ESG investing – new rules coming along soon

Recently, it seems that hardly a week goes by without there being some financial media article about Environmental, Social and Governance (ESG) Investing. There is a debate to be had as to why this is so. Is it because of greater public demand for so called ‘ethical’ investments? Some commentators believe this to be the case, especially in light of what they claim is a changed public perception of the world following the shock of the Covid-19 pandemic. There could be some truth in this – but it’s hard to tell because we have seen little in the way of convincing research to support this view.

It is possible that another factor has raised the profile of ethical investing, namely the legislation coming out of Europe intended to drive environmental sustainability by driving money in that direction. The impact that this has already had can be seen in the FCA’s work around sustainable finance. The latest Feedback Statement on the topic can be read here.

While work continues, new rules and guidance are starting to appear. Already, Pension Schemes must have Independent Governance Committees (IGCs) to oversee and report on firms’ environmental, social and governance (ESG) and stewardship policies. We wrote about that in a previous article.

And Fund Managers will be challenged by the FCA where there appears to be ‘greenwashing’ (claiming ethical credentials for a fund that do not exist in practice).

As a result, many fund houses have been creating or expanding their range of ESG funds, leading to greater marketing efforts around these, so creating at least an increased ‘buzz’ around ESG investing, if not yet a clear increase in demand from investors.

Either way, we can be fairly sure that ESG investing is a coming thing, not least because new rules for advisers are expected to be published in 2021. Until such time as the FCA actually publishes the final rules, we need to look at the original EU proposals to get a feel for what those rules will require. Those proposals are contained in a number of papers, primarily the snappily titled “Delegated Regulation (EU) 2017/565 as regards the integration of Environmental, Social and Governance (ESG) considerations and preferences into the investment advice and portfolio”

What will the new rules require advisers to do?
Under the existing MiFID II framework, firms providing investment advice and portfolio management are required to obtain information about the client’s financial situation and objectives, as well as the client’s knowledge and experience, capacity for loss and risk tolerance. However, the information about investment objectives has generally related to financial objectives, while non-financial preferences of the client, such as ESG preferences, have not been consistently addressed by advisers in assessing the suitability of different investment solutions.

Delegated Regulation 2017/565 aims to clarify that ESG considerations and preferences should be taken into account in the investment and advisory process.

However, the rules will differentiate between investment objectives on the one hand and ESG preferences on the other hand. This differentiation is important in order to avoid unsuitable solutions which might arise if an ESG consideration took precedence over a client’s personal investment objective. So, ESG preferences should only be addressed within the suitability process after the client’s investment objectives have been identified and addressed.


The new requirements (expected in 2021)

  • Firms that provide investment advice and portfolio management should include questions that help identify the client’s individual ESG preferences in their fact finding and advice processes;
    ATEB comment: this will require more than a simple single question along the lines of “Do you want to invest in ethical funds?” There are many more nuances that need to be identified on an individual basis. See below.
  • In accordance with the obligation to act in the best interests of the client, recommendations to clients should reflect both the financial objectives and, where relevant, the ESG preferences expressed by those clients;
    ATEB comment: this is just standard suitability assessment – what is recommended should match, as closely as possible, the client’s identified needs and interests.
  • Firms should also explain to their clients how their ESG preferences for each financial instrument are taken into consideration in the selection process used by those firms to recommend financial products.
    ATEB comment: Again, this is standard suitability.
  • In order to avoid ‘mismatches’, firms providing investment advice should first assess the investor’s investment objectives, time horizon and individual circumstances, before asking the client for his or her potential ESG preferences;
    ATEB comment: investment need ultimately trumps ‘green’ preference where there is a conflict between the two.
  • For existing clients, for whom a suitability assessment has already been undertaken, firms will be able to rely on the existing suitability assessment.

Note that the rules will not oblige firms to offer ESG solutions to all clients, or even at all. The obligation will be to identify clients that have ethical preferences and to give appropriate consideration to ESG investments for those clients.

What do advisers need to discuss with clients?
As mentioned above, it is not sufficient to add a couple of questions to the firm’s fact find document.  Identifying that a client has ethical preferences in relation to investments is only the starting point. There are many different flavours of ethical investing and it is necessary to identify which particular combination of preferences apply to the particular client.

There are three main categories of ethical or socially responsible investment – Environmental, Social and Governance. Ethical investment usually involves investing in companies that create positive outcomes and/or that reduce adverse outcomes.

Environmental: concerns the impact of the company’s activities on the environment – positive outcomes include managing resources and executing environmental reporting / disclosure, or avoiding / minimising environmental liabilities such as climate impact or pollution.

Social: positive outcomes include increasing health, productivity and morale, or reducing negative outcomes such as high turnover and absenteeism.

Governance: concerns the way companies are run – positive outcomes include aligning interests of shareowners and management, improving diversity and accountability and avoiding unpleasant financial surprises, such as excessive executive remuneration.

Next, there are different mechanisms that firms can use to assess funds. Three common techniques are described below.

    Negative screening … allows firms to identify funds that avoid investing in certain types of industry, for example, tobacco, animal testing, arms trade.
    Positive screening … allows firms to identify funds that engage in positive activities – education, equal opportunities – or activities that are aimed at improving the environment
    These funds will invest in sectors that are not obviously ‘ethical’, for example oil and gas, but in companies with, say, a better record on the environment or human rights than others in the sector.
    With this approach, firms identify funds where the managers work with companies in order to improve social, governance and environmental practices

Ultimately, new rules or not, firms should ALWAYS have been factoring in ALL relevant information, including any ethical preferences, to their assessment of suitable investments for clients. But the reality is that many advisers have tended to ignore ESG considerations, either because they believed that better returns would be available with ‘standard’ funds or because the range of ethical funds was for many years limited to the extent that it was difficult to build truly diversified portfolios across the entire risk spectrum or by default because the ethical angle just never came to mind. Whatever the reason that advisers may not have been engaging with ESG funds in the past, that will have to change soon.

Important Note: ATEB news is intended to provide general information ONLY. The content, including any views expressed or guidance provided, does not replace the need to comply fully with FCA Rules and Guidance. Unless you have discussed news article content with ATEB, and specifically how it relates to your circumstances, then ATEB disclaims all liability and responsibility and actions arising from any reliance placed upon it. For the avoidance of doubt therefore, any reliance you place on such information without our consultation is at your own risk.

ATEB Compliance offers compliance and regulatory advice.

ATEB Suitability provides report writing software for the financial services market.

Our View

The detail of the new rules will not be known until they are published in 2021. However, come along they surely will, and we believe it would be prudent for firms to start thinking now about how they will integrate ESG considerations with their investment and advice processes.

As a minimum, fact find documents and, probably, terms of business will need to be amended. Advisers might benefit from some training around discussing ESG investing.

Work will be needed to identify suitable funds to incorporate in the firm’s investment solutions for clients that express ethical preferences. And that might require some firms to build knowledge and competence around how to research and assess ESG funds.

ATEB have created ESG ready template documents and can assist with firms’ preparations for the brave new world of 2021!

Action Required By You

  • Consider when to start preparations for the new ESG rules;
  • Gain a working knowledge of ESG investing, including how to research and assess funds;
  • Review documentation and processes and amend as required;
  • Consider what adviser training might be required;
  • Contact your ATEB Consultant, who will be able to work with you over the coming months to ensure you are ready for the new rules, or contact ATEB here.
SUIT - Beautiful Reports
SUIT - Complete Control
SUIT - Comp confidence
previous arrow
next arrow

About the Author

Technical Manager - Often referred to as the Oracle or the Sage, Alistair has a wealth of financial services experience. He is our go-to Technical Manager and enjoys nothing more than a complicated conundrum. Feel free to test his renowned knowledge by getting in touch.

Contact Us

Brought to you by

Explore more articles in this category

Other articles that you might be interested in