Request Free Trial
August 1, 2022

Fund managers grapple with new MiFID II ‘sustainability preferences’ requirements

Research suggested that as late as last week, nearly half of fund managers were yet to complete the European ESG Template, an important data-sharing exercise under MiFID II sustainability preferences requirements.

Under MiFID II, from August 2 2022 all financial advisers and managers serving EU customers must take the sustainability preferences of these investors into account when they are assessing suitability for investment decisions.

Financial advisers and portfolio managers were already required to carry out thorough suitability assessments before recommending any financial instruments or products. The changes mean that environmental, social and governance or sustainability preferences will now also need to be included in these assessments.

Sustainable Views previously reported that firms may not be ready for the change as a number of key concerns – including confusing terminology, and the quality and quantity of data – are hindering progress.

A European ESG Template (EET) was created and published by FinDatEx (an initiative that brings together European financial services firms to standardise the exchange of data following the application of MiFID II and other financial markets legislation) in March, to aid management of the process. The EET requires fund managers to provide ESG data for all their products marketed in the EU.

To meet MiFID II requirements, fund groups should complete the relevant fields in both the EET and the European MiFID Template. Research from data company FE fundinfo reveals that, as of one week ago, fund managers were still grappling with this challenge. The firm collected ESG data from over 157 fund groups covering 72,000 International Securities Identification Numbers, which is estimated to equate to just over half of the whole market.

Completing the EET is a lengthy process as it is made up of 580 mandatory, conditional and optional fields. There are also additional country-specific requirements, which may make things more complex at a fund and underlying individual share class level. Further complications may lie ahead, as from January 1 2023, additional fields will become mandatory to meet annual Sustainable Finance Disclosure Regulation (SFDR) reporting requirements.

Expected unpreparedness?

Benjamin Maconick, managing associate of the financial regulation team at law firm Linklaters, says it was generally expected that many firms would not be prepared “simply due to the sheer number of in-scope products and data fields to fill out”. Additionally, the European Securities and Markets Authority guidelines supplementing the MiFID II amendments on suitability were only published in draft form in late January, with a final form expected sometime in the third quarter of this year.

This means that there remains some uncertainty over the correct approach to the MiFID II amendments, and firms only had about six months to digest and implement the recommendations of the draft guidelines.

At consultancy firm Charles River Associates, Enrique Glotzer, principal in the energy practice, says it is unsurprising many fund managers have not been ready to submit their EET by the deadline.

Glotzer says many fund managers will not have the internal capabilities and resources to navigate the high level of complexity associated with the MiFID II regulations and complete the templates that have many layers of requirements and hundreds of fields, as well as having frameworks in place for further upcoming changes such as EU Taxonomy compliance.

Continued confusion

Maconick says the key MiFID II amendment relates to the concept of ‘sustainability preferences’. However, he says the concept of ‘sustainability preferences’ is “not what you would expect from a plain English understanding of it”.

Instead, it is a very precisely defined term, which refers to a client’s preference for investments that are aligned with the EU Taxonomy; investments that are ‘sustainable investments’ under the SFDR, which is also a defined regulatory term; and/or consideration of ‘principal adverse impact on sustainability factors’, which are a specific list of sustainability-related metrics set out in the regulatory technical standards under SFDR.

Maconick says for the first point, data availability is currently very limited because of the lack of mandatory reporting on Taxonomy alignment from issuers. For the second and third points, these concepts are partly dependent on the regulatory technical standards under SFDR, which were only fully finalised recently, and only apply from 1 January 2023. “So there have been numerous uncertainties and timing issues around these MiFID II amendments that make issues in implementation quite understandable,” he says.

Charles River Associates’ Glotzer says one major issue with compliance is the current lack of ESG standards and changing regulations for an evolving ESG landscape; this is even more challenging for fund managers with investments outside the EU, as these can have conflicting standards.

Glotzer says another major challenge is the overall availability of robust ESG data that is comprehensive across investments and ESG factors, for example, carbon emissions across the full value chain of operations. Subsequently, “fund managers need to use this incomplete data to develop internal processes to verify the various ESG factors for these investments and build the management of sustainability risk into them”, he says.

He adds there will be challenges associated with the implementation over time. Fund managers will need to thoroughly explain ESG factors to customers to ensure a full understanding of their preferences, and have ongoing conversations with them to assess changes to their preferences over time, based on performance and a changing ESG landscape.

Consequences for missed deadlines

“It is important to distinguish between the EET and the MiFID II amendments,” says Maconick. Filling out the EET is not actually a regulatory obligation in and of itself, he says, as it is a template used by the industry as a means of facilitating information exchange.

He says the EET is intended to help EU investment advisers and portfolio managers reflect clients’ sustainability preferences by giving them the data to do so. “A failure to fill it out is not technically a regulatory breach by a product provider, but it might make their products less commercially attractive if investment advisers and portfolio managers can’t get the information they need to assess whether the product meets a client’s sustainability preferences or not.”

On the regulatory obligation to factor in a client’s sustainability preferences, Maconick says several national regulators have already indicated that initially they will take “quite a light-touch approach to supervision of this, in light of the regulatory and legislative uncertainty and timing issues”.

According to Glotzer, it is still not clear what the immediate consequences of missing this deadline are; it will depend on the overall number of fund managers that miss the deadline and how long these firms remain in non-compliance, he says. “In the near term, there may be continued calls from financial sector players to extend the deadline for later in 2022 or 2023,” he says.

However, barring extensions, there may be direct consequences for non-compliance, such as the risk of fines or the potential for legal action from administrative authorities. Glotzer says there is also the potential for indirect consequences, which could include reputational risk for non-compliance, and competitive disadvantages, such as the risk of loss of clients to firms that meet compliance requirements.

Support for firms

Glotzer says though some guidance has been provided including the European Securities and Markets Authority’s technical advice report, further support would “certainly be welcomed by fund managers to provide more clarity around ESG standards”.

However, he says firms themselves need to develop a robust in-house ESG strategy including a good understanding of the materiality of issues for their investments and customers, which will require new investment decision processes and potentially a broader product offering.

Fund managers will also need to have a clear communication plan for customers, which includes a full disclosure of data limitations and performance risks, as well as more ongoing conversations with their customers. “Firms that have developed a robust ESG strategy, communication plans, and a compliance framework will not only be best placed to meet the current and future regulatory requirement but will also gain a competitive advantage over time,” Glotzer concludes.

A service from the Financial Times