The heat is on asset managers: EU steps up on sustainable finance

The EU Regulation on sustainability-related disclosures in the financial services sector (the Disclosure Regulation) came into force at the end of December 2019 and will apply 15 months later. It is yet another indicator that environmental, social and governance matters are growing in importance as a compliance issue for financial institutions. As we noted in our briefing on the EBA's Action Plan on sustainable finance, regulators are stressing the importance of ESG considerations in business strategies and encouraging firms to be proactive in relation to ESG considerations.

The Disclosure Regulation seeks to harmonise existing provisions on disclosures to investors in relation to sustainability-related disclosures by imposing requirements on so-called financial market participants (e.g. AIFMs and UCITS management companies and investment firms carrying out portfolio management) and financial advisers (firms authorised under MiFID to give investment advice and credit institutions) in relation to financial products (e.g. AIFs, UCITS). The Disclosure Regulation will require the integration of sustainability risks in financial market participants' investment decision-making processes or, where relevant, advisory processes and transparency as regards financial products which target sustainable investments, including reduction in carbon emissions. Specific requirements include pre-contractual disclosures; disclosures on websites and disclosures in periodic reports in relation to financial products.

The Disclosure Regulation forms part of a raft of legislation published by the European Commission as part of its Action Plan on sustainable finance in March 2018. This includes: a Regulation amending the Benchmarks Regulation in relation to low carbon benchmarks and positive carbon impact benchmarks (see briefing here); a Regulation on the establishment of a framework to facilitate sustainable investment (the Taxonomy Regulation); and a Delegated Regulation amending MIFID II Delegated Regulation 2017/565 to integrate ESG considerations and preferences into investment advice and portfolio management. Of chief importance is the Taxonomy Regulation, which is currently making is way through the EU legislative process and which we discuss in our briefing here. It is cross-referred to by other legislation in the EU Action Plan on sustainable finance and introduces a common criteria for determining which economic activities can be considered environmentally sustainable. It also introduces amendments to the Disclosure Regulation, adding additional requirements for ESG products with certain characteristics as provided for under the Disclosure Regulation (explained further below) so as to allow investors to identify the share of investments funding environmentally sustainable economic activities.

The Disclosure Regulation is also supplemented by amendments to Level 2 legislation, notably Commission Delegated Regulation (EU) 231/2013 supplementing AIFMD in relation to exemptions, general operating conditions, depositaries, leverage, transparency and supervision. ESMA published final advice in April 2019 on changes that will need to be made to the AIFMD Delegated Regulation in order to incorporate sustainability risks.

Key terms in Disclosure Regulation

Disclosure of adverse sustainability impacts at entity level

The Disclosure Regulation introduces the idea of "principal adverse impact of investment decisions on sustainability factors" and requires disclosure (at entity level) where a firm has decided to take these into account. Principal adverse impacts are described in the recitals as impacts of investment decisions and advice that result in negative effects on sustainability factors (i.e. environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters).

Firms that have opted to consider the principal adverse impacts of investment decisions on sustainability factors are required to integrate in their due diligence processes procedures for considering these impacts. Such firms will need to publish, on their website, information on due diligence policies with respect to those impacts, taking due account of their size, the nature and scale of their activities and the types of financial products they make available. This information will include details on how principal adverse sustainability impacts are prioritised, brief summaries of engagement policies, reference to any adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting. Firms that have opted not to consider adverse impact of investment decisions must provide clear reasons for not doing so.

Firms with more than 500 employees have no option but to publish a statement on their website in relation to adverse sustainability impacts.

Website disclosures for all investors

Relevant financial market participants – which includes asset managers - will be required to disclose information on their website about their policies on the integration of sustainability risks in their investment decision‐making processes. Where they do not consider adverse impacts of investment decisions on sustainability factors, clear reasons for why they do not do so must be set out.

Pre-contractual disclosures for all investors

Relevant financial market participants must also include descriptions of the following in pre‐contractual disclosures:

• the manner in which sustainability risks are integrated into their investment decisions (i.e. how would an ESG event/condition have a material adverse impact on the value of an investment and how those risks are dealt with); and
• the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.

Where sustainability risks are deemed not to be relevant, an explanation must be provided.

Remuneration policies

The Disclosure Regulation will require AIFMs and other financial market participants to include in their remuneration policies information on how those policies are consistent with the integration of sustainability risks. This information will need to be published on their websites. The recitals to the Disclosure Regulation states that these requirements are intended to sit alongside provisions in AIFMD and other EU legislation concerning remuneration (e.g. proportionality).

Transparency of adverse sustainability impacts at financial product level

The Disclosure Regulation then sets out additional specific disclosure requirements in relation to two types of products (set out in articles 8 and 9).

   (i) products promoting environmental or social characteristics or a combination of these characteristics; and

   (ii) financial products which have sustainable investment as their objective.

The Taxonomy Regulation prescribes additional information that needs to be disclosed in relation to pre-contractual disclosures and periodic reports for these types of products. Following the categorisation of the product, the relevant disclosures, summarised below, may be required.

Pre-contractual disclosures for financial products promoting environmental or social characteristics

In relation to financial products promoting environmental or social characteristics, the following will be need provided:

• information on how those characteristics are met (assuming that the investee companies follow good governance practices);
• where an index has been designated as a reference benchmark, information on whether and how the index is consistent with those characteristics;
• information as to where than index can be found.

Pre-contractual disclosures for certain financial products that have sustainable investment as their objective

Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, information to be included will consist of:

• information on how the designated index is aligned with that objective;
• an explanation as to why and how the designated index aligned with that objective differs from a broad market index.

Where no index has been designated, pre-contractual disclosures will include an explanation of how the sustainable investment objective is to be attained.

Where no EU Climate Transition Benchmark or EU Paris‐aligned Benchmark is available, the information must include a detailed explanation of "how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long‐term global warming objectives of the Paris Agreement". Needless to say, further information will be provided by ESMA and other supervisory authorities in this regard.

Transparency of the promotion of environmental or social characteristics and of sustainable investments on websites

The following information will need to be published on websites in relation to products promoting environmental or social characteristics or a combination of these characteristics; or financial products which have sustainable investment as their objective:

• a description of the environmental or social characteristics or the sustainable investment objective;
• information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources, screening criteria for the underlying assets; and
• the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product.
  The Disclosure Regulation provides that this information will need to be clear, succinct and understandable to investors, as well as published in a way that is accurate, fair, clear, not misleading, simple and concise and in a prominent easily accessible area of the website.

Transparency of the promotion of environmental or social characteristics and of sustainable investments in periodic reports

For financial products that promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics, periodic reports will need to include a description on the extent to which environmental or social characteristics are met (Article 8). For financial products that have sustainable investment as their objective, a description will need to include the "overall sustainability‐related impact of the financial product by means of relevant sustainability indicators". Where an index has been designated as a reference benchmark, a comparison will be needed between the overall sustainability‐ related impact of the financial product with the impacts of the designated index and of a broad market index through sustainability indicators.

Amendments to Level 2 legislation

The Disclosure Regulation has several mandates for European Supervisory Authorities to provide further clarification on certain areas. These include regulatory and technical standards concerning the presentation of information on sustainability indicators; and information relating to promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual information, annual reports and websites.

In April 2019, ESMA published final report in relation to technical advice to the European Commission on integrating sustainability risks and factors in the UCITS Directive and AIFMD. This included proposed amendments to Commission Delegated Regulation (EU) 231/2013 on: organisational requirements; operating conditions; and risk management. Further publications are to be expected.

Co-author: Bisola Wlliams