As for an organic label, the accurate definition of sustainability vary from one country to another. In this article, we focus on the EU definition of sustainable investment.

According to the European Union, an investment is sustainable if it meets one or more of the following three criteria:

• An investment that meets certain environmental, social and governance criteria (so-called “ESG criteria”).
• An investment that meets the criteria in point 1, and also pursues one of the six objectives below (the so-called “European Taxonomy”): Climate change mitigation, Climate change adaptation, Protection of water and marine resources, Transition to a circular economy, Pollution prevention and control, Protection and restoration of biodiversity and ecosystems
• An investment with documented major negative social or environmental impacts. For example, this could be a company that will report on gender pay inequality or carbon emissions.

How to invest in a sustainable product?

Most financial products are being classified according to this European standard (real estate, commodities, funds, etc.). In the future, financial institutions will therefore recommend more and more sustainable products.

In order to invest in this kind of products, we highly recommend that you consult with your advisor. He will inform you about the sustainable products available at your financial institution. In fact, with the integration of the RECOprofiler, you can easily receive recommendations on the financial products that best suit your sustainable preference profile.

Advantages and disadvantages of sustainable investment

• Impact: sustainable investment allows you to have a positive social or environmental impact on the real world.
• Risk: sustainable investments are not guaranteed. It is possible to lose a portion or the totality of the initial investment.
• Diversification: the range of sustainable products is growing rapidly but is still more limited than non-sustainable products. Investing exclusively in sustainable products can therefore affect the diversification of your portfolio.

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• In November 2022, after the decision of the Colombian Ministry of Labor to open an investigation against Teleperformance, the share price of the French call center company fell by 34%.  
• In January 2022, Orpea’s share price fell following revelations on the group’s practices.

In both cases, the companies were given good, or even very good ESG (Environment, Society, Governance) ratings. Within the world of CSR, scandals involving companies considered as exemplary are accumulating. In 2010, it was the case of BP before the explosion of its oil rig Deepwater Horizon [1]. In 2015, it was also the case of Volkswagen before the “Dieselgate” scandal [2].

You will find the answer to these questions in this article.

What is an ESG rating?

An ESG rating is a score, often in the form of letters (AAA, B+, etc.), which claims to represent the overall performance of a company – most often a listed company – in three areas: environment, society and governance. They are issued by ESG rating agencies such as MSCI, ISS, Vigeo Eiris or Sustainalytics. To be more precise, these agencies rate by “pillar” – an E rating, an S rating and a G rating.

In practice, to make these scores, the agencies base their ratings on a set of indicators. For example: 

• Scope 1 greenhouse gas emissions are an environmental indicator
• The rate of workplace accidents per hour worked is a social indicator
• The percentage of independent directors is a governance indicator

These indicators are then grouped by sub-category and used to determine intermediate scores. For example, one could imagine that scope 1 GHG emissions are used to determine a “Climate Impact” score. Or that the work accident rate is taken into account in a “Working conditions” score. Once the scores for each sub-category have been determined, it remains to decide on a weighting for each of them in their respective pillar. This results in an environmental rating, a social rating and a governance rating. By assigning a weighting to each of these pillars once again, we finally obtain an overall ESG rating.

Different methodologies for ESG ratings

We have seen that ESG ratings are weighted averages of various indicators. This aggregation practice can be criticized in itself because it leads to questionable equivalences. For example, how can a company justify offsetting an increase in workplace accidents with a decrease in GHG emissions? 

Moreover, the rating agencies themselves tend to disagree with each other on these equivalence relationships, and these disagreements lead to recurrent criticism – ESG ratings diverge depending on the issuing agencies [3].

In other words, the same company can be rated very well by one rating agency and very poorly by another at the same time. Below, we try to explain that a large part of these divergences in results actually come from differences in methodology.

The choice of indicators

The first element on which the methodologies of the rating agencies diverge concerns the selection criteria for the indicators of interest. Indeed, depending on the sector of activity of the company being evaluated, the indicators to be selected are not the same. 

For example, indicators relating to consumer health will be considered more important in a company in the food industry than in a company in the IT sector. For each sector, the rating agencies must therefore give their opinion on the materiality of the indicators. This is what MSCI does in its “ESG Industry Materiality Map” [4]. 

However, there is no consensus on the notion of materiality of ESG issues. While most rating agencies favor “financially relevant” risks, i.e. a single materiality approach, Europe puts forward the double materiality approach.

“MSCI’s ESG ratings assess the resilience of companies to long-term, financially relevant environmental, social and governance risks.”

Choosing weights for ESG ratings

Once the indicators of interest have been determined, it is then necessary to decide how they will influence the final rating. 

In practice, this is done by assigning a weighting to each indicator in the final score. Once again, however, the assignment of this weighting is subject to debate. For example, how can one decide on the relative importance of biodiversity versus gender equality? Most rating agencies answer this question with simple materiality: The more likely an ESG risk is to materialize financially, the more important it is, and therefore the higher the weighting in the final rating. We return once again to the debate on double materiality.

Managing the lack of transparency

Finally, a major problem for ESG rating agencies is the lack of transparency of the companies evaluated on material issues. 

Indeed, an ESG indicator that is considered material and that is the subject of a significant weighting in the final rating may not be revealed by the evaluated company. The practice to be adopted in this case is, once again, subject to debate. In such circumstances, some agencies choose to give the median rating, while others choose to give the lowest rating in order to penalize the company for its lack of transparency.

Financial or non-financial ratings?

It is common to refer to ESG ratings as extra-financial ratings. This is the terminology used by the French Ministry of the Economy [5]. However, as we have just seen, the majority of ESG ratings are made by taking into account only financially relevant indicators. In practice, they are therefore financial risk ratings.

This observation raises a problem. If ESG ratings, and the underlying ESG indicators, do indeed reflect financial risk, then this implies that conventional financial statements are not exhaustive. If they are not, i.e. if ESG ratings report on a financial risk that is already accounted for in financial statements, then they are useless because they simply repeat information that already exists.

Conclusion on ESG ratings

ESG ratings are scores that claim to represent the overall performance of companies on all social, environmental and governance issues. 

In practice, the majority of them only take into account financially relevant risks. As a result, a gap with the real social and environmental risks tends to be created, and is materialized at the time of various scandals (Orpéa, Téléperformance, etc). 

Therefore, the name “extra-financial rating” should be questioned, since ESG ratings are in fact designed to reflect a financial risk. This raises another problem. If ESG ratings are used to identify financial risks, this means that financial statements are not exhaustive. If they are not, it means they are useless.

At Neuroprofiler, we offer both a tool to collect investors’ ESG preferences and a financial education platform to better understand sustainable finance topics. A combined use of these two modules allows to set investors sustainability preferences and to better understand the sustainable investment choices available.

Please feel free to make an appointment to learn more about our solutions.

Ressources

[1] Reuters Events, Beyond petroleum: Why the CSR community collaborated in creating the BP oil disaster  https://www.reutersevents.com/sustainability/stakeholder-engagement/beyond-petroleum-why-csr-community-collaborated-creating-bp-oil-disaster 

[2] Harvard Law School Forum, Ratings that Don’t Rate: The Subjective World of ESG Ratings Agencies https://corpgov.law.harvard.edu/2018/08/07/ratings-that-dont-rate-the-subjective-world-of-esg-ratings-agencies/ 

[3] SSRN, Aggregate Confusion: The Divergence of ESG Ratings https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533 

[4] MSCI, ESG Industry Materiality Map https://www.msci.com/our-solutions/esg-investing/esg-industry-materiality-map 

[5] Faciléco – Ministère de l’Économie et des Finances et de la Souveraineté Industrielle et Numérique, La notation extra-financière https://www.economie.gouv.fr/facileco/notation-extra-financiere#:~:text=Les%20agences%20de%20notation%20traditionnelles,environnementaux%20ou%20sociaux%20des%20entreprises.

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What is ecological economics ?

Ecological economics is a branch of economics that consists of thinking about the economic sphere from the environmental sphere, and thus from natural sciences. It distinguishes itself by its focus on nature, justice and time, and addresses issues such as intergenerational equalityand the irreversibility of environmental change. Georgescu-Roegen’s work, notably in The Entropy Law and the Economic Process (1971), on what he called the ‘bioeconomy’ is often perceived  as a precursor to the discipline. One of the main discoveries of the Romanian mathematician, statistician and economist was that orthodox economic theories do not respect the principles of thermodynamics, and in particular the second law of thermodynamics which deals with the notion of entropy.

Thermodynamics and economics

In thermodynamics (a branch of physics), entropy can be seen as a measure of the degree of disorder in a system. The higher the entropy of a system, the less orderly its elements are, the less mechanical effects they can produce, and the greater the proportion of energy that is unusable for work.

“The Law of Entropy is in its nature the most economic of all physical laws” – Georgescu-Roegen

According to Georgescu, the economic process consists in transforming material  and energy of low entropy, i.e. raw materials and usable energy, into material and energy of high entropy, i.e. waste and heat. He also notes that the Earth is an open system in terms of energy but not in terms of material. In other words, the Earth system can receive low-entropy energy from its external environment but not low-entropy material (since “matter from meteorites comes to us in an already dissipated form”).

From this he concludes that the economic process is based on the use of mineral resources that are both irreplaceable and non-renewable, and that the realisation of a perfectly circular economy is in practice impossible (since despite Einstein’s equivalence E=mc², it is in practice impossible to transform energy into matter).

Repositioning the sphere of the economy in the sphere of the environment

In general, the ecological economics school of thought distinguishes itself by using knowledge from the life and earth sciences to think about the economy. This includes thinking of finance as a subset of the economy, the economy as a subset of society, and society as a subset of the environment. It’s is in fact the strict opposite of the neoclassical vision which tends to see finance as what should control the economy, the economy as what should control society, and society as what should control the environment. This difference in vision can be summarised by the following diagram from a report by the Shift Project[4]:

A notable example of work in ecological economics that follows this view is Kate Raworth’s Doughnut Theory. The first and best-known principle of this theory relates to what the purpose of the economic discipline should be. According to ecological economists, economics is “the collective organisation of contentment, or at least of the material conditions of contentment.” [5] . Since the economic sphere is included in the environmental sphere, the economy must strive to organise contentment within the new planetary boundaries[6].

For Kate Raworth, this goal of organising contentment to satisfy planetary boundaries can be summarised schematically as a Donut:

Conclusion

Economy comes from the Greek “oikos” and “nomos”, and thus etymologically means the management of the house. In the course of history, the scope of this management has gradually increased. Thus, Adam Smith was interested in the management (or wealth) of nations. What ecological economics proposes to do today can therefore be summed up as a further increase in the scope considered by economics.  The ecological economy is the management of the house we all share, the planet.

At Neuroprofiler, we offer a financial education platform, EduProfiler, which just makes investors aware of different economic and financial concepts. Thanks to its very flexible design, we can adapt its content according to the demands of our clients. For example, it is possible to have a version of our EDUprofiler dedicated to the ecological economy or to sustainable investment.

Ressources

[1] Ralentir ou périr – Timothée Parrique, September 2022

[2] The nine planetary boundaries are thresholds that must not be exceeded in order to ensure the survival of humanity on Earth. They have been defined by scientists at the Stockolm Resilience Center

[3] Climatsup Finance, Former pour une finance au service de la transition – The Shift Project, December 2022

[4] http://paris.tribunal-administratif.fr/Actualites-du-Tribunal/Espace-presse/L-Affaire-du-Siecle-l-Etat-devra-reparer-le-prejudice-ecologique-dont-il-est-responsable

[5] https://laffairedusiecle.net/au-31-decembre-2022-laction-climatique-de-letat-aura-ete-insuffisante/

[6] https://meteofrance.com/actualites-et-dossiers/actualites/climat/un-passage-la-nouvelle-annee-exceptionnellement-doux

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In the following decades, these findings inspired various economic models to characterize investor’s social or environmental concerns (reciprocity, fairness, empathy, kin selection, cooperation…) based on psychological, biological, or economic models. 

More recently, studies have focused on the applications of social preference theories in the business world, including sustainable investments.

Utility Function and Social Preferences

Experimental studies have shown that traditional economic theories have limited predictability because they fail to incorporate human cognitive biases and social preferences.

These traditional theories, as developed in the 1940s, often model investor’s preferences through a utility function. This function transforms the investor’s objective payoffs into the subjective investor’s perception of these payoffs. Traditionally, only the notion of risk is considered as a parameter for this utility function. In other words, the only element that determines the choice of an investor between Investment A and Investment B is their level of risk/payoff and the investor’s risk aversion.

Gary Charness and Matthew Rabin were amongst the first behavioral economists to incorporate social preferences into this traditional utility function model.

They developed a model where the investor’s utility is a combination of their material payoff and social welfare. 

Other behavioral economists have later enriched this promising approach by offering various utility function models incorporating social preferences.

Parameters of this social preference utility function

In order to determine the parameters of this social preference utility function, investors are usually asked to choose a series of investments (or distributions) out of several options where there is a tradeoff between their own material benefit and the benefit  to particular environmental or social issues.

Studies have proved that this approach gives more accurate results than asking directly for the willingness of investors to pay in absolute terms since responses can not easily be evaluated in terms of decision quality.

An example of such an approach to measure social preferences is the Silver Measure developed by Murphy.

A solution integrating this methodology

In line with this methodology, and in order to capture social preferences effectively, the InvestProfiler has developed an adaptive (each question depends on the answer to the previous question) gamified preference-based questionnaire of binary investment choices that measures the investor’s ESG preferences through their utility function.

Our model estimates, in a short number of questions the parameters of an isoelastic utility model. Our model has as many parameters as the number of candidate values that the investor may be interested in. Below is an example of such utility function, where two illustrative topics are presented : water preservations and CO2 reduction. With this model, we can see that the investor pays much more attention to water preservation, as an increase in the score of this topic increases the utility of the agent much more than the same increase on the score of the other topic.

As an indicator of the performance of our model, with 5 questions and 4 different topics proposed to the client, we achieve an accuracy of 94% when recovering the estimated parameters of artificial agents, compared to their true preferences.

Conclusion

Neuroprofiler InvestProfiler methodology is based on the latest advances in behavioral economics, and more specifically in social preference theories.

Its objective is to measure, through an adaptive preference-based questionnaire, the investor’s social preference utility function, in order to rank the ESG impacts the investor would like to have in his investments.

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The fact that the ISSB tries to establish these standards at the international level threatens the more detailed European vision. However, it is the one we need if we want to truly evaluate the environmental performance of companies.

What does the concept of double materiality mean?

What is the position of the ISSB (International Sustainability Standards Board) on this subject, and why is this vision problematic?

In this article, we try to answer all of these questions.

What is materiality?

In accounting, materiality represents the rules for deciding whether and when a piece of information should be taken into account.

According to the current financial accounting system, information is considered material when it exceeds a “materiality threshold“.

Materiality threshold: “The point beyond which economic decisions or judgments based on the financial statements are likely to be influenced.”

In practice, it is often considered that “the decisions that the primary users of general purpose financial statements make on the basis of those financial statements” are those of investors, and in particular of shareholders, who choose whether or not to invest in the company according to its financial results. This view tends to neglect the importance and use of accounting documents by other stakeholders (government, employees, customers, etc).

In the context of ecological accounting (known as ESG), maintaining this view of materiality is particularly problematic. Indeed, some information that is important from an ecological point of view is not material from a financial accounting perspective.

For example, an increase in greenhouse gas emissions or in the number of work-related accidents in a large company will probably not have a material impact on the financial accounts of the company.

The introduction of the term “double materiality”

Faced with this conception of materiality, some European organizations, including EFRAG (European Financial Reporting Advisory Group), proposed to distinguish two types of materiality for environmental accounting:

• Financial materiality: “A sustainability topic is material from a financial perspective if it triggers financial effects on undertakings.”
• Impact materiality: “A sustainability topic or information is material from an impact perspective if the undertaking is connected to actual or potential significant impact on people or the environment and is related to the sustainability topic over the short, medium or long term.”

To differentiate these two concepts, we also speak of outside-in materiality for financial materiality and inside-out materiality for impact materiality.
This new concept makes it possible to take into account a greater number of environmental and social information. In addition, it ensures the non-negligence of certain important information in terms of impact for reasons of financial materiality.

SASB position

The SASB (Sustainability Accounting Standards Board) is a non-profit organization whose purpose is to develop sustainability accounting standards. The model followed is that of IASB (International Accounting Standards Board), the organization that developed the IFRS (International Financial Reporting Standards), which are widely used in Europe today.

In the same way that the IASB has done for financial accounting standards, one of SASB’s goals is to standardize sustainability accounting standards globally. That also includes standardizing the definition of materiality as they define it.

“SASB’s approach to materiality is based on traditional, financially oriented definition that is well accepted globally: information that is reasonably likely to be important in making investment decisions.”

In the interest of simplification and standardization, SASB supports the use of a definition of materiality that is identical for financial and non-financial accounting and equivalent to that already used in financial accounting today.

NB : Since June 2022, SASB is part of the ISSB (International Sustainability Standards Board). It is an organization that combines several previously existing organizations (SASB, IRRC, CDSB).

Europe’s position towards double materiality

Europe’s position is favorable to the use of the concept of double materiality, as we can see in the legal texts relating to the publication of extra-financial information by companies. Especially, the CSRD takes up the concept of double materiality previously introduced in the NFRD (Non Financial Reporting Directive).

“The NFRD introduced a requirement for companies to report both on how sustainability issues affect their performance, position and development (the ‘outside-in’ perspective), and on their impact on people and the environment (the ‘inside-out’ perspective). This is often known as ‘double materiality’.”

Conclusion

The definition of materiality is a crucial issue for ESG accounting. Not taking into account double materiality means ignoring a large part of the environmental performance of companies. In Europe, legislation is moving in the right direction, but at the international level, the IASB does not seem to support this practice. Furthermore, it wants to impose standards based solely on a more traditional financial materiality.

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• Effective financial markets and financial stability
• Supervision and supervisory convergence
• Retail investor protection
• Sustainable finance
• Technological innovation and increased use of data.

As sustainability is not all about the environment, ESMA will also progressively put more attention to the integration of social and governance factors.
In order to achieve those goals, ESMA will start by making sure the regulatory framework is workable. It will contribute to reduce its complexity, increase the availability of ESG data, and improve the consistency of the different requirements.
As the regulation on sustainable finance is new and complicated, it represents a challenge both for financial market participants and regulators. For this reason, ESMA will work together with national supervisors – the National Competent Authorities (NCAs) – to train them on this topic. This new area of regulation also represents an opportunity for ESMA to promote convergent supervisory approaches among NCAs as it is always easier to forge convergence in new areas of regulation.

The European Authority is also ready to assume possible new supervisory mandates if the co-legislators were to decide to grant them to ESMA (e.g. EU Green Bonds reviewers, ESG rating providers).

ESMA might have new ambitions with its new management team!

Last, ESMA wants to make it easier for retail investors to understand and contribute to sustainable finance. In order for them to make more informed investment decisions, ESMA will promote the development of easy-to-read signals and labels and easy access to high quality ESG data. It is worth noting that this represents a very significant challenge for ESMA given the current diversity and heterogeneity of ESG labels and offers and the confusion they create for investors.

What about the coming year?

On top of its five-year strategy, ESMA also publishes Annual Working Programs. Within the ESMA 2023 Annual Working Program, the key objectives related to sustainable finance are the following:

• Deliver on the priorities set out in ESMA’s Sustainable Finance Roadmap 2022-2024.
• Contribute to facilitating the financing of the EU transition towards a more sustainable economy, while preserving market integrity and financial stability as well as a high level of investor protection.
• Promote effective and consistent integration of sustainability-related factors in supervisory, convergence, risk assessment and regulatory activities. In order to fulfill those objectives, ESMA will publish opinions and guidance about regulations such as the new reporting standards under the Corporate Sustainable Reporting Directive (CSRD). Lastly, ESMA will keep contributing to the European standard setting work of EFRAG (European Financial Reporting Advisory Group) and monitoring the work of the ISSB (International Sustainability Standards Board). It will be interesting to see the convergence of the two organizations and how ESMA can contribute to their work.

A working program dedicated to sustainable finance? ESMA’s Sustainable Finance Roadmap 2022-2024

Another document of interest when it comes to anticipate the work of ESMA on sustainable finance is the Sustainable Finance Roadmap 2022-2024.

This document identifies three priorities for the work of the European Authority:

1. Tackling greenwashing and promoting transparency
2. Building NCAs’ and ESMAs’ capacities
3. Monitoring, assessing and analyzing ESG markets and risks

The future of sustainable finance in Europe

Given our analysis of the work programs of ESMA, we can make a few predictions about the future of sustainable finance in Europe.

The first important trend should be simplification: simplification of the regulation to make it easier for companies to comply, and simplification of ESG indicators to make it easier for retail investors to understand and contribute to sustainable finance.

Second, the scope of inclusion of ESG topics should be broadened and social and governance topics should draw more attention.

Lastly, one needs to improve the supervision of ESG markets, in particular thanks to the training of the supervisors on those topics. Therefore, we can expect a reduction in the risk of greenwashing.

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Even if they give a little more flexibility in terms of timing than the version that was submitted for consultation in January 2022, this new regulation only confirms the obvious: the assessment of clients’ ESG preferences will soon be a necessity and, above all, a top priority for all financial institutions.

Some might say that given the challenges facing the planet and the awareness of the ESG issues among the world’s citizens, it is more than timely that this assessment is made a priority and above all mandatory.

The complexity of the regulatory framework

However, others might argue that assessing investment objectives and preferences, without ESG considerations, is already a complicated and often indigestible exercise for clients. On financial matters, assessing sustainability knowledge, experience, status and investment objectives is not easy; adding the ESG label will make it even more difficult.

An additional factor of complexity is the structure of European legislation in this area. The taxonomy regulation with a classification of economic activities that is, to say the least, pretty dynamic and the regulation on transparency that uses complementary but different concepts, do not exactly coincide.

Beyond this complicated regulatory framework, the implementation of ESG preference assessment should generally take place at the very beginning of a customer’s relationship with a new financial institution, which is an important moment in the life of any relationship. It is therefore crucial that this moment is as pleasant as possible in terms of user experience.

This is where technology can and should help and can even become a real strategy asset.

The added value of technology

In recent months, many solutions have emerged that aim to enable a common ESG and investment profiling of clients.

Some have been developed by young fintechs and startups such as Sopiad which operates out of Belgium, or Oxford Risk, which is a little older and established in the UK. Gambit, which is now part of the BNP PARIBAS group, has also developed a module on the subject and Odona Tech, which is based in Grenoble, has done the same. Large companies specialising in financial information, such as Morningstar, have also embarked on this activity and taken this step.

At Neuroprofiler, we were one of the first players to launch an ESG assessment module that fits perfectly into our Risk and MiFID profiling applications. Thanks to the contribution of behavioural finance, a science that we intensively use in all our modules, we are able to accurately identify the wishes of investors in terms of environmental and social criteria.

By comparing the different applications now available on the market, it seems interesting to draw some initial conclusions.

The modules for assessing investors’ ESG preferences must remain very flexible because legislation is bound to evolve and change rapidly. For example, the European taxonomy is far from being stabilised.

The assessment of ESG preferences should be designed not to override other assessment topics required by MiFID, which is easier said than done.

The acceptance by the investor of lower financial performance on his investment in counterparty for a more environmentally virtuous management.

Another important point is that the assessment of ESG preferences should not lead to a deterioration of the customer experience. Whether at the beginning of the relationship or when renewing a profile, the assessment of these preferences is an important moment in the relationship with the bank. This experience should be positive and not just an administrative formality or a simple data collection. This is one of the reasons why Neuroprofiler uses gamification for this evaluation moment in order to involve the investor in a positive moment on motivations that are no less positive.

It is likely that these ESG preference assessment modules will develop strongly as this dimension is expected to grow in the coming years. The surge in extra-financial data from issuers and fund managers expected in the coming months will make this exercise even more necessary. Advances in technology such as the progress on artificial intelligence or the further development of behavioral science will for sure allow the ESG evaluation process to become more robust and hopefully less painful for the clients. With Neuroprofiler and the InvestProfiler, we will strive to remain at the forefront of innovation.

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Sustainable finance is favored by investors’ expectations

Investors, especially younger ones, are also increasingly looking to make a positive impact with their investments. According to a 2020 DeVere study, 80% of Millennials say they are looking for impact in their investments, compared to 60% for other investors.

ESG products supported by regulation

To support the development of sustainable finance and to protect investors, several European regulations have been introduced. One such regulation is the Sustainable Finance Disclosure Regulation (SFDR), which requires distributors of savings and investment products to classify
financial products according to a taxonomy of environmental impacts of 10 March 2021.

European taxonomy

To combat greenwashing, the EU has introduced a classification of financial products according to the degree and nature of their impact, starting with environmental impacts, divided into 6 main categories:

• Climate change mitigation
• Adaptation to climate change
• Protection and restoration of biodiversity and ecosystems
• Pollution prevention and control
• Transition to the circular economy (waste prevention and increased use of secondary raw materials)
• Sustainable use and protection of water and marine resources

The same work will soon be done on the social component. By establishing precise criteria for classifying ESG products, this new regulation aims to provide investors with greater transparency, so that they can invest more easily and with full knowledge of the facts in ESG products.

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Last August, the assessment of retail investors’ sustainability preferences became mandatory for all European financial institutions providing advisory or portfolio management services. 

This new regulation applies under IDD and MiFID.

The regulator defines sustainable investment as a financial instrument that meets at least one of the three criteria below:

1. a financial instrument which is invested in environmentally sustainable investments, as defined in Article 2(1) of Regulation (EU) 2020/852 of the European Parliament and of the Council, in a minimum proportion determined by the client or potential client;
2. a financial instrument which is invested in sustainable investments within the meaning of Article 2(17) of Regulation (EU) 2019/2088 of the European Parliament and of the Council, in a minimum proportion determined by the client or potential client;
3. a financial instrument that addresses the main negative impacts on sustainability factors, with the qualitative or quantitative evidence being determined by the client or potential client.

The publication of guidelines to support financial institutions in the complex implementation of sustainability preferences assessment

This new directive raises many implementation issues. 

First, the ESG offer is still limited, and not well aligned with the strict requirements of the European taxonomy. ESG information is still not widely available. Finally, taking into account both the financial and extra-financial preferences of clients when recommending products is challenging traditional advisory processes from both a human and an IT perspective.

To assist financial institutions in this delicate implementation, the European regulators European Securities and Markets Authority (ESMA) and European Insurance and Occupational Pensions Authority (EIOPA) have published guidance documents for the banking (23rd of September) and insurance (20th of July) sectors.

The guidelines are complemented by a report on the feedback from the various stakeholders to the public consultation on the draft guidelines on integrating customer preferences for sustainability.

The following is a summary of the main points of the two guidelines.

ESMA and EIOPA guidelines on assessing sustainability preferences

Recognition of the difficulty of implementing this new regulation

The guidelines first recognise that the implementation of the new ESG regulation is challenging given the different deadlines of other regulations and the lack of ESG data.

However, they do not give much more flexibility to financial institutions, which will have to make their “best efforts” to implement the directive in the medium term.

More education

In addition, the guidelines are much clearer than in their first version. 

The EIOPA guidelines are illustrated in particular by tables and graphs. The terms and formulations are less ambiguous and more pragmatic. This is particularly the case for the definitions of points a, b and c.

• EU Taxonomy: is a classification system that lists environmentally sustainable economic activities. The Taxonomy does not list socially sustainable economic activities. Sustainable investments with an environmental objective may or may not be aligned with the Taxonomy.
• Sustainable investment: an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly undermine another environmental or social objective and that the investee companies follow good governance practices.
• Main negative impacts: These are significant negative impacts on sustainability factors related to environmental and social issues (employees, respect for human rights, anti-corruption, etc.).

More flexibility on implementation times

Recognising the various issues surrounding the implementation of these new regulations, the ESMA, in its publication of 23rd of September, postpones the application date by 6 months from the date of the publication of its translated versions, a period initially set at 2 months.

Furthermore, the ESMA advises financial institutions to “actively” collect ESG preferences from all their clients within the 12 months after the directive implementation.

More financial education for customers

Furthermore, the ESMA stresses the importance of financial education for advisors and retail investors on these new topics of sustainable investment, but also on the mechanisms of financial products more broadly. 

They mentioned that this will be a priority in the coming years for European regulators.

More flexibility on the positioning of the questionnaire on sustainable investment preferences

In the first draft of the ESMA and EIOPA guidelines, it was recommended that the section on the assessment of sustainability preferences be placed at the end of the suitability questionnaires. The new guidelines provide more flexibility.

For the purposes of assessing suitability, it is important for insurers and insurance intermediaries to obtain information on sustainability preferences during the collection of information on investment objectives; this information may be collected as the last element of the collection of information on investment objectives. However, in the latter case, this should not prevent the client, on his own initiative, from mentioning his sustainability preferences in an earlier part of the information gathering.

Guidelines on the integration of sustainability preferences in the assessment of suitability under the Insurance Distribution Directive (IDD), July 2022.

More flexibility on the collection of key negative impacts

In the EIOPA guidance, a categorisation of the main negative impacts is clearly suggested: environment, employee issues, human rights, anti-corruption and anti-bribery issues.

This was not the case in the first ESMA/EIOPA draft guidelines.

However, ESMA points out that this type of list is just a suggestion and that financial institutions are free to define others.

Furthermore, the EIOPA and ESMA directives were contradictory on the need to collect information on PAIs that the client wishes to consider in a quantitative AND (EIOPA) or OR (ESMA) qualitative manner. 

The ESMA’s guidelines clarify this point by giving the flexibility to capture these PAIs in a quantitative OR in a qualitative manner.  

Process where the client has ESG preferences, but does not wish to give further details

The EIOPA guidelines also provide further information on the situation where clients state that they have ESG preferences, but are not willing to provide more details on their appetite for a, b or c.

This can be quite common as clients may be reluctant to answer a long questionnaire assessing their ESG preferences using technical terms such as taxonomy, PAI, SFDR… after a suitability questionnaire which is already quite long and laborious.

In this case, according to the EIOPA guide, the financial institution should ask additional questions to the customer to verify that he/she really does not have any specific preference regarding points a), b) or c).

If the client maintains his or her position, the financial institution may still recommend a product whose sustainability characteristics best match the client’s preferences, taking into account the sustainability preferences as expressed by the client in general terms.

The ESMA is more vague on the subject, suggesting only that a process should be in place for such situations.

Process when no product meets the customer’s sustainability preferences

Given the challenges mentioned above, it is very common that no product exactly matches the customer’s sustainability preferences.

This will be particularly the case in relation to taxonomy alignment, where many customers may wish to have high taxonomy alignment, whereas products currently available on the market often have a maximum alignment of 20%.

Previously, the guidelines required to reassess the client’s ESG preferences if no suitable ESG product was found. Given the very high number of possible combinations of a, b and c, this would have meant answering the questionnaires a large number of times until finding the right document.

In their guidelines, the EIOPA and ESMA take a more pragmatic approach. The financial institution will have the opportunity to show clients the most suitable ESG product, and to ask them if they are willing to change their ESG preferences to invest in this product or not.

Conclusion

The two guidelines, although more pedagogical than their consultation version, do not make major changes to the original texts. 

Well aware of the difficulties of implementing this new MiFIDII and IDD regulation, regulators nevertheless do not seem ready to make the assessment of sustainability preferences less granular or more tailored to the reality of the current ESG offering.

L’article ESMA guidance sustainability preferences assessment est apparu en premier sur Neuroprofiler.

In a regulatory environment that is increasingly vigilant about respecting investor preferences, asset managers have a crucial role in designing products tailored to their client’s expectations. Here are some explanations.

Responsible investment: a sustainable and growing trend

ESG products have become increasingly popular in recent years. Between 2015 and 2020, the total volume of sustainable bond issuance in Europe increased 18-fold, from €26 billion at the end of 2015 to €476 billion in 2020.

This trend was accelerated mainly by the Covid crisis. EFAMA, the European asset management association, reports an increase in sustainable bond assets to EUR 707 billion in the first 10 months of 2021[1] .

Indeed, the fiscal policy response to the Covid-19 pandemic has led to a significant increase in green bond issuance, which has further increased the liquidity and depth of the market, making it more attractive to investors. In addition, more and more assets managed under dedicated mandates for institutional investors are also subject to extra-financial approaches.

Thus, ethical considerations are increasingly replaced by financial arguments to promote the sale of ESG products. The most virtuous companies in terms of ESG have indeed performed better during the health crisis. More generally, taking extra-financial risks into account would help limit losses during emergencies.

More and more individuals are turning to responsible investment to make sense of their investments, where institutional investors have already led the way. In order to meet the growing customers expectations on ESG, asset managers face a significant regulatory challenge.

Asset management: a restrictive regulatory framework

The European regulation on the assessment of sustainability preferences under MiFDII, a first guidance document published last January, requires fund managers to provide exact information on financial products (alignment with the taxonomy, PAI, alignment with the SFDR definition of sustainable finance…).

This information is currently complicated to obtain (e.g., assessing a company’s impact on biodiversity or the circular economy).

The second challenge will be to create ESG products in line with the sustainability preferences of customers collected under the new regulation.

Indeed, if we stick to the current ESMA guidelines, a client could require a level of taxonomy alignment of 100%. Today, it is challenging to find ESG products with more than 20%…

Thus, the challenge for fund managers is not to seek out exotic investor appetites but to design products that fit the regulatory framework.

The problem is that while the regulations on ESG products, which are full of technical terms that are incomprehensible to the average person, do not allow for any freedom in the topics to be addressed, the fact remains that investors’ expectations are focused on specific and varied subjects.

The appetite for ESG products is there, but the offer must be intelligible and accessible. Therefore, the challenge for asset managers is to reconcile investor expectations with the existing MiFID II compliant product offering. In short, it is about reconciling regulatory compliance with the marketing and psychological understanding of clients. To do this, asset managers need to rely on appropriate tools.

InvestProfiler: a tool to make it fun to capture ESG preferences and then sell the right financial products

To survive in the current environment, asset managers need to:

• Capture ESG preferences by MiFID II regulations without making the questionnaire indigestible for potential investors
• Linking investor preferences with ESG products available on the market, free from the complexity imposed by regulation

To address this issue, the start-up Neuroprofiler has developed an InvestProfiler. This unique tool, based on the principles of gamification and behavioural finance, allows you to survey the ESG expectations of your end customers to help you match existing ESG products with their preferences. By using ESGprofiler, asset managers will be able to support better their institutional clients, who will be able to sell better and more to their end clients. Want to know more? Request a demo!

[1] https://www.efama.org/sites/default/files/files/Asset%20Management%20Report%202021_4.pdf

L’article ESG criteria: how to design products that meet customer expectations? est apparu en premier sur Neuroprofiler.