New legislation due to come into effect in March promises to pave the way for better reporting and disclosure of ESG risks. The Sustainable Finance Disclosure Regulation comes hand in hand with the EU’s new taxonomy, designed to bring clarity to ESG and sustainability definitions. Will it make advisers’ conversations with clients on ESG any easier?
Under MiFID II rules, advisers must now capture the ESG preferences of their clients. At the moment, they are flying blind, with no specific format for the assessment prescribed by the EU’s requirements, myriad definitions and wildly differing client views on what ESG might look like. But the new rules help fill the current gaps in advisers’ ESG strategies by providing a framework for better definitions?
A recent paper by Deloitte highlighted some of the difficulties facing advisers, from “explaining E, S and G and the scope of the suitability exercise to clients in plain language” to “obtaining clients’ preferences at a suitably granular level, differentiating between the respective E, S and G factors, highlighting any tensions or contradictions between these, and explaining the consequences on risk and return of favouring one or more over others.”
Equally, the suitability requirements don’t go away. ESG preferences need to be combined with clients’ existing requirements in areas such as liquidity and risk. It is complex balancing act for advisers and many will be hoping that the new rules bring some order to the word salad of definitions.
The new rules should be a path to greater transparency on ESG risks. The intention is that they help investors determine whether a fund is sustainable and if there are sustainability risks, what financial price should be placed on those risks.
However, the execution has been patchy – the Principal Adverse Sustainability Indicators, a key part of the new legislation, were excessively detailed and prescriptive to the extent that regulators have been sent back with a flea in their ear to rewrite the rules. The rules to be introduced in March are a watered-down version.
Part of the problem is that disclosure from companies isn’t yet granular enough to meet SFDR requirements for fund managers. It’s all very well saying that fund groups need to disclose on biodiversity, but not if they can’t get the information from the companies in which they invest.
In the longer-term, there is more optimism that the new rules will ultimately help investors distinguish the wheat from the chaff on ESG funds, which should help advisers build appropriate ESG portfolios for clients. However, the revised rules aren’t due until 2022.
The taxonomy may prove more useful. Definition has certainly been a challenge for ESG funds and this has allowed fund groups to set their own rules on what constitutes ESG, sustainable, ethical and so on. The result is a hotch-potch of definitions. For the adviser, this means having to explain different ethical parameters to clients depending on the fund.
This is unworkable in the longer-term. As such, the EU taxonomy regulation should enable fund managers to gather specific, comparable information from companies, incorporate it into their decision making and disclose it in a standardised way.
This should provide genuinely useful information, such as the proportion of companies’ turnover derived from products or services associated with environmentally sustainable economic activities. This makes it notably more difficult for companies to greenwash their activities and for investors to mistake a good investor relations department for real progress on environmental or social issues.
As always, the risk may be that the format is too complex to provide real insight. The final taxonomy is due to be published in June and is likely to apply in practice from 1 January 2022. If properly executed, this should help advisers in building ESG portfolios and explaining them to clients.
It is clear that regulation alone won’t come to advisers’ aid, at least in the short-term. The rating agencies are going to work on sustainability ratings, though risk-rated multi-asset funds remain a tough nut to crack. For the most part, advisers will have to rely on their own ingenuity and established best practice to meet the new rules.