Integrating sustainability into MiFID II
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, which is the topic of this newsletter, relates to the integration of sustainability risks and factors into MiFID II. The consultation paper covers organisational requirements, risk management and product governance. In addition, it also suggests amendments to the ESMA guidelines on MiFID II product governance requirements and the ESMA guidelines on certain aspects of the MiFID II suitability requirements.
The European Securities and Markets Authority (ESMA) published on 19 December 2018 three public consultations on sustainable finance initiatives 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
Steven Maijor (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.
This newsletter focuses on the consultation paper relating to integrating sustainability risks and factors into MiFID II (the «Consultation Paper»), while our earlier newsletter focused on how to integrate sustainability into AIFMD and the UCITS directive.3
The Consultation Paper covers organisational requirements, risk management and product governance. In addition, it also suggests amendments to the ESMA guidelines on MiFID II product governance requirements and the ESMA guidelines on certain aspects of the MiFID II suitability requirements.
3. Organisational requirements
3.1 General approach
When setting out the organisational requirements, MiFID II follows a principles-based approach. ESMA is of the view that integration of sustainability risks within the MiFID II requirements is also best done through a high-level principle-based approach, as detailed prescription at this stage could enhance regulatory arbitrage and create regulatory errors taken into consideration ongoing legislative procedures in EU.
3.2 General organisational requirements
ESMA proposes to amend article 21 of the Commission Delegated Regulation 2017/565 ("MiFID II Delegated Regulation") so that firms incorporate environmentally, social and governance ("ESG") considerations within their processes, systems and controls in order to ensure the investment and advisory process correctly takes them into account (where relevant).
ESMA expects firms to ensure that staff involved in the advisory process possesses skills, knowledge and expertise for the assessment of sustainability risks.
3.3 Risk management
ESMA proposes to change article 23 of the MiFID II Delegated Regulation so that when firms establish, implement and maintain risk management policies and procedures, they also take into account ESG factors.
ESMA expects that both the compliance function and internal audit will consider issues related to sustainability risks, as both functions are responsible of monitoring the adequacy and effectiveness of the firms risk management policies and procedures.
4. Conflicts of interest
ESMA considers it useful to add a recital in the MiFID II Delegated Regulation to clarify that when identifying the types of conflicts of interest whose existence may damage the interest of a client, investment firms should include those that may stem from the distribution of environmentally sustainable investments, social investments or good governance investments.
Further, firms should have in place appropriate arrangements to ensure that the inclusion of ESG considerations in the advisory process and portfolio management does not lead to miss-selling practises.
5. Product governance
When identifying a target market pursuant to Commission Delegated Directive 2017/593 ("MiFID II Delegated Directive"), the integration of sustainability factors by the investment firm manufacturing financial instruments and their distributors is currently not explicitly laid out.
ESMA proposes to amend the MiFID II Delegated Directive as well as the guidelines relating to product governance requirements, in order to include ESG preferences in relevant articles. ESMA considers that both the manufacturer and the distributor should take into account ESG preferences or ESG considerations while identifying the target market for the financial instruments they manufacture or distribute.
ESMA notes that manufacturers and distributors should specify with a meaningful level of granularity which ESG preferences the investment product fulfils. For example, ESMA is of the opinion that it would not be sufficient to specify that the investment product has, as a target market, clients who are interested in ESG investments.
ESMA has currently included in the existing suitability guidelines a good practice provision for firms to consider non-financial elements when gathering information on the client's investment objectives, and collect information on the client's preferences for ESG factors.
ESMA now proposes to amend the suitability guidelines, so that firms should (i.e. a strengthening of the requirements) take into account ESG preferences in the context of assessing clients' investment objectives, and consider ESG factors in the context of product classification. ESMA is of the view that these changes represents a high-level approach that leaves sufficient flexibility for implementation by firms and for developing some supervisory practice by local authorities in a field where there is currently limited practical experience.
The proposed amendments will require firms to take into account ESG considerations in the investment and advisory process as part of their duties towards clients. ESMA clarifies that the amendments to the guidelines (if implemented) would apply to all kind of clients, including existing clients. However, firms would not be expected to immediately update clients' profiles, but would be expected to take into account these amendments when they review the client's profiles.
7. Concluding remarks
The inclusion of ESG factors and considerations for investment firms represent for a large number of firms something entirely new. However, with the growing focus on ESG (and climate change in particular), we believe it would only be a matter of time before firms would have to consider such matters anyhow. Done correctly, firms could use this as a competitive advantage.
If the proposed amendments are implemented prior to the finalisation and adoption of the taxonomy, firms will face a somewhat challenging task in having to implement these requirements prior to a uniform "ESG language" having being developed and agreed upon. For example, in respect of risk management, ESMA points out that while the Commission is developing the taxonomy on what can be considered an environmentally sustainable economic activity, investment firms shall take a broad approach to assessing potential sustainability risks.
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