Investors face information asymmetry: Linklaters lawyers on the Action Plan’s disclosure hurdles

Responsible Investor’s latest instalment of The EU Action Plan: What Matters To Me

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This is the 10th in RI’s ‘The EU Action Plan: What Matters To Me’ series, providing insights from market experts on the implications of the EU Action Plan on Sustainable Finance. Today, Ben Maconick and Raza Naeem, lawyers from Linklaters’ Sustainable Finance Team, highlight how heavily the current package relies on disclosure.

The EU Sustainable Finance Package (SFP) and other proposed measures (e.g. proposals to amend MiFID II and other key pieces of financial services legislation) are focused on implementing the EU’s objectives of reorienting capital flows towards sustainable investments, managing the financial risks of climate change, and fostering transparency and long-termism in financial and economic activity. As we will go on to consider, provided the standards are defined carefully, disclosure is a key piece of the puzzle.
Readers are probably already familiar with the disclosures that are being implemented by the SFP. These can be summarised at a high level as:

1. The requirement for “financial market participants” that offer financial products as environmentally sustainable investments to disclose information on how and to what extent the regulated taxonomy is used to determine the product’s sustainability;

2. The requirements for sustainable investment benchmark providers to disclose information about their methodologies used for the calculation of their benchmarks; and

3. The requirements for “financial market participants” and certain investment advisors to provide information on the integration of sustainability risks into their investment decision-making process, and how sustainable investments target sustainability and are assessed against that target.

These obligations sit alongside, and are intended to assist compliance with, other sustainable finance initiatives being led out of Europe – e.g. the obligation to incorporate ESG considerations in suitability assessments, product governance and in overall risk management frameworks. The investor community, be it asset managers, insurers or pension schemes, will therefore rely heavily on the disclosures produced by financial market participants and benchmark providers to ensure they are able to assess and track on an ongoing basis the sustainability of products being offered in the market for the purposes of meeting their own sustainability-related obligations.

Asset managers, insurers and pension schemes will rely heavily on the disclosures produced by financial market participants and benchmark providers

These investors will however be faced with a number of hurdles in the form of information asymmetry, along the way.
Firstly, the disclosure obligations noted above only apply to regulated institutions and not to the vast majority of unregulated corporate issuers. Whilst reporting and disclosure standards are separately being introduced for corporates in the context of climate change, that only ticks off one component of the overall sustainable finance picture.
Secondly, most specific disclosure obligations are only triggered where financial market participants wish to offer sustainable investments or benchmarks (although there are other, more general, disclosure requirements).Whilst we agree with this outcome – as it would otherwise be disproportionate to apply exacting disclosure standards in all contexts – it does mean that investors are left with little information on the sustainability of products that are not branded or marketed as such, when it comes to complying with their suitability or risk management obligations for example. Investors would therefore need to find alternative ways to assess the sustainability of products on offer in these instances – perhaps through industry led solutions or external data analysts / providers (a market that is relatively undeveloped still in the ESG space).
Another hindrance in this regard is posed by the slower progress on the Taxonomy Regulation, which will likely follow once the above disclosure obligations are already in force for some time. It is difficult to speak the language of ESG and provide helpful disclosures, if the vocabulary (i.e. what it means for a product to be sustainable) has yet to be formally pinned down in legislation.

Investors are left with little information on the sustainability of products that are not branded sustainable when it comes to complying with their suitability or risk management obligations

However, the EU Technical Expert Group on Sustainable Finance has recently published a draft technical taxonomy which is intended to be finalised by the end of 2019. Once in final form and in force via a delegated act under the Taxonomy Regulation, it will require the application of a series of tests to determine whether activities qualify as climate mitigation-focused activities or climate adaptation-focused activities, each eligible for sustainable finance. So, whilst the Taxonomy Regulation will not be in force for some time as a matter of EU regulation, it is possible that the market may choose to apply the proposed taxonomy voluntarily, for example in response to customer or other regulatory expectations, and the market could initially look to the Technical Expert Group’s draft technical taxonomy before it is formalised in a delegated act under the Taxonomy Regulation.
As noted in point 3 above, the regulated investor community will also be obliged to disclose how it incorporates sustainability risks into its investment strategy and decision-making process, and report on its progress annually. This increased transparency is likely to be helpful to the clients and beneficiaries of these firms, but once again the ability of regulated investors to embed ESG into their investment processes will be heavily reliant on their ability to source information and disclosures on the sustainability of their investments from issuers and product providers. Additionally, much of the detail of the disclosure obligations has been left to “Level 2” measures that will be adopted in the future, on which the investor community currently has limited visibility.
These “Level 2” measures must perform a delicate balancing act. On the one hand, being too prescriptive as to the details of the disclosures to be made could have the effect of hampering the emergence of disclosures that meet investor demand. Disclosures that are too rigid may not be adaptable enough to change to provide information that investors think is important. On the other hand, not being prescriptive enough risks creating inconsistency and an unlevel playing field in the market. Minimum standards of information, and a certain degree of comparability are important to ensure that investors are actually able to digest and compare the disclosures in a useful manner. The “Level 2” measures will be consulted on, and it is paramount that both providers of sustainable financial products, and investors engage with that process to ensure that the detail of the disclosures successfully tread this fine line.

Ben Maconick is a lawyer in the Sustainable Finance team at Linklaters, and Raza Naeem is Managing Associate in the same team.