This article was written by Nadia Humphreys, Business Manager, Sustainable Finance Solutions at Bloomberg, Co-rapporteur on the Platform for Sustainable Finance of the European Commission.
Since August 2022, investment managers need to take into account the sustainability preferences of retail investors when marketing investment products, as part of the revision of the suitability process under MiFID II. This means that not only will retail investors be asked whether they have any sustainability preferences, they will also need to be able to quantify, among others, the amount of sustainable investment (SI) in a product. In principle, this is a great step forward, providing a much-needed list of ESG ingredients in an investment product and how much of it is truly sustainable. In practice, the application of this requirement could lead to unintended consequences, and firms should make sure to understand the baseline of information to report, and be careful of generic offerings.
The methodology
To help investment firms, the European Supervisory Authorities have defined indicators for Principal Adverse Impacts (PAI), which need to be used to quantify the amount of SI in a product. Some are mandatory and others optional, which means product providers may choose to use them, based on an assessment of their investments. Mandatory indicators include carbon emissions, fossil fuel exposure and gender pay gap (the latter being a data set not often reported by global companies.)
To quantify the amount of SI in a product, article 2(17) of SFDR then clarifies three main steps:
- Contribution to an objective: it can be social or environmental, but needs to be specific to the product and measurable
- Do no significant harm (“DNSH”): product providers need to take into account principal adverse impacts (PAI), which means they need to use PAI indicators to check that a sustainable investment does not cause significant harm to any environmental or social objective. The regulators have not set threshold values for DNSH purposes, how PAIs are taken into account should be defined by the product provider, and provided to the client in the form of a disclosure.
- Good governance: all investee companies must meet a baseline of sound management structures, employee relations, remuneration of staff and tax compliance.
This approach is similar to the nutrition label of a food product described as “healthy”. There are many different definitions of “healthy”, but all food producers are expected to give a baseline label of fat, carbohydrate, and protein content. Financial products described as making “sustainable investments” are expected to provide the same baseline data and explain how their “sustainability” is achieved.
Most importantly, different products will have different objectives. If a client prefers a decarbonizing investment, the objective could be related to the carbon emissions of the investee companies, and the client could expect the carbon footprint of the investment to reduce over a period of time.
Concerns from the market
Unsurprisingly, there are concerns that higher SI values will drive flows. With no clear and comparable way of building a sustainable investment, this can become a misused tool. In the above example, if instead of getting an SI that measures the rate of decarbonization, the clients get a generic metric showing the quantity or quality of an ESG rating or score, then whilst that score or rating may consider carbon, it would likely not be the overriding metric corresponding to the fund’s objective.
Worse still, some bad practices are starting to emerge where:
- The objective is not specific to the product but based on a generic set of ESG data
- The provider doesn’t disclose how the investment is doing no harm based on PAI indicators, but uses some other data set as a proxy to harm
- The provider defines good governance by a lack of social controversies
Firms are eagerly anticipating more guidance from the European Commission and the ESAs recently posed a set of questions to the Commission (link) seeking clarifications on some of these concerns. In the interim, it is important to understand the baseline of information to disclose, and watch out for generic sustainable investment offerings.