The European Commission (the Commission) has made sustainable finance an express initiative within its overall plans to strengthen capital markets in the European Union. In July 2018, the Commission sought advice from the European Securities and Markets Authority (ESMA) on potential legislation under EU directives governing fund managers and investment firms with regard to sustainability. ESMA published its advice on 30 April 2019.
Following a consultation process, ESMA published "technical advice" to the Commission on 30 April 2019 on how fund managers and investment firms should integrate sustainability considerations into their processes and procedures. This advice takes the form of two final reports targeting fund managers and investment firms, respectively.
It is notable that ESMA has decided to take a principles-based approach to integrating sustainability risks and factors within the frameworks of the EU Alternative Investment Fund Managers Directive (AIFMD), the EU Markets In Financial Instruments Directive (MIFID) and the EU UCITS Directive, similar to the approach already taken to other risks within those frameworks. In response to concerns over smaller firms struggling with implementation costs and independent firms being driven out, ESMA confirmed that all the proposed changes under the three directives would be subject to proportionality by virtue of existing legislative provisions. A substantial number of proposals take the form of recitals in the preambles to EU legislation, rather than operative articles. The recommended use of recitals represents a reasoned, balanced approach by ESMA in order not to give excessive prominence to ESG principles and to retain flexibility to adjust to future developments.
Considering that there are still several ongoing Commission legislative procedures, as referred to below under “Update on Related Measures”, prescriptive requirements relating to sustainability risks at the current stage in development could enhance the risks of regulatory arbitrage by authorised entities, create regulatory inconsistencies, and subsequently result in legal uncertainty.
The Final Report on integrating sustainability risks and factors in the UCITS Directive and AIFMD (the UCITS/AIFMD Report) sets out ESMA’s advice on how the relevant EU legislation should be modified to address ESG concerns. Sustainability risks in this context are the risks of fluctuation in the value of positions in a fund’s portfolio due to ESG factors.
Under the UCITS Directive, while management companies must have in place certain organisational procedures and well-documented structures and practices, they are not required to take ESG considerations into account or consider conflicts of interest that could arise from sustainability risks. Similarly, under the AIFMD, AIFMs are not expected to take into account ESG considerations.
The majority of the respondents agreed with ESMA’s principles-based approach. ESMA confirmed this approach and acknowledged concerns that a more prescriptive approach to this dynamic area of regulation could potentially stifle innovation and allow regulatory inconsistencies to emerge and take hold. Consequently, ESMA’s advice is sufficiently general and broad to allow fund managers to assess how to best take into account ESG considerations.
ESMA recommends changes in the following areas of the UCITS and AIFMD frameworks:
We note the provisions in the final version of the Disclosure Regulation (see further below under “Update on Related Measures”) relating to disclosures of principal adverse impact that are required for regulated firms with more than 500 employees and that are based on a comply or explain mechanism for regulated firms with fewer than 500 employees. These deregulatory provisions would bear cross-referencing in any revised texts.
The Final Report on integrating sustainability risks and factors into the MiFID framework (the MiFID Report) sets out ESMA’s advice on how the relevant EU legislation should be modified to address ESG issues, recommending changes in the following areas:
The Commission has made sustainable finance an express initiative within its overall plans to strengthen capital markets in the European Union, stating that: “Re-orienting private capital to more sustainable investments requires a comprehensive rethinking of how our financial system works. This is necessary if the EU is to develop more sustainable economic growth, ensure the stability of the financial system, and foster more transparency and long-termism in the economy.”
The Commission adopted a package of measures on 24 May 2018 on sustainable finance that included proposed regulations aimed at establishing a unified EU taxonomy of sustainable economic activities (the Taxonomy Regulation), improving disclosure requirements on how institutional investors integrate ESG factors in their risk processes (the Disclosure Regulation), and creating a new category of benchmarks to help investors compare the carbon footprint of their investments (the Low Carbon Benchmark Regulation). In addition, the Commission has been seeking feedback on amendments to the MiFID framework published in January 2019 to include ESG considerations and preferences into advice that investment firms offer to clients and portfolio arrangements. Our previous LawFlash includes further details on those MiFID proposals and the Disclosure Regulation.
Low Carbon Benchmark Regulation
Political agreement was reached on 25 February 2019 on the Low Carbon Benchmark Regulation, which, in short, amends the Benchmark Regulation framework by
Political agreement was reached on 7 March 2019 on the Disclosure Regulation, which sets out how financial market participants and financial advisors must integrate ESG risks and opportunities in their processes, as part of their duty to act in clients’ best interests. It also sets uniform rules on how those financial market participants should inform investors about their compliance with the integration of ESG risks and opportunities. The regulation is built around three main pillars:
The Commission continues to work with the co-legislators to reach an agreement on the remaining part of the package, the Taxonomy Regulation.
The European Union’s willingness to make progress on integrating sustainability in European financial services legislation by itself, and without waiting for a global converging regime, is laudable. However, the involvement of global regulators will be necessary, as sustainability is a global issue. To be critical, the EU approach to legislative proposals is uneven and somewhat back to front, given the inevitably slow progress of the Taxonomy Regulation – which will, it is hoped, provide a common set of definitions and classifications designed by experts (e.g., physicists and biologists) to determine which economic activities are or are not ESG compatible – and its lagging behind all other measures made to date.
Indeed, the Securities and Markets Stakeholder Group, which exists to facilitate consultation between ESMA and stakeholders on ESMA’s areas of responsibility, has stated its concerns in this regard and that it would have “much preferred the adoption of a clear and appropriate taxonomy and labels before investment firms, institutional investors and asset managers were requested to disclose how they integrate sustainability risks in the investment decision-making or advisory process”.
We are closely monitoring developments in the area of sustainable finance and its impact on financial services regulation across the United Kingdom and the European Union. Morgan Lewis will continue to publish regular LawFlashes as the regulatory framework continues to evolve.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers: