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Navigating through changing ESG requirements

2020 is set to be the year in which environmental, social and governance (ESG) factors will have to be incorporated into advisers’ suitability processes.

The driver will be EU legislation which will still apply in the UK for at least the next 12 months and perhaps longer.

The EU agreed the relevant changes to the MiFID II directive in mid-2018 with countries expected to apply the changes in the next 18 months. The key passage runs as follows:

 “To enable investment firms to recommend the most suitable products to the client, investment firms providing investment advice and portfolio management should introduce questions in their suitability assessment that would help identify the client's investment objectives, including Environmental, Social and Governance (ESG) preferences.

“The final recommendations to the client should reflect both the financial objectives and, where relevant, the ESG preferences of that client.”

There is also an obligation on asset managers to provide more information reflected below:

“Investment firms should disclose, where relevant, information on the ESG preferences of each financial product offered to clients before providing investment services.”

The above section has prompted a huge amount of work by the UK’s Investment Association, which we will look at in a little more detail later.

The EU is applying a similar approach to the Insurance Distribution Directive.

Indeed, the EU and its regulatory institutions have also been creating a taxonomy - or classification - of what is sustainable economic activity with other work to encourage green finance including green bonds.

What about Brexit? Will all these rules still apply to the UK?

As it stands, the UK remains aligned in this area of regulation regardless of the other rather fraught debates around the nature of Brexit. It involves different EU institutions and regulators where, for obvious reasons, there is now limited UK influence.

While we are still waiting confirmation about how this will work in practice from UK regulators, these rules are expected to start applying sometime next year.

Another headache is that there are a lot of terms in use, sometimes used interchangeably, sometimes with slightly different meanings, ranging from sustainable, ESG, responsible, green and ethical, although one aim in both the EU and UK is to get these terms nailed down in terms of what they mean.

A positive view

Yet, despite the somewhat confusing regulatory picture, the situation is not as challenging as on first view. First, the retail market can benefit from changes already demanded by the institutional market.

Institutional investors have been encouraging asset managers to adopt ESG and similar practices for several years. It is a common requirement within investment mandates, and UK pension trustees are already required to have a stewardship policy which considers ESG.

Many asset managers have created sustainability and ESG teams to offer specific funds and portfolios to both the institutional and retail markets, with most managers integrating ESG.

So even without new regulatory requirements, it is clear a set of agreed terms and disclosures will help boost investor understanding.

I am part of the advisory group that has contributed to the efforts in this area by the Investment Association (IA) and which produced its final report on creating a Responsible Investment Framework in late November.

The IA is aiming to create a green label which will give an indication of a fund’s green credentials. This should eventually help advisers really get to grips with what funds are offering and therefore better meet clients’ requirements.

All funds will have an ESG credential or score of some sort as part of phase one and that will apply whether the fund manager is ESG-friendly or not, so it will cover the whole market.

In addition, funds that adopt negative screening processes or are designed to create a positive impact will be separately identified.

The first aspect borrows from the existing ‘ethical’ approach of screening out, and allows you to meet client needs where they are clear about what they don’t want to be invested in.

The negative screening process does create interesting debates around what is ‘ethical’ – you can have a moral debate about everything from tobacco and alcohol and which is potentially more destructive to people’s lives through to whether you regard the whole defence sector or only certain kinds of armaments as unacceptable.

Meanwhile, positive impact funds allows the client to invest in firms that are making a difference so obviously this could include renewables, but perhaps also clean tech or smart cities, amongst many other assets.

Yet it may also involve what is called ESG integration. That is where ESG factors are incorporated into mainstream portfolios in a range of ways. Fund managers may approach this through engagement to encourage companies to improve governance, to meet sustainability and environmental challenges and/or social obligations to staff, suppliers and society. This could, for example, mean a fund will invest in a traditional energy firm that had set out a clear path to meet the Paris climate change targets but avoid one that had not.

It might mean tilting portfolios towards certain firms that perform better on ESG criteria. ESG integration is also used as a risk management tool to exclude firms with a high risk to their reputation and bottom line.

It will be interesting to see how this is finally reflected in what funds disclose and how they describe this activity.

We do have a few concerns. For example, society is engaged in a fundamental debate about what speed of energy transition is credible, and we wouldn’t want to see a system where fund managers and indeed advisers are almost expected to manage clients’ morals as well as their money.

It is interesting to note that France has taken a leading role in the ESG debate with many of the funds available for sale having been deemed to have passed a minimum ESG threshold. This is not France of course, but we think that if advisers concentrate on what clients want and demand, it will not be too difficult for advisers to meet the new requirements. Moreover, it may also allow you to reinforce your relationships with clients when you begin asking specific ESG questions.

 

Peter Toogood is the Chief Investment Officer of Embark Group

Peter launched The Adviser Centre in May 2014, whilst employed by City Financial He was co-founder of the original Forsyth-OBSR Ratings Service in 2002. He joined OBSR in 2008 and was responsible for establishing the firm’s fund advisory business as well as continuing to conduct manager research.

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