The Forthcoming EU ESG Regulations – A Roadmap for Fund Managers in Ireland

Background

The focus on environmental, social and corporate governance (ESG) principles-based sustainable investing is ever-increasing. In Ireland, EU ESG-related rules and regulations apply to AIFMs, UCITS ManCos, Super ManCos, MiFID-licensed firms (together Firms) and the AIFs and UCITS they manage.

With its origins in the 2015 Paris Agreement on climate change and the United Nations 2030 Agenda for Sustainable Development, the European legislative agenda has been driven by two main imperatives identified in January 2018 in the European Commission (the Commission) High-Level Expert Group, namely:

• to improve the contribution of finance to sustainable and inclusive growth as well as the mitigation of climate change; and
• to strengthen financial stability by incorporating ESG factors into investment decision-making.

The related recommendations form the basis of the Commission’s March 2018 action plan on sustainable finance which sets out a comprehensive strategy and three distinct proposals aimed at integrating ESG considerations into the investment process:

• a regulation on the establishment of a framework to facilitate sustainable investment creating a classification system (taxonomy) on what constitutes an environmentally sustainable activity (the Framework Regulation);
• a regulation on disclosures relating to sustainable investments and sustainability risks introducing disclosure obligations on asset managers regarding how ESG factors are integrated into risk management processes (the Disclosures Regulation); and
• a regulation amending the benchmark regulation – including the introduction of a new category of low-carbon and positive carbon impact benchmarks.

Building a Framework to Label Green Activities – Framework Regulation Categories

The lack of a common language and framework with which to describe different approaches to responsible investing was identified as a key barrier to the promotion and development of responsible investing across Europe. In seeking to implement reliable parameters that are consistently applied both within jurisdictions and across Europe, the Framework Regulation effectively establishes a requirement for all funds/accounts to be categorised with regard to their environmental/sustainability objective (or lack thereof) based on the fund’s prospectus disclosure regarding the environmental sustainability of the strategy. Three category tiers are suggested, as follows:

• Positive – the product is environmentally sustainable when assessed as against the taxonomy;
• Neutral – the product does not have a significant sustainability impact when assessed as against the taxonomy and can provide evidence to the Central Bank of Ireland (the Central Bank) of this; or
• Negative – the product does not pursue sustainability objectives and includes a risk warning that the product has an increased risk of supporting non-sustainable economic activities.

Simply put positive or neutral labels can only be ascribed to products that meet the taxonomy criteria. Failing this, a negative categorisation must be attributed to the fund.

In terms of screening investments, qualitative (ie the type of investment) and quantitative (ie the level of exposure to this investment) data points will need to be relied upon as part of this assessment and as such the taxonomy’s success will depend on robust, standardised, quantitative and reliable publicly available ESG data. The European Fund and Asset Management Association (EFAMA) has set out its concerns in this regard in light of the final phase of negotiations between the European Parliament and the European Council which commenced on 23 October. Where data is not publicly available and reliance is placed on third party data providers, concerns linger regarding, for example, comparability and reliability of the information, insufficient transparency regarding methodologies used, the consolidation of the industry and the cost of data. Regulators across Europe, including the Central Bank, have been keen to highlight related issues such as “green washing” (providing misleading information or data about how environmentally sound a product is) and to reiterate that investors must receive accurate information to make informed choices which is a key Central Bank regulatory and supervisory focus.

The Central Bank has cited the below as acceptable examples of data about company or issuer performance against the taxonomy activity criteria which would be eligible to use as part of a Firm’s assessment as to a fund’s categorisation:

• revenue breakdown by taxonomy-eligible activities, or expenditure allocation to each taxonomy-eligible activity;
• performance against the technical screening criteria, or environmental management data where this is an acceptable proxy for compliance with the technical screening criteria; and
• management data on social issues such as labour rights policies, management systems, audits, reporting.

Helpfully, on 25 November the global index provider MSCI made public the ESG ratings of over 2800 companies in the MSCI ACWI Index with plans to make public another 7500 index constituents in 2020.

Sustainability Disclosure Requirements

The Disclosure Regulation focuses on the integration of sustainability risks in investment making processes within a Firm’s business and also considers the potential adverse impacts investment decisions may have externally on sustainability factors. Additional disclosures are prescribed for products that are expressly ESG-focussed. Firms will have to make a commercial decision regarding the extent to which either or both will be relevant to the business and proceed accordingly.

The new internal and external disclosure rules mean Firms will have to take positive steps to satisfy the new requirements introduced by the Disclosure Regulation. Chief among these are:

Internal integration:

• Firms must have a policy on integration of sustainability risks into investment decision-making processes. Forthcoming changes to MiFID, AIFMD and UCITS deal with integration of sustainability into multiple facets of a Firm.
• Remuneration policies must include information on how remuneration in the Firm is consistent with integration of sustainability risks.
• Firms must assess the likely impact of sustainability risks on the returns of each financial product (or decide that sustainability risks are not relevant).
• The Disclosure Regulation effectively requires returns on all funds and accounts to be either assessed against sustainability risks, or for Firms to decide that these are not relevant.

External adverse impacts

Firms must also implement investment due diligence policies to consider principal adverse impacts of a Firm’s investment decisions on sustainability factors. There initially will be a comply or explain obligation however this requirement is mandatory for Firms or groups with > 500 employees.

In Summary: What and How to Disclose

Public website

• Policy on integration of sustainability risks
• Due diligence policy on the principal adverse impacts of investment decisions on sustainability (or clear concise explanation of why not implemented)
• Information on how remuneration policy is consistent with the integration of sustainability risks

Fund Prospectus/Ts&Cs for managed account

• Integration of sustainability risks into investment decision-making
• Results of impact assessments on investment returns (or clear concise explanation of why not relevant)
• Due diligence policy on the principal adverse impacts of investment decisions on sustainability (or explanation of why not implemented)

Expressly ESG-focussed Funds

• Additional pre-contractual, public and periodic disclosures

The concept of suitability already applies under MiFID when giving investment advice or making portfolio management decisions, as does the existing requirement on AIFs and UCITS to carry out due diligence when investing. However, the proposed new requirement will mean taking into account a client’s ESG preferences when establishing the mandate and making investment decisions on a client’s behalf.

Together with broader organisational requirements under each of MiFID, AIFMD and the UCITS Directive, ESG must be integrated into the overall organisational structure of the Firm including for its risk management policy and conflicts policy.

Lastly, it is worth noting that, in light of the taxonomy and enhanced disclosure requirements of the Framework and Disclosures Regulations, industry–lead initiatives such as The Investment Association in the United Kingdom (which represents 250 UK investment manager members) are seeking to agree a framework for common approaches to responsible investment in order to categorise and provide standard definitions for the different components of responsible investment.

Two New Benchmark Categories

One final effort to address the risk of greenwashing relates to disclosure requirements for benchmarks and seeks to improve transparency and comparability of information across all benchmarks. Two types of climate benchmarks will be introduced, namely the EU Climate Transition and EU Paris-aligned benchmarks. ESG disclosures will also be required for all benchmarks (excluding interest rate and currency benchmarks). As part of this, benchmark administrators responsible for publishing and maintaining reference benchmarks will be required to comply with the rules governing these benchmarks if they want to label the benchmarks they issue as sustainable and Firms should seek comfort around this point in time. Administrators of significant benchmarks ie benchmarks that are above certain thresholds in terms of usage will be required to disclose the degree of “Paris alignment” of those benchmarks.

In this regard administrators should be mindful of having the data required to build reporting capabilities to appropriately enhance ESG disclosures and ensure the scope of planned disclosure is wide enough to meet the new requirements. For some administrators this may mean investing in a new reporting framework for some/all of the business if the existing reporting framework cannot generate the level of granularity of information required.

Timeline to Implementation

Although Level 1 proposals in respect of the Framework Regulation and taxonomy were published by the Commission in May 2018, indications are that it will be implemented on a phased basis (1 July 2020, 31 December 2021 and 31 December 2022). Level 2 technical standards are unlikely to be finalised before this date however despite industry lobbying, including EFAMA, who are calling for a “realistic and well sequenced application timeline”.

The Disclosures Regulation was finalised in April 2019 and will apply fifteen months after being published in the Official Journal on 9 December 2019 along with the regulation amending the benchmark regulation (ie Q1 2021 application).

Following a consultation in May 2018, the Commission published a draft Delegated Regulation to amend the MiFID II Organisational Requirements Regulation (known as the Suitability Regulation) and is yet to be adopted. At its earliest, this will apply 12 months after publication (ie end 2020).

The requisite delegated Acts for MiFID 2, the UCITS Directive and AIFMD were subject to an ESMA consultation paper (December 2018) and a final report was published in May 2018. ESMA has suggested that the application date will be aligned with the Disclosures Regulation and, in any case, is not expected before mid-2020.

Fionán Breathnach is a Partner and Grace Lumsden is a Supervising Associate in the Investment Funds practice of Simmons & Simmons, Ireland.