Consideration of clients’ preferences on ESG factors when evaluating the adequacy of providing financial advice or portfolio management

The key building blocks are as follows: 

1. EU taxonomy investment
The development of a common methodology for defining “sustainable”

2. Corporate disclosure
The obligation for EU-based entities to publish the amount of revenue they earn based on activities aligned to an environmental or social sustainability objective

3. Product design
The definition of common disclosure standards for packaged financial products promoting ESG or sustainable investments

4. Service delivery
The incorporation of clients’ sustainability preferences into the suitability process when recommending investment services or financial instruments

Put simply, the EU Commission is creating an ecosystem which will reward companies considered “sustainable” (based on strict regulatory defined standards) by channelling capital flows from investors with sustainability preferences to these companies. While this sounds simple, the implications are staggering. 

Let’s focus on the service delivery element and the consideration of clients’ sustainability preferences. This is a key piece of the puzzle, as it acts as the hinge between the real economy on the one side and the investment needs of the end-client on the other side.

Today, non-financial considerations are rarely part of the investment decision making process – at least not in a systematic manner. Studies show that end-investors in general are little knowledgeable about the sustainable finance services or product shelves available to them. At the same time, the market is complex, characterised by a wide variety of financial instruments with greatly differing levels of sustainability-related ambitions, ranging from “best-in-class”, deep green investment strategies to basic exclusion approaches - often leading investors to compare apples with pears.

inancial institutions, notably banks and insurance companies, will have to consider clients' sustainability preferences when assessing the adequacy of a financial instrument or investment service. The existing MiFID-based suitability test shall be updated to include non-financial considerations expressed through a client’s sustainability preferences. In this context, there are three key constraints that are vital to consider:

1. Constraint 1: The regulatory definition of sustainability preferences 

2. Constraint 2: The underlying investable universe

3. Constraint 3: The recent ESMA consultation on Sustainability Guidelines

Constraint 1: 

To enable clients to understand the different degrees of sustainability and allow them to take informed investment decisions, the regulator provides a precise definition of the type of financial instruments that qualify as meeting a client’s sustainability preferences. These are: 

• Financial instruments that qualify as “sustainable investment” according to the Taxonomy

• Financial instruments that qualify as “sustainable investment” as defined by Art.2 (17) of the SFDR and 

• Financial instruments that consider principle adverse impacts (PAI) on sustainability factors

This is a rather narrow definition of how a client could express any sustainability-related investment ambitions. Notably, it may be observed that there is a misalignment between the MiFID and SFDR regulations in this regard. The latter provides for the classification into 2 distinct product categories: Article 8 financial products that promote environmental or social characteristics and Article 9 products that focus solely on sustainable investment. A basic Article 8 product relying solely on an ESG type of investment strategy (e.g. a vendor based ESG risk rating approach) may not qualify as meeting a client’s sustainability preferences and may thus not be marketed as a suitable financial instrument to a client having expressed such sustainability preferences.

This is significant as Article 8 products represent a large portion of the available financial products under SFDR. For instance, in France there is a well-established methodology around Socially Responsible Investment (SRI). This methodology however does neither account for sustainable investments as defined by the new EU regulation, nor does it account for PAIs. As such, any investment strategy based purely on the SRI methodology may qualify as Article 8 under the SFDR but not as meeting a client’s sustainability preferences under the MiFID.

It follows that the narrow definition of a client’s sustainability preferences has major implications on the product manufacturers and their product design process. In order for their products to be deemed “suitable” to the end-investor the investment strategies have to be enriched in order to account either for sustainable investment or for PAI considerations. 

Constraint 2: 

The definition of sustainability preferences within the suitability process puts an important focus on the investable universe linked to sustainability-related investments. This makes sense, as it is the overarching objective of the European Commission to foster capital flows towards companies that generate revenue based on sustainable economic activities. In support of this, the regulation is pushing for a common methodology on how to define a sustainable investment. As a consequence, sustainable investments actually become comparable. 

The underlying framework for defining a sustainable investment consists of 3 distinct assessment criteria, which are derived from the underlying regulatory definition of a sustainable investment within the SFDR (Art.2(17)):

• Assessment 1: Positive contribution - an investment in an economic activity that contributes to an environmental or social objective

• Assessment 2: Do no significant harm – an investment that does no significant harm from a sustainability perspective to any other environmental or social objective (e.g. no or little negative externalities) 

• Assessment 3: Minimum safeguards – an investment that respects good governance practices

The EU Taxonomy is one approach on how to apply this framework, based on regulatory defined and scientifically sound technical screening criteria and controls. This approach however features a major weakness: the regulatory timeline. 

Neither is the underlying regulation regarding the Taxonomy finalised, nor are EU companies yet obliged to report on the sustainability of their business activities. This reporting will be subject to the regulatory corporate reporting – incorporated into the CSRD (as mentioned above) – date of application in 2023 with first reports expected in 2024. As such, the currently available Taxonomy data are either (i) vendor proxies (with varying degree of quality), (ii) data published by early-movers looking to advertise the sustainability of their business model (likely non-audited) or (iii) data based on internal due-diligence resulting from bilateral data gathering (seems inconceivable for large data lakes). 

As an alternative to the Taxonomy, it is possible to develop an internal proprietary model. Such a model is also embedded within the 3 assessment criteria, while however relying on internally defined thresholds and limits. For instance, financial institutions may rely on SDG alignment when assessing the positive contribution of an investment. Such investments would qualify as sustainable investment in accordance with Art.2(17) of the SFDR and thus be eligible to meet a client’s sustainability preferences.

Independent of the development of the Taxonomy, such internal models will remain of importance in order to assess non-EU based companies and corporations, as these are neither subject to the EU reporting standards nor to the EU Taxonomy. 

Today, we are at the beginning of the sustainability journey and the level of sophistication of the described sustainable investment framework is still at an infant level. These factors combined lead to sustainable investments becoming a rare good to come by. Financial institutions should closely analyse the level of coverage they have with regards to these types of instruments prior to developing their underlying service offering as well as their sustainability client questionnaire. 

Constraint 3: 

Last but not least, one has to account for the recently published ESMA Consultation when considering the adequacy of sustainability preferences. It is through the suitability assessment that the sustainability preferences shall be incorporated into the investment process; either as investment advice or via a DPM mandate. 

The Consultation of ESMA had been eagerly awaited to provide clarifications and certainty with regards to the implementation of these substantiality preferences. It seems though that the level of ambition expressed by ESMA has taken many in the market on the back foot. 

Let’s focus on the three most relevant points:

1. Narrow definition of sustainability preferences

2. Granular approach to collecting information on sustainability preferences

3. Clarification with regards to the suitability test 

(i) 

ESMA confirms the narrow definition of the term sustainability preferences. As already outlined, this puts the focus on a significantly small portion of the currently existing investable universe, completely excluding ESG-type of investment strategies (i.e. basic Art.8). 

Furthermore, ESMA highlights the need that clients are properly informed about the concept of sustainability preferences and the choices to be made in this context. Financial institutions shall explain the following: 

• the meaning of having sustainability preferences but also the distinctions between the financial instruments qualifying as such preferences (refer to Constraint 1),

• the distinction between instruments qualifying as sustainable preferences and instruments without such sustainability features (or with other sustainability features) and 

• the meaning of environmental, social and governance matters. 

Given the underlying complexity of the subject matter, this is a major challenge. How should this education take place: via physical meetings, telephone calls, educational seminars, videos, or marketing material? The decision will largely depend on the underlying service offer and the knowledge and experience of the clientele. In any case, it seems doubtful that a client will fully grasp the concept of sustainability preferences by reading a leaflet or a flyer. In the same way, it seems doubtful that banks will have the time or the resources to educate each and every client in a direct manner. 

(ii)

Second, ESMA proposes a rather granular approach to the collection of the information for determining a client’s sustainability preferences. ESMA defines the following as the minimum information to be collected:

• Whether the client has any sustainability preference?

• Whether the client has any preference or preferences between the respective financial instruments (refer to Constraint 1)?

• What is the minimum proportion in these investments?

• Whether the client has any preference or preferences with regards to certain principal adverse impacts (PAIs)?

Three key implications can be deduced from this:

• Firstly, the above provides the basic building blocks for the sustainability questionnaire. The requirements of the ESMA leave little room for manoeuvre. 

• Secondly, ESMA confirms the self-assessment nature for determining a client’s preferences. As such, any attempt to deduce a client’s preferences through behavioural type of questions doesn’t seem to be aligned with the regulatory standards. This comes as a surprise, as ESMA highlights in the same guidelines that banks should restrain from using self-assessment type of questions – in particular with regards to their knowledge and experience, but also with regard to their risk appetite. This means that ESMA deems clients not fit to self-assess their knowledge and experience, for instance on bonds or equities, but fit to define the proportion of taxonomy sustainable investment and PAI considerations to include into an investment portfolio. One might argue that there is a lack of cohesion in the propositions of ESMA. 

• Thirdly, based on the granularity of the required information and the numerous different combinations thereof, it seems that multiple sustainable investor profiles appear necessary to meet these diverging sustainability preferences. This is significant, as up to this point many financial institutions had oriented themselves on the logic of the SFDR, meaning 3 profiles: 

  • a traditional profile who has no interest in sustainability (Art.6 type of investor)

  • a middle investor who aims at reducing or at least managing any potential negative externalities (Article 8 type of investor) and

  • a sustainable investor who aims at achieving a positive contribution through his/ her investments (Article 9 type of investor).

Such classification no longer seems possible, in particular due to the fact that multiple sustainable investor profile seems necessary to account of the varying combinations of sustainable preferences and because the middle investor does not qualify as expressing sustainability preferences 

(iii) 

ESMA clarifies the functioning of the suitability test. It is outlined that the suitability shall be viewed as 2-step control. Sustainability preferences shall only be assessed once the financial suitability – based on investment objectives, financial situation and knowledge and experience – has been successfully passed. As such, the financial suitability takes precedence over the sustainability preferences. This is a very important clarification indeed. 

Furthermore, ESMA specifies that a failure to not meet a client’s sustainability preferences is not a blocking issue. Rather, it is defined that a recommendation may still be treated as suitable as long as the financial criteria are met and the client “adopts” the underlying preferences for this individual transition. Such adoption of the preferences shall be duly documented in the ex-ante suitability statement, shall not impact the profile as such (only applicable to this one transaction) and be considered as a non-standard approach. In the end, it remains to be seen whether such an exemption is actually beneficial or not. In particular in a portfolio-based suitability set-up any exemption of the portfolio defined thresholds seems problematic as such deviations will impact the on-going ex-post suitability controls and may lead to involuntary investment breaches.

In the grand scheme of things, everyone can agree that our economy and society have to become more sustainable. Developing processes to reward sustainable business models is a great idea. However, when looking at the building blocks intelligently developed by the regulator, one needs to pause and wonder about the misaligned timeline. Why are clients invited to express preferences to financial instruments that are currently unavailable on the market? Why does the suitability of a recommendation have to be assessed on the basis of metrics that are not yet published? 

It seems political eagerness is creating an unnecessary level of complexity that may actually damage the transition into a more sustainable economy in the short term as investors are simply overwhelmed by the responsibility unloaded upon them. 

^{1. Please refer to Regulation EU 2020/852, on the establishment of a framework to facilitate sustainable investment}

^{2. Please refer to proposed Directive 2021/0104 (COD), constituting the new Corporate Sustainable Reporting Directive (“CSDR”), applicable to approx. 49.000 companies within the EU}

^{3. Please refer to Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial sector}

^{4. Please refer to Delegated Regulation 2021/1253, amending Del Reg 2017/565 as regards the integration of sustainability factors, risks and preferences into certain organisational requirements and operating conditions for investment firms}