Assessing sustainability preferences
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:
(a) 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;
(b) 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;
(c) 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.
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.
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.