A new EU law was agreed in April 2019 which compels professional investors and financial advisors to disclose, in quite some detail, how the risks of negative environmental, social and governance (ESG) impacts may affect the value of the investment. In addition, they will have to be transparent about whether and how they take account of longer term negative ESG impacts. Investment products with sustainability claims have stricter disclose standards about their claims. This information needs to be made available to all (individual) potential investors. In the meantime, the European Commission (EC) has already regulated that advisors must ask potential individual investors whether they prefer investments with ESG considerations. In the long term, the EC wants to adopt binding regulations to ensure professional investors and advisors actually undertake assessments of ESG risks, and, to a certain extent, ESG impacts.
Legal transparency obligations for all investors about sustainability risks and impacts
In April 2019, the EU agreed on a new EU law on “disclosures relating to sustainable investment and sustainability risks” (DSR). In a first phase, the law compels all kinds of investors to be more transparent about how sustainable their investments are.
This regulation applies to all professional investors, including pension funds and hedge funds, investment managers and fund managers, insurance companies and insurance products. The law also applies to investment advisory enterprises (that employ more than three persons). It does not apply to banks, except if the banks conduct investment management on behalf of others.
Information that needs to be available (gradually up to three years after the law taking effect) by institutional investors to the potential (individual) investor, i.e. when marketing an investment product, must include:
- Policies and the manner in which ESG risks are being integrated into investment decision-making or advice, and if not, why not; the ESG or sustainability risk means a potentially negative impact on the value of the investment due to an adverse ESG impact; the result of the ESG risk assessment must be described to potential investors.
- The institutional investors that consider negative impacts from the investment on sustainability factors must state their policies, including on due diligence and any actions taken related to the described adverse sustainability impacts; if the investment companies do not consider adverse impacts on sustainability factors, they must state why and whether they intend to consider them in the future; sustainable factors refer to environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters.
- Advisors must provide information as to whether they take negative impacts on sustainability factors into account; and if not, why not and whether they intend to do so in the future; they must describe the results of the sustainable risk assessment before an investment is contracted or why they do not deem sustainability risks to be relevant.
- On their websites, all professional investors and advisors must publish how the remuneration policy integrates ESG risks.
Additional transparency for sustainable investments
Investment products, such as investment funds, which claim to have ESG characteristics or climate, environmental or sustainability objectives, have additional transparency obligations when marketing, contracting and reporting about those investments, such as:
- Information as to what the sustainability characteristics or objectives are, and how they are (to be) achieved (details on methodology, periodic reports), including when an index is used as a reference benchmark;
- Information must relate to achieving the long-term Paris climate targets in case the investment objective is to reduce carbon emissions;
- What the overall sustainability impact is;
- The above-mentioned public information needs to be up-to-date, fair, easily accessible and not misleading.
The various details, about how the information needs to be transparent and published, will be decided by the EU’s supervisory authorities and the EC. The preamble of the law indicates, among other things, that guidance on how to apply due diligence policy in the case of negative sustainability impacts can be taken from the OECD guidance on due diligence and the UN-supported Principles for Responsible Investment.
This law needs to be enforced with sufficient powers by the supervisory authorities overseeing each of the investment actors covered, in addition to existing reporting requirements. Member states may decide to apply this law to pensions in national security schemes.
The text of the DSR law agreed in April is being legally verified and translated before it being officially published. The law is expected to go into force in 2020 but this deadline is already being opposed by the financial lobby.
For those interested in technical details, the EU laws and implementation regulations that require amendments are the UCITS Directive 2009/65/EC, the AIFM Directive 2011/61/EU, the MiFID II Directive 2014/65/EU, the Solvency II Directive 2009/138/EC and the IDD Directive 2016/97.
Regulating advisors to propose sustainable investments
To ensure that investment advisors take an investor’s preference for environmental, social and governance (ESG) considerations into account, and not only to avoid undue financial risk, the EC amended regulations about implementing the investment law (MiFID II) and the insurance-based investment product law (IDD). This means, for instance, that advisors must ask whether potential investors are interested in investing sustainably and explain what the options are. Until recently, investment advice did not automatically include proposals to invest in sustainable investment products.
Regulating investors to apply ESG risks assessments
Beyond detailed transparency, requirements to actually compel integration of ESG risk assessment into investment decision-making processes, along with other sustainability factors, will be further specified as being part of investors’ duties towards investment beneficiaries. The EC intends to do so through the powers it already has to regulate by “delegated acts” under each of the laws related to the different institutional investors and investment products covered by DSR (see above). The EC has already sought advice from the supervisory authorities (ESMA, EIOPA) on how to do so.
The new EU law on “disclosures relating to sustainable investment and sustainability risks” (DSR) is the first to stipulate that all professional or institutional investors make information publicly available as to whether and how they take ESG risks and ESG factors into account, and if not, why they do not do so. However, the transparency focus is on ESG risks that might have a negative effect on the value of the investment. The wider, longer-term ESG impacts on the environment, workers and society only require general reporting, thereby making the law less effective for achieving the Paris agreement and the UN Sustainable Development Goals. Many investments cover activities all over the world, including in developing countries. If negative ESG risks or impacts are disclosed, this still does not prevent institutional investors from offering that particular investment.
Investment products claiming to be sustainable are legally required to provide more detailed information, which could support investor choices in avoiding false claims.
Since many specifics on the detailed information to be made available still need to be defined and standardized by the EC and supervisory authorities in the coming three years, the full implementation will still take some time. However, climate and inequality problems are urgent. Given their opposition, financial actors may lobby to reduce the strictness of details that need to be disclosed. The lack of ESG information provided by companies and the lack of expertise in performing ESG risk and ESG impact assessments might dampen the positive effects of the law on positive ESG impacts on the ground.
The EC’s commitment to also stipulate by binding regulation that professional investors and advisors actually undertake ESG risk assessments, and, to a certain extent, ESG impact assessments, is important. The EC Directorate General responsible for financial laws (DG FSIMA) will be again be under the leadership of Commissioner Valdis Dombrovskis from November 2019 onwards. He promoted the EC’s sustainable finance policy and legislation so far and created a unit at DG FISMA on sustainable finance and financial technology (fintech). Given that the DSR and imposing ESG risk assessments will be obligatory, and not voluntary as is the case with the new taxonomy and benchmark laws, the EC is already facing opposition by the financial industry while some member states are also reluctant. Especially NGOs and (younger) citizens are urging further steps to be taken to ensure positive climate, environmental, human rights and social impacts are actually achieved and negative impacts are avoided.