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Environmental, Social and Governance (“ESG”)

The European Regulatory Journey


ESG is no longer the latest hot topic or buzzword in asset management, it is forming the basis of a new regulatory regime for the sector. As these regulatory developments gather pace, we have set out below, the European regulatory journey, the developments to date and direction of travel, and the potential impact on the asset management industry. The European Commission states that...

To achieve more sustainable growth, everyone in society must play a role. The financial system is no exception. 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.

ESG regulation in 2018

March 2018

The European Commission publishes its Sustainable Finance Action Plan for a greener and cleaner economy. The EU Action Plan on sustainable finance is part of the Capital Markets Union's initiative (CMU) and a key step towards implementing the Paris Agreement and the EU's agenda for sustainable development.

May 2018

The European Commission followed up its Sustainable Finance Action Plan, with legislative proposals aimed at creating an EU sustainability taxonomy, developing disclosures relating to environmental, social and governance factors and the creation of low carbon and positive carbon impact benchmarks.

The European Commission delivered what it called the “first concrete actions to enable the EU financial sector to lead the way to a greener and cleaner economy”.

The legislative proposals set out to clarify which activities are considered sustainable. They propose a taxonomy with standards and labels for sustainable financial products, so that investors can make informed decisions. They also look at how asset managers and investment advisors should integrate (ESG) factors in their investment decision-making process, how investments can be aligned with ESG objectives and how this alignment is disclosed to investors. They contained proposed rules to create a new category of benchmarks, to reflect companies' carbon footprint and give investors greater information on their investment portfolio's carbon footprint. 

November 2018 

The EU Commission presented its strategic long-term goal of a climate-neutral economy by 2050. The aim of this strategy is to have a climate-neutral future and meet the Paris Agreement’s objective to keep the global temperature increase to well below 2°C and pursue efforts to keep it to 1.5°C. In addition the European Commission launched a consultation to assess how best to include ESG considerations into the advice that investment firms and insurance distributors offer to individual clients. The aim is to amend the Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive.

ESG Disclosure Rules

March 2019

Political agreement was reached by the European Parliament and EU Member States on new rules on disclosure requirements related to sustainable investments and sustainability risks. Sustainability risks are defined as an ESG event that could cause an actual or potential negative impact on the value of the investment arising from an adverse sustainability impact.

By the end of 2020, firms will be required to publish their policies on the integration of sustainability risks in their investment decision-making process. They will have to demonstrate if they have considered the impacts of sustainability factors on investments and provide relevant information to investors. If a firm has not made these considerations they will have to explain that they do not and if and when they intend to.

Aim: One of the main aims of the regulation is to eliminate greenwashing (unsubstantiated or misleading claims about sustainability characteristics and benefits of an investment product). The regulation also requires disclosures to be made where there is an adverse impact on ESG matters.

Impact: The regulation will impact the financial services sectors; investment funds, insurance based investment products, private and occupational pensions, individual portfolio management, and both insurance and investment advisors.

  • Rules on how firms should inform investors about their compliance with the integration of ESG risks. 
  • Remuneration policies will be required to be updated to include that they are consistent with the integration of sustainability risks. 
  • A fund product with sustainable objectives will be required to disclose their methodology in the prospectus, descriptions will be required on how sustainable risks are integrated in the investment decision making process and explanations required on the potential impact of sustainability risks on investor return.

IOSCO recently established a Sustainable Finance Network of securities regulators to engage in discussions about developments in the market and across jurisdictions. In the US, IOSCO produced the "Statement on Disclosure of ESG Matters by Issuers", but as yet, have not reached consensus on the disclosure rules. 

Next Steps: This political agreement will now enter the EU legislative process and European Parliament and European Council will be called upon to adopt the proposed regulation.

ESMA and ESG Regulation

The European Securities and Markets Authority (ESMA) established a Coordination Network on Sustainability. This network will work with national regulators on policy development and on the integration of sustainability considerations in financial regulation. ESMA has explained that what it means by “sustainability risks” is the risk of change in the value of positions of a fund’s portfolio due to ESG factors.

April 2019

ESMA published a Consultation Paper which sets out a series of measures dealing with sustainability risks and sustainability factors that managers of both UCITS and AIFs should integrate in the day-to-day management of their organisations.

May 2019

ESMA published its technical advice to the European Commission on Sustainable Finance initiatives in the areas of investment services and investment funds.

The reports contain technical advice to the EU on the integration of sustainability risks and factors into the Markets in Financial Instruments Directive II (MiFID II), the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings in Collective Investment in Transferable Securities (UCITS) Directive (investment funds).

ESMA’s proposals will impose new requirements on fund management companies to integrate sustainability risks within their organisations. These proposals will apply to the organisational structure, resourcing, senior management oversight, conflict of interests, and investment due diligence and risk management processes.

July 2019

ESMA published its technical advice on sustainability considerations in the credit rating market and its final guidelines on disclosure requirements applicable to credit ratings. ESMA’s advice is that the European Commission should assesses whether there are sufficient regulatory safeguards in place for other products that will meet the demand for pure sustainability assessments. ESMA acknowledge the role that credit ratings have in the EU regulatory framework for the purposes of assessing credit risk and they are not advising the amendment of the CRA Regulation to mandate the consideration of sustainability characteristics in all rating assessments.

ESMA confirms that it has found that, while credit rating agencies are considering ESG factors in their ratings, they are using different methodologies across asset classes.

The detailed guidelines on disclosure requirements for credit ratings are intended to improve the overall quality and consistency of CRAs’ press releases related to their rating activity. They also set out that there should be greater transparency around whether ESG factors were a key driver of the credit rating action. This will allow the users of ratings to better assess where ESG factors are affecting credit rating actions.

Looking towards the future for ESGs

For the asset management sector, achieving compliance with ESG regulation, as it evolves, will mean that investors can access sustainable products and services on demand. The global impact of which will last for generations to come. More and more firms are including sustainable finance in their purpose driven ambitions for the future, and the regulatory environment should be welcomed as a support infrastructure within which firms can make a worthy contribution to this global initiative. This is not a case of ‘comply or explain’, non-compliance is simply not an option.

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