ESG: ESMA consults on MiFID II product governance guidelines

In January, we reported on ESMA’s consultation on MiFID suitability guidelines and flagged then that a separate consultation would follow on the product governance changes to MiFID II made under the EU's ESG framework in August 2021 - see our summary here.

On 8 July 2022, the product governance consultation paper (the CP) was duly published.

What happens next?

The consultation period closes on 7 October 2022.

During Q4 2022, ESMA will consider the responses received and aims to publish a final report and final guidelines in Q1 2023 (i.e., after the sustainability-related changes at Level 2 start to apply on 22 November 2022).

Why is ESMA consulting?

The product governance requirements in MiFID II are intended to ensure that financial instruments and structured deposits are only manufactured and/or distributed when this is in the interest of clients.

This means that a target market of end clients must be identified and periodically reviewed for each product, and the distribution model used must be consistent with the identified target market.

The CP sets out proposed changes regarding the MiFID II product governance requirements which ESMA seeks to make to its 2017 guidelines (the Guidelines). These take into account:

• the European Commission’s Capital Markets Recovery Package and subsequent Amending Directive
• sustainability-related amendments to the MiFID II Delegated Directive
• recommendations on the product governance guidelines by ESMA’s Advisory Committee on Proportionality (ACP)
• findings of ESMA’s 2021 Common Supervisory Action on product governance.

Note that this article looks only at the sustainability related changes contained in the CP.

Sustainability-related changes to Level 2 of MiFID

As part of the Commission’s March 2018 Action Plan ‘Financing Sustainable Growth’, the MiFID II Delegated Directive was updated to integrate sustainability factors into the product governance obligations. These amendments will apply from 22 November 2022.

In summary, manufacturers and distributors must specify, as part of their target market assessment, any sustainability-related objectives with which the product is compatible. These objectives must also be reviewed on a periodic basis.

Firms do not, though, have to perform a negative target market assessment in relation to any sustainability-related objectives identified for a product.

These ESG-related amendments have led ESMA to look to amend its Guidelines covering the target market categories to be considered and the negative target market assessment.

What is ESMA proposing?

(a) Identifying sustainability-related objectives in the target market assessment

ESMA proposes to add a new paragraph 20 to the Guidelines.

This would clarify that firms should identify sustainability-related objectives as part of their target market assessment, which ESMA considers should be done within the broader category of clients’ objectives and needs.

In particular, the amendment suggests the possibility of aligning the definition of “sustainability-related objectives” with that of “sustainability preferences” under Article 2(7) of the MiFID II Delegated Regulation and as further detailed in the ESMA Guidelines on the MiFID II suitability requirements.

Specifically, ESMA:

• would expect firms to consider the elements listed in the proposed new paragraph 20 when they are identifying the target market for products with sustainability factors, although ESMA accepts that not all the elements listed in the paragraph will be relevant
• notes that in the MiFID context, the term ‘minimum proportion’ should be read broadly and may apply to products with sustainability factors which are not in scope of the SFDR and/or the Taxonomy Regulation
• seeks input from stakeholders on whether there are categories of financial instruments for which the reference to “minimum proportion” would not be possible

When determining its potential target market, a manufacturer may specify sustainability-related objectives with which a product is compatible by referring to the sustainability data (such as the taxonomy alignment, KPIs concerning PAIs etc) of either (i) the issuer of the product or (ii) the product itself.

ESMA would like feedback on the benefits of clarifying when either approach (i) or approach (ii) might be justified – such as for structured products not covered by SFDR. Views are also sought on the criteria which would make one approach more relevant than the other.

ESMA reminds stakeholders that sustainability-related objectives must also be covered by the periodic review obligation.

(b) Identifying the ‘negative’ target market

ESMA has also proposed the addition of a new paragraph 81 to the Guidelines on the negative target market assessment in relation to sustainability-related objectives.

The MiFID II Delegated Directive requires firms, as part of their target market identification, to identify any groups of clients with whose needs, characteristics and objectives the product is not compatible, except where the product considers sustainability factors.

ESMA proposes clarifying that, for products which consider sustainability factors, the firm should always perform a negative target market assessment with respect to the five target market categories

• client type
• knowledge and experience
• financial situation
• risk tolerance and
• objectives and needs

but should not consider the sustainability-related objectives of the products when performing such a negative target market assessment.