MiFID II and the implications for ESG investing

In June 2020, rating agency Morningstar reported that global investments in environmental, social and governance (ESG) funds had reached a record high of $1.06 trillion, with capital inflows into sustainable funds up 72% in the second quarter alone.

25 November 2020

Worldwide governmental support for greener post-pandemic recovery strategies, growing choice in the sustainable fund market, and evidence of the long-term performance benefits of improved corporate responsibility are among several factors contributing to the rising popularity of ESG investment.

This surge in interest, especially among a new generation of investors, comes at a time of considerable change in regional politics and investment regulation. In Europe, the second cut of the Markets in Financial Instruments Directive (MiFID II) was developed to further harmonise financial regulation among member states and improve transparency through increased reporting across a wider spectrum of financial instruments. A significant regulatory development for the ESG market is an amendment to the existing MiFID rules regarding the mandatory consideration of non-financial factors in assessing product suitability.

In 2019, the European Union (EU) Commission in partnership with the European Securities and Markets Authority (ESMA) stated that all financial advisers would have to integrate ESG factors and risks into their selection and management processes before offering investment advice, regardless of their clients’ ESG preferences or appetite for values-based investing. The recognition of a relationship between sustainability and suitability reflects a changing investment universe and adds a potentially complex assessment of sustainability risks and impacts to advisers’ existing due diligence.

ESMA’s recommendations recognise that changes to ESG considerations in MiFID II should be proportional, reflecting an evolving market. Investment companies are advised to incorporate sustainability risks into their own internal processes, systems and controls, and risk management strategies. Sustainability risks in this instance are broadly defined as adverse environmental, social, or governance conditions likely to have an actual or potential material impact on the value of investments. Additionally, ESMA recommends investment companies establish ‘appropriate arrangements’ to ensure ESG integration doesn’t lead to product mis-selling and include their sustainable holdings when investigating conflicts of interest. Some flexibility is given to the consideration of clients’ “needs, characteristics and objectives” to differentiate between ESG preferences and investment goals and avoid mis-selling where ESG considerations outweigh financial requirements.   

Within this new regulatory framework, it will be incumbent on investment companies to review and revise existing sustainability policies, act on new and evolving compliance guidance, engage with companies on core ESG topics, and track developments which may ultimately affect their business interests.

Assuming UK financial regulation remains broadly aligned with EU directives post-Brexit (the Financial Conduct Authority has already indicated it will work to mirror European initiatives in ESG integration), investment advisers face some complicated implementation challenges going forward. Overall, most advisers view the mandatory integration of ESG considerations as a positive development, indicative of their increasing importance to long-term investment performance and risk mitigation. However, there are concerns that compliance with changing regulation is being hampered by a lack of standardisation and commonly shared definitions of ESG features and functions. Many advisers also highlight the absence of an agreed ESG taxonomy, a limited range of ESG products, and the potential for values-driven investment objectives to further restrict product choices.

Some implementation issues, however, indicate a more general lack of preparedness among investment advisers. Many have attributed their own lack of ESG knowledge to the limited levels of interest currently shown by their clients. Consequently, recent adviser surveys conducted by Rathbones and Square Mile have revealed that a significant number of advisers are not yet incorporating ESG into their research processes or raising specific enquiries in their Attitude to Risk Questionnaires. Survey results also indicated wide disparities in readiness for regulatory change across the investment industry – while some advisers have already developed clearly articulated propositions on ESG integration, others admitted to being unaware of regulatory developments.

Work is nevertheless underway within the UK investment industry to bridge significant ESG knowledge gaps and improve adviser competencies. In 2019, the Investment Association launched a broad consultation to establish common definitions of ESG methodologies and an approved taxonomy. Greater clarity on the differing applications and impacts of ESG will be important for future due diligence and dispel a common assumption that ESG terminologies and strategies are interchangeable. The consultation also aimed to improve and standardise reporting frameworks and proposed a labelling system to make it easier for advisers and investors to identify suitable investment products. The UK’s first Certificate in ESG Investing, launched by CFA UK in September 2019, was developed by practitioners to provide investment professionals with the skills and benchmark knowledge to effectively integrate ESG considerations into their investment processes. In response to their adviser survey findings, Square Mile – in association with ESG Clarity – created ESG Pathway, an interactive series of webinars bringing together advisers, asset managers, IFAs and independent experts to share ESG perspectives and clarify integration processes.

The MiFID amendments are reflective of changing investor perspectives and an acknowledgement that ESG investment is more than a binary choice between values and performance. Even if the scale of regulatory adoption in the UK is still a matter for debate, there is considerable momentum for deeper ESG integration in investment strategies and a succeeding generation of wealth owners who place a greater emphasis on ensuring their spending habits reflect their values. The investment industry would be wise to take note and transform with the times.

First featured in Professional Adviser.