Amid the flurry of EU sustainable finance announcements on 21 April, the European Commission adopted six amending Delegated Acts to ensure investment advisers, asset managers and insurers include sustainability in their procedures and advice to clients.
The move was somewhat overshadowed by updates on the Taxonomy and the new Corporate Sustainability Reporting Directive, but it is an important piece in the EU’s plan to shift capital towards sustainable economic activities and address greenwashing.
The amendments – which will be scrutinised by the Parliament and Council and are expected to apply from October 2022 – will update existing directives including UCITS, AIFM, Solvency II, the Insurance Distribution Directive (IDD) and MiFID II.
For the latter, which entered into force in January 2018 in order to strengthen investor protection across the EU, as well as for the IDD, the Commission has proposed that a client’s sustainability preferences should be considered in suitability tests. This is in line with a recommendation from the EU’s High Level Expert Group on Sustainable Finance, whose final report said that the EU should “require investment advisers to ask about, and then respond to, retail investors’ preferences about the sustainable impact of their investments, as a routine component of financial advice”.
The reason why changes to suitability test rules are of huge importance to advisors and asset managers is two-fold. For advisers, any changes to existing directives will likely mean making significant – or at least time consuming – changes to their current processes, as well as getting their heads around new and fast-moving updates to regulations such as the EU Taxonomy and Sustainable Finance Disclosure Regulation (SFDR). For fund managers, the incorporation of sustainability preferences in suitability tests could effectively mean, depending on the final rules and how they are interpreted, that some of their products end up reaching a smaller market if advisers do not recommend clients with sustainability preferences to invest in them.
It is no wonder then that the proposal published in April had seen significant changes since it was first consulted on last summer. A raft of consultation responses highlighted concerns around the proposed categories of financial instruments that advisers should recommend to a client with sustainability preferences. Respondents said they were too focused on specific financial products, particularly those that would likely fall under the Article 8 or 9 categories of the new SFDR – promoting environmental and social outcomes or pursuing such objectives, respectively.
'I’m aware that some firms in the market have essentially decided they want to transition all their funds into Article 8 or 9 and one of the main reasons for this is to gain a commercial advantage' – Daniel Nevzat, Norton Rose
According to a PRI consultation response, the previous draft “defined a consumer’s preference in relation to a regulated fund category” and “it is very unlikely that an end-investor will formulate their preference in this way”.
Crucially, the new draft says that sustainability preferences are not restricted to financial products that fall under the SFDR and taxonomy regulation, but are “instead based on the regulations’ sustainability-related concepts” to allow advisers to recommend not only investment funds but other relevant financial instruments.
The rules also clarify that advisers will not be required to stop advising on non-green products if their clients have sustainability preferences, which was a previous misconception, according to Suzanne Kröner-Rosmalen, Senior Associate at Benelux law firm Stibbe. “Sustainability preferences require advisers to present the sustainability features of the financial instruments in a transparent way. Sustainability preferences are a top-up on a client’s personal investment objective – and that’s been further clarified in this update.”
The categories have also effectively been broadened and tightened in terms of their expected alignment with the taxonomy and SFDR. The previous draft, for example, was expected to have seen a smaller universe of Article 8 funds qualify.
The three categories of products that can be considered within a client’s sustainability preferences are:
1. Those pursuing a minimum proportion of investments in activities that qualify under the taxonomy (meaning that they substantially contribute to one or more of the framework’s six environmental objectives). The minimum proportion is defined by the client or potential client.
2. Those pursuing a minimum proportion of sustainable investments as defined under the SFDR. The minimum proportion is defined by the client or potential client.
3. Those that consider principal adverse impacts (PAI) on sustainability factors. Elements demonstrating that consideration are determined by the client or potential client.
The updated categories were welcomed as an improvement by the PRI in a statement last week, which added it is important to allow investors to be “active owners for the percentage of their products which aren’t defined as sustainable investments; in many cases, exposure to harmful activities is essential to influencing environmental performance of underlying investee – for example, through voting in support of adoption of meaningful climate transition plans”.
Victor van Hoorn, Eurosif’s Executive Director tells RI the update provides an important clarification as “the categories are no longer so SFDR-product specific but instead focus more on a client's preferences”.
He adds, however, that the categories will be difficult to implement. “In the category linked to the taxonomy we will see relatively low alignment [with the needs and preferences of retail investors], which needs to be explained to clients. In the second [linked to the SFDR] we will see comparability issues between products, while the third category is not yet well defined. So, essentially, you’re left with three categories and none are really ideal – they’re all going to be quite difficult to implement.”
He explains that asking clients about their sustainability preferences is a major positive step, but that big challenges remain around how advisers will act on this information.
It is expected that many advisers will lean towards advising clients with sustainability preferences to invest in funds that fall under Article 8 or 9 of the SFDR, says Daniel Nevzat, Senior Government Relations Manager at Norton Rose Fulbright. “Advisers will probably be quite cautious here and think Article 8 and 9 are defined by EU legislators as being sustainable funds, so it would be difficult to advise clients to invest in something that’s not considered ‘green’ under the SFDR framework if they have sustainability preferences. I think that will be the general approach.”
This is triggering a rush by managers to ensure they offer products within the Article 8 and 9 scope.
“I’m aware that some firms in the market have essentially decided they want to transition all their funds into Article 8 or 9 and one of the main reasons for this is to gain a commercial advantage – in large part because advisers will become subject to new rules around integrating sustainability preferences into the suitability process,” says Nevzat.
One industry source, who wanted to remain anonymous, echoes this view. “Before, the name of the game was to ensure your product wasn’t in scope of Article 8 or 9 because it was cumbersome to comply. Then last summer, the Commission consulted on MIFID and the penny dropped and now they want to be in scope.”
The expectation that advisers and investors will view the suitability rules as intrinsically linked to SFDR will likely fuel the perception that Article 8 and Article 9 are EU fund labels rather than categories against which fund providers can self-certify.
“The problem is that as soon as the Commission made it clear that sustainability preferences were linked to these types of products, it has material impacts on the distribution side of your funds,” says the industry source. “Therefore, it has de facto transformed itself as a standard used by the market. It was never meant to be like that, but the problem is connecting the two policies will have that result.”
Meanwhile, there are question marks around how the updated suitability test rules will work in practice.
“I think the main concern is going to be around the administrative burden of introducing these new requirements around suitability,” says Nevzat. “Firms will have to go through their entire client bases and amend their suitability questionnaires to ensure they ask the right questions, which in itself is quite a difficult process. Clients with sustainability preferences will also want to focus on different areas – some might feel strongly about climate mitigation and others about plastic pollution in the ocean. Capturing such details within a questionnaire will be a challenge.”
Everyone contacted by RI agrees that a significant amount of upskilling of advisers as well as their clients will be needed for the updated Directive to truly work in practice, and more guidance will be required on how to structure questionnaires to incorporate sustainability preferences. NGO Share Action suggested in its consultation response last year that the Commission could address this “by mandating the European Supervisory Authorities to develop a template questionnaire for introducing a consistent framework for the assessment by advisers”.
The idea of templates will be welcomed by some firms, but not everyone is in favour as they may “restrict those who are already quite advanced in their sustainability thinking”, says Kröner-Rosmalen.
“Firms covered by the rules are still figuring out how to factor this into their systems and processes,” she says. “There is no reluctance to comply, and I think there’s indeed a lot that they can already be doing, but there is a bit of hesitation that any further guidance – which it is inevitable that we’ll see in the next 18 months – may change the course of the preparation work they’re doing now.”
In terms of what firms can do now, in the absence of future guidance on – for example, product categorisation – she says: “They are still able to guide their clients towards investments by making their own assessment on what falls into the three categories and share this with their clients in a transparent way. That’s definitely possible to do”.