Climate change, the health crisis and corporate governance concerns have increased awareness regarding the limits of our traditional economic model. People are now looking to have a positive impact on the society and the planet. This awareness is reflected through a growing appetite for ESG investing on financial markets (ESG: Environmental, Social and good Governance).
To address the new consumer preferences, the European Securities and Markets Authority (ESMA) will make it compulsory for investment firms to integrate the assessment of sustainability preferences into the client suitability assessment process to promote ESG companies.
These new regulations will be part of the Markets in Financial Instruments Directive (MiFID II).
A major challenge for investment managers will be to find relevant methodologies to capture their client’s sustainability preferences accurately and integrate them in their investment strategies, without affecting business and client experience.
If they manage to do so, sustainable investments can become a real competitive advantage for them.
The new MiFID II requirement for ESG preferences assessment
To face the growing demand for socially responsible investing, the European Sustainable Finance Disclosure Regulation (SFDR), the Insurance Distribution Directive (IDD) and the Markets in Financial Instruments regulation (MiFID) have provided a solid framework for classifying financial products on capital markets according to their sustainability risks and impacts.
The second step is to make sure that investment firms integrate these ESG factors (Environmental Social and Governance) in their financial recommendations, in line with their client’s personal values.
These new requirements should come into force in 2022. It will apply in the European Union for investment services such as investment advice or portfolio management.
In doing so, the European Commission gives the regulatory pressure to empower investors to decide where and how they want to make a sustainable investment.
How can investment firms assess their client’s ESG preferences?
An intimate discussion
Gauging whether the client wants to make a responsible investment is delicate. Cognitive biases, emotions and personal beliefs play a great role in the client’s investment decision-making.
The discussion can even become quite intimate when controversial subjects like nuclear power, wind turbines or meat consumption are treated.
As a result, sustainable investing is not a straightforward tick-box exercise but requires a real preparation from financial institutions.
An assessment methodology not yet mature
Since the appetite for responsible investing is quite new, few advances have been made so far to create a reliable suitability process that truly captures client’s attitudes towards sustainability.
Most investment firms decide to add a simple question to their suitability questionnaire like “What percentage of your portfolio would you like to dedicate to sustainable finance?” which has a very low chance to capture the investor preferences accurately.
Several issues with the current ESG assessment methodology
There are indeed several issues with this kind of approach:
- Based on recent surveys, there is still a limited number of retail investors who is familiar with the notion of sustainable finance, impact investing or responsible investment. Asking to a retail investor if he wants to invest in ESG related products may be thus misunderstood. There is moreover a strong cliché which remains about the fact that ESG investments affect expected returns. The first step, before assessing the client’s appetite for responsible finance, is thus financial education.
- Based on the limited financial literacy of most investors, the notion of “portfolio” is not always understood.
- Cognitive studies show that percentages are misperceived by human brains, by comparison to absolute numbers (ratio bias).
- Most behavioral finance studies show that self-assessment does not help capture the true social preferences, since our answer to this kind of question will be affected by many cognitive biases (social pressure, framing effect, herding effect…)
- Most clients will be frustrated by such a question since they will not understand exactly what it means and how they should answer. They will also have the feeling that the financial advisors does not make any efforts to understand their true personal values and recommend suitable sustainable investments.
- Self-assessment is not recommended and even prohibited by the ESMA, for instance to assess risk appetite or financial knowledge. There is a chance that similar guidelines for sustainability preferences will apply in the future.
- The use of behavioral finance is highly recommended by the ESMA to capture investment preferences. So far, these guidelines published in 2018 have applied for risk appetite. There is similarly a high chance that these recommendations will apply for sustainability preferences in the future.
- With the new Sustainable Finance Disclosure Regulation (SFDR), an investment advisor should collect enough client’s information about his ESG objectives and desired impacts to justify that, for instance, this clients wants to invest in Article 9 rather than in Article 8 products. This level of details will be hard to capture with a traditional checkbox questionnaire.
The necessity to have a structured and scientific approach to address the new sustainable finance policy
To address such a complex question, the use of a psychometric or behavioral finance questionnaire is essential to have a scientific approach of ESG appetite assessment.
The use of psychometric or behavioral finance based questionnaires could help not only capture these preferences accurately, but also to boost ESG investing and improve user experience.
Thanks to behavioral finance, the ESGprofiler offers an predictability rate of 95%. With its interactive and gamified user interface, 80% of clients prefer our client journey by comparison to a traditional checkbox questionnaire.
If you would like to know more about our ESGprofiler, do not hesitate to contact us at firstname.lastname@example.org