a description of the principal adverse sustainability impacts and of any actions in relation thereto taken or, where relevant, planned;
- brief summaries of engagement policies in accordance with the Shareholder Rights Directive (Article 3 of Directive 2007/36/EC), where applicable; and
- a reference to their adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement.
In making pre-contractual disclosures, such as prospectuses/PPMs, financial market participants will have to include descriptions of: (a) the manner in which sustainability risks are integrated into their investment decisions; and (b) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available (Article 6). Note, therefore, that while the rules first apply to financial market participants, disclosures will still be required in the offering materials of the products that they manage.
Financial market participants and financial advisers will also be required to include information in their remuneration policies on how those policies are consistent with the integration of sustainability risks and publish that information on their websites (Article 5).
It should be noted that these provisions apply to the firms and not their products. However, from 30 December 2022 product disclosures will need to include:
- a clear and reasoned explanation of whether, and, if so, how a financial product considers principal adverse impacts on sustainability factors; and
- a statement that information on principal adverse impacts on sustainability factors is available in the manager’s financial report.
All disclosures should be kept under ongoing review (Article 12) and all marketing communications must be consistent with these (Article 13).
Finally, there will be a requirement for the inclusion in periodic reports on how a financial product considers principal adverse impacts on sustainability factors (Article 11).
As mentioned above, the more specific requirements and guidance will not be available until the RTS are published, which is not expected until the end of 2020.
No “E” or “S” without the “G”
Article 8 includes a very specific provision for financial products that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics. Where they do so, firms must also ensure that the companies in which the investments are made follow good governance practices and include further information in the product’s pre-contractual disclosures on how these characteristics are met.
Where indices are used as reference benchmarks, information should also be provided on how these are consistent with the characteristics in question and where the calculation methodology can be found.
For these financial products financial market participants must also publish and maintain additional information on their websites for each financial product (Art 10):
- a description of the environmental or social characteristics or the sustainable investment objective;
- information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources, screening criteria for the underlying assets and the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product; and
- the information required in the pre-contractual disclosures and the periodic reports.
The information to be disclosed must be clear, succinct and understandable to investors and published in a way that is accurate, fair, clear, not misleading, simple and concise and in a prominent easily accessible area of the website.
Products that have sustainable investment as their objective (Article 9)
The Disclosure Regulation includes a very prescriptive definition of sustainable investment, which “means an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance;”.
Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, the pre-contractual disclosure information also must include:
- information on how the designated index is aligned with that objective; and
- an explanation as to why and how the designated index aligned with that objective differs from a broad market index.
Where the financial product with sustainable investment as its objective has no index designated as a reference benchmark, the pre-contractual disclosure information must include an explanation on how that objective is to be attained.
Where a financial product has a reduction in carbon emissions as its objective, the information disclosed must include the objective of low carbon emission exposure in view of achieving the long-term global warming objectives of the Paris Agreement.
This information is also required on the website of the financial market participants, as described above (the Article 10 requirements described above).
The Disclosure Regulation is an impressive piece of regulation in terms of the breadth of its application and lack of drama with which it has come to market. This means it is likely to catch a lot of firms out, particularly given its application to firms that do not currently engage in sustainable finance.
The requirement for firms including environmental or social characteristics in their products also being required to ensure good governance of investee companies is illustrative of quite how far reaching the new wave of sustainable finance rules will be. Firms in this space should be mindful of the forthcoming RTS, which will provide some much-needed colour on what is captured by these requirements, and what will be required in order to comply.
While the draft RTS are pending, the fact that so many of the rules will apply from 10 March 2021, critically those for pre-contractual disclosures, means that firms should start considering their approach now and factor it into their product development cycle.
For any enquiries about ESG implementation or the ESG regulatory landscape in Europe or Luxembourg, please do not hesitate to contact Partner Mark Shaw.