The European Union's ESG initiative - Part 1

Climate change gets the regulatory treatment

"We should put our money into projects that are compatible with our decarbonisation objectives and the fight against climate change. This is important for the environment and the economy, but also for financial stability." 1

Governments globally are taking sustainability seriously, keenly aware that a failure to do so risks accelerating the negative impact caused by climate change. In 2015, international agreements, such as the Paris Climate Agreement (COP 21) and the United Nation's 2030 Agenda and Sustainable Development Goals (UN SDGs) were finalized in what is likely to help drive financial flows into low carbon and climate change initiatives.2

As part of its efforts to achieve these goals, the European Commission (EC ) unveiled its Action Plan on Sustainable Finance in May 2018, a proposal which will introduce a regulatory framework supporting sustainable investment. The EC has said it wants agreement on the proposals from the European Parliament and European Council in 2019, which the authorities have said will form a key component of the Capital Markets Union.3 The rules are likely to be phased in between 2019-2022, and the EC estimates it will need to allocate EUR 180 billion each year to meet the European Union's (EU) 2030 targets as agreed in Paris.4

Creating rules around labelling and disclosure of ESG investments

Key insights

  • The EC's Sustainable Finance initiative is ambitious and market participants are urging regulators to avoid being overly prescriptive in relation to disclosure obligations
  • Incorporating sustainability considerations into regulations such as MiFID II and IDD needs to be carefully considered to avoid the risk of causing confusion and additional costs for the industry

One notable barrier facing Environmental, Social and Governance (ESG) and sustainable investing is in its labelling. Consensus on the type of assets or instruments that can be classified as ESG-compliant or sustainable has yet to be reached, although the EC confirmed it intends to develop an EU-wide taxonomy for climate change, environmentally and socially sustainable activities, using input from various non-governmental organizations and institutions.5

“This should provide economic actors and investors with clarity on which activities are considered sustainable so they take more informed decisions," read an EC statement.6 Once agreement is attained on taxonomy, institutional investors including asset managers, insurers and pension funds will need to report to clients or stakeholders on how they integrate ESG risks into their investment processes.7

The EC has said that financial products being marketed as sustainable investments must publish details about the sustainability impact of those investments, along with targets and the methodologies used to quantify them.8

Consensus on the type of assets or instruments that can be classified as ESG-compliant or sustainable has yet to be reached

 “The intention of this new regulation is that better disclosure will lead to greater and more comparable information on sustainability risks and opportunities being made available to end investors."9

ESG disclosures will be in addition to existing regulatory reporting requirements contained in rules such as the UCITS regulatory framework and the Alternative Investment Fund Managers Directive (AIFMD).10 While acknowledging that sustainability and ESG were important criteria in portfolio allocations, pension funds and asset managers have suggested that the EC should avoid being too prescriptive. They argue that a one-size-fits-all approach is counterintuitive as different organizations will have their own unique ESG and sustainable investment processes.11

Updating existing regulations to incorporate ESG

The EC has also said it will conduct a consultation into how sustainability considerations can be incorporated into investment advice provided to clients by asset managers and insurance distributors.12 Ensuring that ESG and sustainability are in tune with investor preferences will require the EU to make amendments through Delegated Acts13 to the Markets in Financial Instruments Directive II (MiFID II) and the Insurance Distribution Directive (IDD).14

Industry bodies have been supportive of the EU's proposals but some have advised regulators to exercise caution when implementing changes to MiFID II's suitability rules. “Any attempt to rush the incorporation of ESG considerations within the MiFID II suitability assessment without a rigorous process which includes phasing requirements, longer implementation times and more consultation with industry participants will harm the overall objective of the Commission's action plan," said the Association for Financial Markets in Europe (AFME).15

Industry bodies have been supportive of the EU's proposals but some have advised regulators to exercise

AFME added that a “flexible and dynamic taxonomy" needed to be produced prior to wholesale reforms being made to MiFID II.16 Meanwhile, the European Fund and Asset Management Association said incorporating sustainability considerations into suitability tests in such a short space of time risks causing delays to the implementation of MiFID II requirements, creating “additional substantial costs, further ambiguity and disruption to the whole distribution chain, not even a year after the going live date".17

Regulatory amendments to MiFID II and IDD incorporating ESG will require industry input and guidance to ensure the final requirements are achievable, sustainable and not arbitrary in order to reduce the potential for conflicting or ineffective rules.

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  1. European Commission (May 24, 2018) Press Release
  2. European Commission – Sustainable Finance
  3. Ibid . European Commission press release (May 24, 2018)
  4. Ibid. European Commision - Sustainable Finance
  5. Business Green (March 8, 2018) EU sustainable Finance Action Plan: Your need to know guide
  6. Ibid. European Commission press release (May 24, 2018)
  7. Ibid.
  8. Clifford Chance PDF (June 2018) The EU's Sustainable Finance Legislative Proposals: What you need to know
  9. Ibid.
  10. Ibid.
  11. IPE (March 2018) ESG: European Commission triggers unease with ESG approach
  12. European Commission press release (May 24, 2018) Sustainable finance: Making the financial sector a powerful actor in fighting climate change
  13. Slaughter & May (May 24, 2018) Financial Regulation Weekly Bulletin
  14. KPMG Luxembourg (June 5, 2018) European Union: EU gets Sustainable about Finance: The New Legislation Explained
  15. AFME (June 21, 2018) AFME response to the Commission's amendments to the delegated act supplementing MiFID II on suitability requirements
  16. Ibid.
  17. EFAMA (PDF) EFAMA's comments on the European Commission's legislative proposals in relation to the sustainable Finance Initiative and the MiFID II suitability requirements