Asking investors about their ESG preferences will soon become part of the routine for financial advisors. By the recommendation issued by the European Commission’s HLEG (High-Level Expert Group), investment companies will have to consider the impact desired by investors in terms of sustainable finance as of 2 August 2022. The final text of the European Commission’s draft Delegated Regulation was published in the Official Journal on 2 August 2021. Here are the main changes relating to the introduction of sustainability factors in the MiFID 2 suitability questionnaires.
Assessing Sustainability Preferences: Regulatory Developments
According to MiFID 2 regulations, financial institutions must know the profile of their clients, notably through the suitability test. Traditionally, the latter aims to ensure that:
- The client has the experience and knowledge to understand the risks associated with the transaction or the management of their assets.
- The client is financially able to bear any investment risk related to their investment objectives
- The financial product meets the investment objectives of the client in question, including their risk tolerance.
The Delegated Regulation has added to this last point the consideration of the “possible sustainability preferences” of the investor. Thus, from 2 August 2022, banks, management companies, and investment advisory firms will have to ensure that the proposed investment corresponds to the sustainable impact desired by the investor.
Article 54 on the assessment of suitability has also been expanded to include a reference to this effect:
“Information about the client’s or potential client’s investment objectives shall include, where appropriate, information about the length of time they wish to hold the investment, their risk-taking preferences, their risk tolerance and the purpose of the investment, as well as any sustainability preferences.“
“Sustainability preferences” shall mean the following definition, as defined by Article 1 of the Commission Delegated Regulation (EU) 2021/1253 of 21 April 2021. Sustainability preferences means “whether and to what extent a client, or potential client, chooses to include one or more of the following financial instruments in their investment:
a) a financial instrument that is invested in environmentally sustainable investments, as defined in Article 2(1) of Regulation (EU) 2020/852 of the European Parliament and f 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 the Council (**) in a minimum proportion determined by the client or potential client;
c) a financial instrument that addresses key adverse impacts on sustainability factors, with the qualitative or quantitative elements that demonstrate this being determined by the client or potential client.
The difference between a) and b) is tenuous but essential: an investor can either invest in activities that pursue an environmental objective specifically addressed by the European taxonomy (biodiversity, pollution…), or in activities with a social or environmental objective not (yet) listed by the European taxonomy.
Sustainable finance: what to do when investor preferences do not match the supply of financial products?
If a client’s sustainability preferences are not compatible with the financial products offered, the new EU regulation stipulates that advisory and asset management companies must refrain from recommending unsuitable services. They must then explain to their clients why they are unable to offer them financial products that are in line with their ESG expectations and keep a record of these reasons.
If the client decides to adjust his sustainability preferences to better match the financial products offered, the investment company shall keep a record of the client’s decision and the reasons for it.
In all cases, the report provided to the client following an investment advice interview must include a summary of the advice given and an explanation of how the recommendation provided is suitable for the client insofar as it meets:
- His/her investment objectives
- His/her situation about the required investment period
- His/her knowledge and experience
- His/her attitude to risk
- His/her ability to bear losses
- His/her preferences in terms of sustainability.
Risk management, identification of conflicts of interest, governance obligations… Sustainability factors have been considered in all articles of the relevant Delegated Regulation (EU) 2017/565. Similar changes have also been made to the AIFMD, which provides a regulatory framework for AIFMs in Europe, as well as within the UCITS Directive which aims to harmonize European markets.
Financial institutions: how to assess the impact desired by the investor in terms of sustainable finance?
To comply with regulations, financial institutions face the challenge of being able to assess the sustainability appetite of their customers.
The aim is to understand each client’s ESG strategy, to assess whether they have a preference between environmental, social, or governance aspects, and to determine the proportion of their assets that they wish to devote to these aspects… And therefore, to make an already difficult questionnaire much longer.
To help financial institutions in this process, the start-up Neuroprofiler has developed an “ESGprofiler”.
The ESGprofiler is an adaptive and fun questionnaire based on behavioral assessing clients’ preferences in terms of sustainable investment, by the new MiFIDII requirements. This tool not only helps to improve process compliance but also to boost sales of sustainable products. Indeed, at the end of the test, the investor is offered financial products that are perfectly in line with his/her expectations. It is, therefore, possible to transform this regulatory constraint into a commercial opportunity, based on a better knowledge of the customers. Discover the power of ourESGprofiler, ask for a demo!
(*) “environmentally sustainable investment” means an investment in one or more economic activities that can be considered environmentally sustainable according to the European taxonomy. The unified classification system for sustainable activities distinguishes 6 main categories of environmental impacts: climate change mitigation/adaptation, biodiversity protection and restoration, pollution prevention, and control, transition to the circular economy, sustainable use, and protection of water and marine resources.
(**) “sustainable investment”: an investment in an economic activity that contributes to an environmental objective, measured for example through key indicators in resource efficiency regarding the use of energy, renewable energy, raw materials, water, and land, in waste generation and greenhouse gas emissions, or the impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular, an investment that contributes to the fight against inequality or promotes social cohesion, social inclusion, and labor relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not materially prejudice any of these objectives and that the companies in which the investments are made apply good governance practices, in particular about sound management structures, employee relations, remuneration of relevant staff and compliance with tax obligations