Sustainability preferences under MiFID II, what does it imply ?

A growing interest for sustainable investing

Sustainability - Free nature icons

Global warming, governance and social tensions have increased awareness among retail investors regarding the limits of our traditional economic model.

Investors are now looking to have a positive impact on the society and the planet, in their daily purchases but also their investments.

This awareness is reflected through a growing appetite for ESG investing on financial markets (ESG: Environmental, Social and Governance).

A strong appetite for socially responsible investing among Millennials

Based on a study by the DeVere Group, 80% of Millennials want to make a socially responsible investment, compared to 60% for the rest of the population.

However, based on a 2021 Ailancy survey, only 17% of investors have already invested in sustainable finance.

There is thus a real gap between the demand and the ESG offer on the markets for retail investors.

A European Commission proposal to integrate sustainability preferences

This trend is reinforced by the new requirements of the European Sustainable Finance Disclosure Regulation (SFDR), the Insurance Distribution Directive (IDD) and the Markets in Financial Instruments regulation (MiFID II) for investor protection, which provide a solid framework for asset managers for classifying financial products on regulated markets according to their social and environmental impact and insuring that investment services are in line with investors’ ESG investment strategies.

This new requirement may apply whether giving advice on a particular product or service or in case of portfolio management.

In doing so, the European Commission aims to empower investors to make sustainable investments.

Thanks to this new input from the markets authority, ESG (Environment, Social and good Governance) products could therefore play a part in reviving the economy and financial markets, provided that financial advisors manage to understand their clients’ expectations on the subject.

What do we mean by sustainability preferences ?

The integration of the notion of sustainability preferences and responsible investment in MiFID II

With the new financial instruments directive, financial firms will have to take into account ESG factors and preferences such as good governance or environment to support a client suitability assessment and not only investor preferences like risk tolerance, risk capacity and financial expertise, as in the Markets in Financial Instruments (MiFID II).

This new requirement will have a major impact on the IT systems and internal processes of most financial institutions and fund managers which are used today to consider only the financial elements (mainly financial knowledge and risk profile) when recommending suitable financial products to their clients.

Such an integration will be a complex operation for financial advisors and asset managers but also an opportunity to reconsider traditional investment advice approaches and increase the customer experience on this point, by integrating, for example, elements of gamification and behavioral finance.

“To enable investment firms that provide investment advice and portfolio management to recommend suitable products to their clients, those investment firms should introduce in their suitability assessment questions that help identify the client’s individual ESG preferences.“ Markets in Financial Instruments (MiFID II), European Securities and Markets Authority (ESMA)

But what does the European Union mean by sustainability preferences?

The Markets in Financial Instruments regulation (MiFID II) definition of sustainability preferences in the legislative framework refers to an appetite expressed by the client for financial instruments that:

  • Pursue a minimum proportion of sustainable investments in economic activities that qualify as environmentally sustainable under the EU Taxonomy Regulation;
  • Financial instruments that pursue a minimum proportion of sustainable investments as defined in SFDR
  • Financial instruments that consider principal adverse impacts on sustainability factors, where elements demonstrating that consideration are determined by the client.

What happens if financial advisors recommend non-SFDR instruments?

It seems like all financial instruments (including products which are not regulated by SFDR) are in the scope of this new requirement of the European Union.

As a reminder, financial products in the scope of SFDR regulations include instruments like investment and mutual funds,  Exchange Traded Funds, insurance-based investment products and pension funds.

With this new MiFID II regulation on sustainability, investment companies and asset managers will thus need to do their own ESG assessment of products which are not concerned by the new rules of SFDR like shares, bonds, private equity, derivatives… to be sure that they meet the sustainability expectations of their clients.

What happens if no products match the client’s sustainability expectations?

In this new MiFID II requirement, there is a specific prohibition on financial institutions to recommend products which do not meet the client’s sustainability objectives.

Additionally, where no financial products meet the client’s sustainability objectives and the client decides to change its preferences as a consequence, financial advisors must keep a record of the client’s reasons for the change.

The next challenge: how to establish an assessment of client’s ESG preferences in line with MiFID II?

A major challenge for banks will be to make these ESG investing complex legislative rules accessible to retail investors and ensure to have a proper process in place to capture these preferences accurately.

The use of a scientific-based approach through psychometric or behavioral finance questionnaires will be key to make sure to deliver compliant and relevant ESG recommendations to clients, without affecting the user experience and the business.

For more information about how to assess clients’ ESG sensitivity, see our dedicated article and ESGprofiler.