At a Glance
MiFID II suitability rules are being amended to require investment advisers and investment managers to obtain retail clients’ “sustainability preferences” i.e. clients’ views on how they want their capital to be used to influence environmental, social or governance (ESG) related issues.
Sustainability preference is a new concept in regulation. With the implementation deadline of 2 August almost upon us, we surveyed over 50 Deloitte practitioners who are supporting firms with implementing the requirements across the EU. The survey highlighted several key challenges firms are facing:
- Communication: having to collect preferences at a “granular” level will require firms to explain technical concepts to their clients and word suitability questionnaires carefully if they are to convey a good understanding of what this means for clients’ investments in a way that does not unduly influence them.
- Greenwashing: incomplete ESG data from investee companies and unfamiliar new terminology create the risk of greenwashing when deciding which products to offer and matching products to preferences.
- Lack of an adequate product offering: since firms will have to ask their clients specific questions about their interest in sustainable investments and explain to them what this means, clients’ demand for sustainable investments is likely to increase. In order to remain competitive, firms in scope of the rules should review their product range and/or model portfolios to determine whether they can cater for the different types of sustainable preferences that investors may have.
Whilst these rules only directly affect firms operating in the EU, the FCA is working on sustainability preferences rules for the UK. The principles and motivations behind the EU and UK sustainable finance regulatory frameworks are similar. Firms in scope of COBS 9 suitability rules in the UK may benefit from reading this blog to anticipate how the FCA may approach its rule‑making.
Read on for insights on how firms may tackle these challenges. The slide-pack accompanying the blog provides an overview of the rules and a summary of our key insights on leading practice.
A new suitability requirement
A key part of the EU’s Sustainable Finance Action Plan (SFAP) is a delegated act published by the European Commission (EC) which expands existing MiFID II suitability assessments to include clients’ “sustainability preferences”. Investment advisers and portfolio managers in the EU will, from 2 August 2022, be required to obtain clients’ investment preferences in relation to ESG issues alongside conventional suitability information.
EU policymakers have defined sustainability preferences by reference to other sustainability regulations as being preferences for financial instruments that either:
- pursue a minimum proportion of sustainable investments in economic activities that qualify as sustainable under Article 3 of the EU Taxonomy; or
- pursue a minimum proportion of sustainable investments, as defined in the SFDR; or
- consider principal adverse impacts on sustainability factors.
Clients define both “minimum proportions” and, in the case of principal adverse impacts, the E, S or G factor on which the impact is being considered.
The technical nature of this tri-partite definition and the expectation in ESMA’s draft guidelines (published in Jan 2022) that sustainability preferences should be collected at a “granular level” raise implementation challenges for firms. This is particularly the case for the requirement that clients define minimum proportions of sustainable investments when the concept of sustainable investing is still relatively new and clients have varying interpretations and levels of understanding.
In this blog we have set out our insights on how firms can approach communication in the process of collecting sustainability preferences, so as to give clients the understanding they need to express their preferences, whilst avoiding wording that influences them towards specific preferences that are aligned with the products the firm offers.
Communication, communication, communication…
Several key aspects of the new requirements call for clear communication between in-scope firms and clients, as detailed below:
- Explaining sustainability preferences: ESMA’s draft guidelines recommend that firms should explain the concept of “sustainability preferences” to clients and the different types of products included under this definition. In our view, firms could provide a “context” or “overview” page at the start of their suitability questionnaires, where they explain, in a non-technical and succinct manner, what the definition means, including what “sustainable investments” mean under the EU Taxonomy and SFDR, and what is consequently required from clients. Here it would also be useful to provide an explanation of what each of the E, S and G components of “ESG” mean in practice. As part of the narrative on E, S and G, we think clients would benefit from understanding how positive impact in these areas is actually measured and what real world change their capital is likely to create e.g. reduction of carbon emissions or provision of social care to certain communities.
- Minimum proportions of sustainable investments: in practice, we expect that the manufacturer of a sustainable product will have already made clear what proportion of sustainable investments it contains. As such, when suitability questionnaires explain the concept of minimum proportions and pose the question of what proportion the client would prefer, they should also provide information about the proportions actually available in the products on offer.
- Principal adverse impacts: the ESMA draft guidelines indicate that, when firms provide an explanation of “principal adverse impacts”, they may use the broad categories from the Level 2 Regulation under the SFDR. A good explanation of the various categories and a clear caveat about the current data limitations that apply in terms of assessing principal adverse impacts will help clients to understand exactly what can and cannot be achieved through this type of investment strategy.
- Interaction with existing suitability requirements: firms are required by the new rules to assess a client’s existing suitability information such as financial objectives, time horizon and risk appetite before asking for their sustainability preferences. Clients could potentially choose sustainability preferences that conflict with their existing requirements - where this occurs, firms will need to be proactive about reaching out to clients to clarify how they want to prioritise their objectives. A further complication is that the impact of sustainable investing on financial returns is a matter of debate in the industry. Firms will need to make evidence-based judgements about how different types of sustainable investing could affect financial returns and be transparent with clients about the data limitations in this area.
Treading a fine line between guiding and influencing
The ESMA draft guidelines specifically state that firms should not influence clients’ answers to suitability questionnaires.
One of the key risks that arises here is that the questionnaire is worded, or appears to be worded, in a way that attempts to influence clients to opt for sustainability preferences that match the products which the firm offers. To avoid this, we think firms should ask open-ended questions and explain the range of products they offer. For example, when asking clients about “minimum proportions”, firms should avoid questions that only allow clients to choose from a set number of specific proportions.
Comprehensive guidance should also be provided around what E, S and G mean in relation to sustainable investments and the fact that there might be trade-offs between them should the client choose investments that are heavily catered to one of these areas. Open-ended questions about clients’ preferences in terms of E, S and G will demonstrate the firm’s interest in understanding its clients’ preferences – questions biased towards a particular component of E, S and G might suggest that clients are being “nudged” towards the available products.
Furthermore, the ESMA guidelines state that, even if the firm does not offer any products that would cater to sustainability preferences, it should still ask questions, but it should make clients aware that no products are available which match their preferences. The firm should then give the client the option to “adapt” their preferences. In our view, questions and explanations on sustainability preferences in such cases should still be sufficiently detailed to avoid the perception that the firm is discouraging clients from considering their sustainability preferences so that they will accept products that do not match them.
EU and UK regulators are highly concerned about the risk of “greenwashing” i.e., a situation where a firm makes misleading or exaggerated claims about the environmental benefit of its product or services. The EC is clear that one of the sustainability preferences rule’s key objectives is to mitigate the risk of greenwashing. Although greenwashing has conventionally been seen as a conduct risk i.e., an act of deliberate misconduct through mis‑selling or misrepresentation, it can also occur inadvertently due to a lack of standardised and complete ESG data from investee companies and a new landscape of unfamiliar sustainability‑related terminology.
For both manufacturers and distributors that are in scope of the rules, documenting preferences in suitability reports will be crucial in demonstrating that they have not engaged in greenwashing. At a basic level, suitability reports should have a thorough account of the client’s stated sustainability preferences, whether additional discussions took place to iron out misunderstandings, and how the firm matched the client’s preferences to certain products. If the firm has recommended a product that does not match the client’s initial sustainability preferences – for example, because the client wants to prioritise their financial objectives or because the firm does not have any products that match the sustainability preferences – then the reasons for this should be clearly documented. Clear and consistent documentation will be useful not only for supervisory reviews but also for facilitating smoother investigations in the case of greenwashing‑related complaints.
Separately, given the widespread use of ESG ratings for the creation of sustainable products, firms in scope should be mindful that ESMA has voiced concerns about the lack of transparency in the methodology of these ratings. When matching funds to sustainability preferences, distributors should not overly rely on ESG fund ratings or ESG ratings for underlying stocks and instead determine whether other evidence is available in the prospectus and other fund documents about the fund being sustainable under the EU Taxonomy or the SFDR. The issue of ESG ratings is particularly important where a portfolio of individual stocks is being put together - if ratings are being used to determine the sustainability of stocks, firms need to ensure there is enough information available about their methodology to confirm that they cater to the definition of sustainability preferences.
MiFID II requires distributors to obtain information from manufacturers to gain the necessary understanding and knowledge of the products before distributing them. In our view, where firms are distributing other firms’ sustainable products they should be particularly mindful of the risk of greenwashing and conduct additional due diligence, particularly on any disclosed data limitations. Distributors should not only have a thorough understanding of the sustainable product’s objectives and strategies but also endeavour to have sufficient market expertise to be able to spot potentially exaggerated claims and understand the types of sustainable investment strategies that exist and the level of success they have had so far. Whilst a third-party distributor will ultimately rely on product manufacturers for the bulk of the information about a product, being able to speak to clients at a granular level about the limitations of products and about market trends and developments in this area, will build trust and reduce the incidence of greenwashing complaints.
To learn more about how asset managers can address the risk of greenwashing please see our paper from May 2022 here.
Distributors will need to ensure that their existing processes for identifying target markets are adapted to include sustainability-related objectives and that those responsible for these processes are well versed in the concept of “sustainability preferences” and associated definitions.
Where the product manufacturer is an EU MiFID firm, that firm will be required from 22 November 2022 to specify the sustainability‑related objectives that their products are compatible with as part of identifying their target market, and ESMA suggests that they may specify sustainability objectives in a way that is aligned with the definition of sustainability preferences. In most cases the manufacturer’s identified target market should be sufficiently clear and granular such that the distributor would not need to do much further assessment. In our view this will be particularly true for cases where sustainability‑related objectives are framed in terms of quantified minimum proportions of sustainable investments. However, where sustainability‑related objectives are framed in terms of principal adverse impacts, due to the inclusion of qualitative indicators, a distributor may want to use its own judgement on whether a more specific target market can be identified. For example where a fund considers the principal adverse impacts of certain factors, the distributor may conclude, based on an analysis of the prospectus and underlying stocks, that the target market could include clients who want to consider impacts on a wider set of factors. We think it would be prudent to verify such conclusions with the manufacturer to avoid the risk of greenwashing or social-washing due to marketing the product to a client base not originally identified by the manufacturer.
Where the product manufacturer is not an EU MiFID firm, the distributor should take all reasonable steps to obtain sufficient information from the manufacturer to help it identify the target market.
Review of existing product range
ESMA’s 2020 Common Supervisory Action on MiFID II suitability requirements found that the vast majority of firms in the sample did not ask clients about their sustainability preferences and that most clients would not raise such preferences themselves. This means that many clients may be considering their sustainability preferences for the first time as a result of this regulation, which could in turn result in an increase in demand for sustainable products as investors become more aware of what options are available. It would therefore be advisable for firms to review their existing product range and/or model portfolios and consider whether they are able to cater to the different types of sustainable preferences that clients may have.
If firms decide to expand their product range to include more sustainable products, they will need to carry out research and ongoing training on the ESG landscape and on how the new products affect ESG issues and financial returns, access ESG data and potentially recruit new hires that already have expertise in ESG to guide the process. Compliance procedures will also need to be updated to mitigate the risk of greenwashing. This work will have resource implications so firms will need to weigh up the commercial benefit against the additional costs.
Clear and non-technical communication with clients in suitability questionnaires, presented in a way which does not unduly influence their choices, will be key to collecting information on sustainability preferences. Relevant staff will need periodic training to be able to do this, particularly given how quickly ESG investing is evolving.
Firms need to control for greenwashing risk, particularly when matching products to preferences – a thorough understanding of products’ credentials and clear suitability reports will help mitigate this risk.
Asking clients about their sustainability preferences may increase demand for sustainable investments. Firms should review their product range, consider whether they can cater to the different types of sustainable preferences that clients may have, and decide whether it would be commercially beneficial to add any additional products or model portfolios to their range.
The attached slides give an overview of the rules and a summary of key insights on implementation.
 Whilst the definition of sustainability preferences itself does not mention the term “ESG”, in essence the linked definitions of “sustainable investments” under the EU Taxonomy and SFDR can be broadly categorised into these three issues. ESMA’s draft guidelines also ask firms to explain the difference between E, S and G (pg 25).
 i.e. framed in terms of minimum proportions of sustainable investments under the EU Taxonomy or SFDR, or in terms of principal adverse impacts and qualitative/quantitative indicators