Implementing the amended Markets in Financial Instruments Directive II (MiFID II), starting on 2 August 2022, will require financial advisors to consider clients’ sustainability preferences when conducting suitability assessments.
To avoid misrepresentations, investment advisers should assess their objectives, time horizon and individual circumstances (as already required by local regulations and following best practices) before asking for the client’s potential sustainability preferences.
Financial instruments will need to have specific features to be able to meet the client’s potential sustainability preferences. Clients will either need to have a minimum proportion of their investments in sustainable investments, as defined under the European Union (EU) Taxonomy or Sustainable Finance Disclosure Regulation (SFDR) or consider principal adverse impacts on sustainability factors on a quantitative or qualitative basis as defined under the SFDR, i.e., have a list of environmental, social and governance key performance indicators (ESG KPIs). The adviser needs to determine the proportion of the client’s investments in sustainable investments, or the consideration given to adverse impacts, with the products identified accordingly.
This development is considered key for ESG funds; however, it also has significant implementation challenges. The void left by the SFDR regarding the Sustainable Investment definition and, notably, the application of the Do Not Significantly Harm (DNSH) principle renders the comparison of products almost meaningless. The Principle Adverse Impacts (PAI) reporting is also subject to data gaps and aggregation challenges, formulating absolute numbers that may be hard to interpret by both financial advisors and retail investors. The short-term unavailability of taxonomy data (disclosure to take effect on 1 January 2024) and the uncertainty around the use of estimates also put asset managers and financial advisors in a difficult position.
Challenges with the DNSH component
Under the SFDR, “sustainable investment means an investment in an economic activity that contributes to an environmental objective or an investment in an economic activity that contributes to a social objective, 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”.
The conditions under which the DNSH test could be considered positive or negative are not defined and are currently left at the discretion of asset managers. The list of PAIs must be considered for the purpose of the DNHS test. Still, there are no thresholds specified by the regulators, as indicated by the European Supervisory Authorities (ESAs) in their clarification statement on 2 June 2022.1
Challenges with the sustainable investment component
Adding further complexity, the SFDR definition of sustainable investment refers to “an investment in an economic activity that contributes to an environmental objective or an investment in an economic activity that contributes to a social objective”. This implies that sustainable investment should be calculated at the activity level, an approach similar to the EU Taxonomy.
SFDR’s sustainable investment definition creates an inconsistency in the granularity of the data leveraged to calculate the portion of sustainable investment with an apparent reference to economic activity, and the DNSH leverages PAIs captured at the issuer level while being calculated and reported at the portfolio level. Therefore, the calculation of the “sustainable investment proportion” leaves room for interpretation in three different applications, each with its own pitfalls:
The activity-based approach
Method: The proportion of revenue generated from sustainable economic activities, e.g., as aligned with the United Nations Sustainable Development Goals (UN SDGs) of companies with DNSH at the activity level (e.g., sectorial materiality thresholds defined for each PAI).
- Provides a fair representation of revenue that is driven by the sustainable activities of the companies in the portfolio.
- Ensures consistency in the granularity of indicators used to calculate sustainable investment at the activity level.
- Follows the EU Taxonomy philosophy to ensure a more consistent calculation of the sustainable investment proportion in the long term, as the EU Green Taxonomy unfolds to include other objectives and if the proposed Social Taxonomy is created.
- Using PAIs at the activity level to measure DNSH will cause a data gap issue.
- Following the EU Taxonomy philosophy will generate the same outcome for numerous funds due to the sustainable investment proportion, a situation reflecting the reality of our economies.
The stringent approach
Method: The proportion of revenue generated from sustainable economic activities and DNSH at the company level.
- Demonstrates a high level of commitment to ESG investing. For example, it would exclude the revenue derived from renewable energy by a utility company that also generates electricity from fossil fuels, as PAIs at the company level are unlikely to pass the DNSH screening.
- Expect a positive trend as the sustainable investment proportion will likely increase in the future.
Limitation: Delivers an even lower proportion of sustainable investment than the EU Taxonomy approach, creating a clear challenge in terms of market positioning.
The threshold approach
Method: An investment is considered sustainable if a company or portfolio generates revenue above a certain threshold and is aligned with a sustainable objective (SDGs) and the DNSH objective. For example, one could consider that if 25% of a company’s revenue is aligned with environmental objectives and does not significantly harm these objectives through its remaining business activities, then an investment in the whole company is considered a sustainable one.
- Discloses a higher proportion of sustainable investment in funds. This is more imperative as the market is concerned that regulators might impose Article 9, where funds are required to contain 100% sustainable investments.
- Delivers consistency between the level of analysis of the DNSH and the outcome (e.g. at the company or portfolio level).
- As new regulations unfold, there will likely be a decline in the sustainable investment proportion in the future.
- Creates challenges of consistency in the European ESG Template (EET).2 The EET includes reporting on the “share of sustainable investment environmental [that is] not EU Taxonomy aligned”, which would be like removing apples from an orange basket.
- Depending on how low or high thresholds are set, it could allow for greenwashing practices to remain. For example, a media conglomerate that generates 5% of revenue from activities related to education could be considered a sustainable investment if the threshold is set at such a low level.
The various interpretations of the sustainable investment definition introduced by the SFDR and leveraged in MiFID II leave many market participants unsettled, having to decide between approaches that have different benefits and limitations in the short to medium term. Therefore, although the recent EU Taxonomy and SFDR were designed to clarify the definition of “sustainable investment” and reduce opportunities for greenwashing, their current state can be described as “work in progress” and we expect additional clarification to be provided in the near future. In the meantime, the level playing field that the market is looking for remains in limbo.
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 Chapter 48: “The ESAs acknowledge that their final reports did not specify exactly how the PAI indicators should be used for the purpose of the DNSH disclosures for sustainable investments in the RTS or the financial product disclosures. However, best practice could be to disclose DNSH for sustainable investment by extracting the indicators from Table 1 of Annex I, and any additional relevant indicators from Table 2 and 3 of Annex I, and show the impact of the sustainable investments against those indicators, proving through appropriate values (e.g. where feasible in compliance with the Climate Delegated Act12 and the Complementary Climate Delegated Act13) that the sustainable investments do not significantly harm any environmental or social objectives.”
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