Integrating sustainability into AIFMD and the UCITS directive
ESMA published on 19 December 2018 three public consultations on sustainable finance to support the European Commission's sustainability action plan. One of the consultation papers relates to the integration of sustainability risks and factors into AIFMD and the UCITS directive. If implemented, authorised alternative investment fund managers and UCITS management companies will be legally required to incorporate ESG into its organisation and operations.
The European Securities and Markets Authority (ESMA) published on 19 December 2018 three public consultations on sustainable finance to support the European Commission´s (EC) sustainability action plan1 in the areas of (i) MiFID II, (ii) UCITS and AIFMD, and (iii) credit rating agencies (CRA).2
The first two consultations seek input on draft technical advice for the integration of sustainability risks and factors into MiFID II, AIFMD and UCITS directive. The third consultation relates to CRA guidelines aimed at improving the quality and consistency of disclosures of environmental, social and governance (ESG) factors when considered as part of a credit rating action.
Steven Maijoor (Chair of ESMA since 2011), said, amongst others:
"Climate change is a reality. Therefore, moving our economies to a greener, more sustainable path has become a necessity and as financial regulators we have to ensure that the financial sector supports this shift."
The EC has requested ESMA to provide technical advice on the integration of sustainability risks and factors in the UCITS directive, AIFMD and MiFID II by 30 April 2019. ESMA will use the consultation feedback to finalise its draft advice to the EC.
We will in this newsletter focus on the consultation paper relating to integrating sustainability risks and factors in AIFMD and the UCITS directive. We will follow-up with a separate newsletter covering MiFID II.
2. Which entities are covered?
It is proposed that only authorised UCITS management companies and authorised AIFMs are covered (hereinafter referred to as "Authorised Entities"). That means that e.g. AIFMs that are not subject to authorisation, but merely registration with local supervisory authorities (Finanstilsynet in Norway), are not covered by the rules.
3. What parts of AIFMD and the UCITS directive are affected?
3.1 General approach
Large parts of AIFMD and the UCITS directive (as well as delegated acts) follow a principles-based approach when setting out its requirements. ESMA is of the view that integration of sustainability risks is best done through a high-level principle-based approach.
ESMA faced challenges in preparation of the consultation paper with regards to the terminology and concepts to be used, given the ongoing legislative procedures in EU and the fact that neither AIFMD nor UCITS include a legal definition of "sustainability risks". However, ESMA proposes that "sustainability risk" is to be understood as the risk of fluctuation in the value of positions in the fund's portfolio due to ESG factors.
3.2 General organisational requirements
ESMA proposes to amend certain key level 2 provisions3 on organisational requirements, so that Authorised Entities are explicitly required to:
- incorporate sustainability risks and factors within their internal organisational procedures, systems and controls in a way and to the extent that is appropriate to the size, nature scope and complexity of their activities and the relevant investment strategies pursued;
- consider whether they have sufficient human and technical resources for the assessment of sustainability risks within their organisation and governance structure. ESMA notes that it is important that Authorised Entities employ individual(s) that possess the relevant skills, knowledge and expertise in sustainability risks; and
- ensure that its senior management is responsible for the integration of sustainability risks and factors.
ESMA expects that both the compliance function and internal audit incorporate their control programs issues related to the integration of sustainable risks and factors.
3.3 Operating conditions
Neither the UCITS directive nor AIFMD currently establish details of the integration of sustainability risks within the conduct of business or prudent person rules and due diligence requirements.ESMA proposes that Authorised Entities should follow an integrated due diligence and risk management approach, meaning that sustainability risks should be considered along with all other relevant risks and that Authorised Entities should apply their due diligence and risk framework consistently in order to identify, monitor and manage all relevant risks related to their investments including sustainability risks. This means, amongst others, that Authorised Entities:
- should consider sustainability risks associated with their investments and detail their consideration in their investment analysis. Further, where those risks are considered material for the financial return of investments, authorised entities should identify the factors that are relevant for each type of risk and the relevant indicator(s) to monitor that factor;
- should develop specific methodologies to process the data sourced on sustainability risks; and
- should implement effective arrangements for ensuring the investment decisions on behalf of funds managed are carried out in compliance with the analysis performed on sustainability risks.
Further, when identifying conflicts of interest, Authorised Entities should include those that stem from the integration of sustainability risks and factors. ESMA expects Authorised Entities to include a clear reference in their conflict of interest policy on how relevant conflicts are identified and managed.
3.4 Risk management
ESMA is of the view that sustainability risks should be considered along other relevant risks such as market, interest or credit risk. This means, amongst others, that Authorised Entities should:
- ensure that sustainability risks are mapped by the risk management function and monitored on an ongoing basis;
- perform a formalised assessment on sustainability risks and their materiality, taking into account several aspects such as the identification of sustainability factors linked to the positions managed and the probability of occurrence and time horizon of sustainability risks with regards to the expected time of holding of the positions bearing the risks; and
- perform regular reviews of their methodologies and data in order to highlight the potential limits of the risks monitoring and adopt dedicated measures where required.
Bearing in mind the ongoing development of the taxonomy by the Commission, ESMA expects Authorised Entities to take a broad approach to assessing potential sustainability risks.
4. Concluding remarks
The consultation paper from ESMA is quite far reaching, and (if implemented) implies that all Authorised Entities will be legally required to incorporate (with the principle of proportionality in mind) ESG into its organisation and operations. This means, amongst others, that Authorised Entities must ensure that its internal routines and procedures is updated and that Authorised Entities employ individual(s) that possess the relevant skills, knowledge and expertise in sustainability risks.
If implemented prior to the finalisation and adoption of the taxonomy, Authorised Entities will face a somewhat challenging task in having to implement these requirements prior to a uniform "ESG language" having being developed and agreed upon.
We note that the rules are proposed to be applicable only for authorised entities. With the increasing focus and awareness on ESG in general, and climate risk in particular, we would not be surprised if also registered AIFMs would be subject to certain ESG requirements sometime in the future.
3 I.e. Commission directive 2010/43/EU and Commission delegated regulation (EU) 231/2013
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Klaus Henrik Wiese-Hansen
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