A seismic market shift in mindset and behaviour, alongside new law and regulation, is driving an evolution of Environmental, Social and Governance practices, with ESG funds expected to more than triple in asset size by 2025 and increase their share of the European fund sector from 15 to 57% (PwC research, reported in the FT).

The EU has introduced a package of sustainable finance reforms that affect EU firms and those wanting to do business in the EU. The Disclosure Regulation and Taxonomy Regulation both apply to “financial market participants”, including AIFMs, UCITS ManCos and MiFID investment firms providing portfolio management advice. Because of the scope and application of the proposed rules that surround these two key measures, it is also expected that managers who are (or who manage funds) outside the EU will also need to comply with many of the measures if they wish to market their products to EU investors. To help achieve smooth implementation of the new rules across their organisations and products, we would highlight a few key action and practical points for asset managers.

  • A scoping exercise: There are greater disclosure and other obligations for those firms that have a sustainability focus as part of their business. This includes firms having to differentiate between their marketing of “Article 8” products (that promote environmental and/or social characteristics) and “Article 9” products (that have a sustainable investment objective). In addition, firms that are categorised as “large” will have to comply earlier than others (in June 2021).
  • A strategic approach: The extent that a firm incorporates ESG into its services will shape its strategy, whilst ensuring that governance, policy and risk issues are taken into account. For example, Article 8 and 9 products that are within scope of the Taxonomy Regulation (ie they contribute substantially to one or more of the Regulation’s 6 Environmental Objectives) will need to make supplemental disclosures, comply with certain safeguards and confirm the “do no significant harm” principle applies to those investments that take into account sustainable economic activities.
  • A holistic approach: Firms will need to integrate other sustainability requirements (as may be prescribed under AIFMD, MiFID II, UCITS Directive, Insurance Distribution Directive and Solvency II) with industry best practices as may be relevant on a sectoral level. For example, MiFID firms are required to integrate sustainability preferences into the product oversight and governance process. Investment advisers and discretionary managers will also be required to ask clients about their ESG preferences during the suitability assessment which is expected to drive greater interest in sustainable products. AIFMs are to ensure that sustainability risks and sustainability factors are integrated within their organisational, operating, risk management and due diligence processes.
  • A resilient approach: The principal rules under the Disclosure Regulation come into effect on 10 March 2021, albeit that the publication of and compliance with the final Level 2 measures has been delayed (with 1 January 2022 being the expected new compliance deadline for the initial set of RTS). This is likely to result in a two-tier approach and having to re-visit disclosures and other obligations once the Level 2 measures are finalised. Another issue for UK firms affected is to what extent the “in-flight” legislation will apply at the end of the transitional period. In our view, it seems unlikely that the UK will want to materially diverge its rules with those of the EU, and at least want to be able to facilitate business continuity for cross-border fund operations. Finally, the lack of any grandfathering at the moment means that firms will need to assess and classify existing funds/products as well as those being developed.

The table below sets out the broad application and key impacts of the primary EU legislative package (we have not included any details on the proposed delegated acts that integrate sustainability requirements into other directives). We also discussed the proposals and specifically how they impact asset managers during our Emerging Themes webinar on 26 January 2021.

We expect the current 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.

THE UK’S APPROACH:

Nikhil Rathi, the FCA’s CEO, spoke at a Green Horizon Summit in November 2020 about the FCA deepening its sustainable finance strategy in order to drive best practice and support the transition to net zero, and the importance of collaboration with other regulators, the Government and industry to achieve this. We would draw out three themes which provide useful markers for the UK’s expected approach in this area. First, the FCA has extended and accelerated its plans to introduce mandatory climate-related financial disclosure requirements for listed issuers and large asset owners that are aligned to the Taskforce on Climate-related Financial Disclosures’ (TCFD) recommendations. For asset managers, along with life insurers and FCA-regulated pension providers in the UK, the FCA intends to consult in the first half of 2021 on proposed new disclosure rules. The TCFD’s Taskforce Roadmap expects 75% of asset managers to be covered by the regulatory/legislative requirements for TCFD reporting in 2022, increasing to 96% by 2023.

Secondly, the Government has announced its own UK taxonomy for determining which activities can be defined as environmentally sustainable, and that this will take the scientific metrics in the EU taxonomy as its basis. Thirdly, whist referring to “interactions with related international initiatives, including those that derive from the EU’s Sustainable Finance Action Plan” one could easily infer that the UK has more ambitious regulatory and industry objectives than the EU in this space.

CONCLUSION

Our view is that these ESG developments provide an exciting opportunity for asset managers across all asset classes and sectors – whose actions can unlock investment opportunities and have tangible effects on economic prosperity and the health and wellbeing of stakeholders.

Whilst not without challenge, embracing sustainable investment best practices, alongside implementation of the regulatory initiatives, will help drive scrutiny of investment products and avoid potentially problematic commercial and regulatory consequences of greenwashing and misleading product labelling.