The integration and disclosure obligations on sustainability risks and factors in the UCITS and AIFs regulatory frameworks
In May 2018, the European Commission adopted a package of measures aiming at reorienting capital flows towards sustainability and providing investors with more clarity and transparency when investing in “green” products. These measures consist of:
- The Regulation on the establishment of a framework to facilitate sustainable investment (the “Taxonomy Regulation”), which establishes uniform criteria to determine whether an economic activity is environmentally sustainable;
- The Regulation (EU) 2019/ 2088 on sustainability-related disclosures in the financial services sector (the “Disclosure Regulation”), which sets out what information managers and advisers must disclose to provide more transparency to investors;
- The Regulation (EU) 2019/2089 amending Regulation (EU) 2016/1011 as regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks (the “Low Carbon Benchmark Regulation“), which establishes a new category of benchmarks comprising low-carbon and positive carbon impact benchmarks; and
- various amendments to the Undertakings for Collective Investment in Transferable Securities (UCITS), the Alternative Investment Funds (AIFs) and the Markets in Financial Instruments Directive 2004/39/EC (MiFIDII).
While the Taxonomy Regulation and the amendments to the directives outlined above are yet to be finalised, the Disclosure Regulation and the Low Carbon Benchmark Regulation were published in the Official Journal of the European Union on 9 December 2019. The Low Carbon Benchmark Regulation came into effect on 10 December 2019 and the Disclosure Regulation will be effective from 20 March 2021.
This article analyses how the proposed amendments on the integration of sustainability risks and factors will impact the UCITS and AIFs frameworks as well as the information asset managers and advisers must disclose under the new EU law.
The integration of sustainability risk and factors in the UCITS and AIFs space
The European Commission intends to ensure that asset managers and insurers integrate sustainability risks and factors in the areas of organisational requirements, operating conditions and risk management. To this effect, the European Commission asked the European Securities and Markets Authority (ESMA) to provide technical advice on how to integrate sustainability risks in those areas. The below proposed amendments regarding the Commission Directive 2010/43/EU (the “Directive 2010”) and the Commission Delegated Regulation (EU) No 231/2013 (the “Regulation 2013”) were recommended by ESMA in a report which was issued in April 2019.
Despite the Securities and Markets Stakeholder Group’s (SMSG) recommendations of introducing a qualified person responsible for the integration of sustainability risks and factors, ESMA is of the opinion that that asset managers should have the freedom to designate a specific person within their organisation who should not be an expert or perform exclusively this task.
According to the proposed amendments, managers of UCITS and AIFs must:
- consider sustainability risks when establishing and implementing decision-making procedures as well as ensuring compliance and reporting (Article 3 of the Directive 2010 and Article 57 of the Regulation 2013);
- consider the necessary resources and expertise for the effective integration of sustainability risks (Article 5 of the Directive 2010 and Article 22 of the Regulation 2013); and
- ensure that the senior management is responsible for the integration of sustainability risks (Article 9 of the Directive 2010 and Article 60 of the Regulation 2013).
The above proposed amendments will compel managers of UCITS and AIFs to designate a senior person within their organisation to consider sustainability risks and to assess the necessary resources and expertise for the integration of those risks.
To integrate sustainability risks, managers UCITS and AIFs should assess risks of a decrease in the financial value or performance for the investment portfolios caused by sustainability-related causes and the potential long-term impact of the investee companies’ business activities on sustainability factors.
ESMA stated that managers of UCITS and AIFs must actively engage with investee companies (i.e. through voting strategies to address material sustainability risks, or research to supplement data, employing investment strategies…). This is in line with the principle of stewardship where managers would encourage companies in which they are investing in to consider sustainable economic activities in their strategy and business.
In accordance with the new recital 17 (bis) and 48 (bis) of the Directive 2010 and the Regulation 2013 respectively, managers of UCITS and AIFs should:
- include conflicts of interest that may arise in relation to the integration of sustainability risks and that can damage the interests of a UCITS or an AIF;
- include in the identification process, for example, conflicts arising from remuneration or personal transactions of relevant staff as well as any sources of conflicts that could give rise to greenwashing, misselling, misrepresentation of investment strategies;
- consider conflicting interests between funds with different investment strategies managed by the same UCITS or AIF manager; and
- include situations where there are other business-relationships with investee companies, conflicting group interests, investments in entities with close links or similar circumstances.
In addition to the above, ESMA suggested amending Article 23 of the Directive 2010 and Article 18 of the Regulation 2013 to ensure that UCITS and AIFs managers take into account sustainability risks and, where applicable, the principal adverse impact of investment decisions on sustainability factors as well as developing engagement strategies with a view to reducing the principal adverse impact of investee companies on sustainability factors. This is also outlined in the Disclosure Regulation analysed below.
Managers of UCITS and AIFs must establish, implement and maintain an adequate and documented risk management policy which identifies the risks the UCITS or the AIFs they manage are or might be exposed to.
The risk management policy will comprise such procedures as are necessary to enable managers to assess the exposure of that UCITS or AIF to market, liquidity, sustainability and counterparty risks, and all other risks, including operational risks (Article 38 (1) of the Directive 2010 and Article 40 (2) of the Regulation 2013).
The managers and advisers’ obligations to disclose sustainability risks and factors under the Disclosure Regulation
The Disclosure Regulation will come into effect on 10 March 2021. It applies to managers and advisers of UCITS, AIFs, EuVECA and EuSEF, insurers and pension products providers which will be referred to as participants. It is also applicable to the financial products above mentioned. The Disclosure Regulation provides new definitions which were expected in to enhance clarity amongst asset managers and advisers.
Article 2 (17) of the Disclosure Regulation defines a sustainable investment as an investment in an economic activity that contributes to an environmental objective or a social objective, or in human capital or economically or socially disadvantaged communities. Such investments must not significantly harm any of those objectives. In addition, companies where money is invested in must follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance. It must be noted that this definition provides some examples of what can be considered an environmental objective but, in theory, it is the Taxonomy Regulation, which is yet to be finalised, that defines an environmental objective in more detail.
Sustainability risk and factors are also defined in the Disclosure Regulation. Article 2 (22) of the Disclosure Regulation defines sustainability risk as an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment while sustainability factor is defined by Article 2 (24) of the Disclosure Regulation as an environmental, social and employee matter, respect for human rights, anti‐corruption and anti‐bribery matter.
The Disclosure Regulation sets out the information on sustainability risks that participants must disclose on their websites, pre-contractual disclosures and periodic reports. This will provide investors with more detailed information on the green funds offered to them. A summary of what information must be disclosed on websites, pre-contractual disclosures and periodic reports is given below.
Participants are required to publish and maintain on their website the following information:
- information about their policies on the integration of sustainability risks in their investment decision-making process and keep these policies up to date (Article 3 & 12 of the Disclosure Regulation);
- information on their due diligence policies when considering principal adverse sustainability impacts and indicators with the proportionality principle in mind (i.e. taking into account the size, nature and scale of their activities). Where the above impacts have not been considered, clear reasons must be stated including if and when these impacts will be considered (Article 4 of the Disclosure Regulation);
- a brief summary of engagement policies (Article 4 (2) (c) of the Disclosure Regulation);
- a reference to their business conduct codes and international standards for due diligence and reporting and the degree of their alignment with the objectives of the Paris Agreement (Article 4 (2) (d) of the Disclosure Regulation);
- information on how their remuneration policies are aligned with the integration of sustainability risks (Article 5 of the Disclosure Regulation).
The following descriptions must be included in pre-contractual disclosures:
- the manner in which sustainability risks are integrated into investment decisions or advice and the results of the assessment of the likely impacts of those risks on the returns (Article 6 of the Disclosure Regulation);
- if environmental or social characteristics are being promoted, information on how those characteristics are met following good governance practices (Article 8 of the Disclosure Regulation);
- if an index has been designed as a reference benchmark, information on whether and how this index is consistent with the above characteristics as well as how this index is aligned with the objective from a broad market index (Article 8 (1) (b) and Article 9 (1) (b) of the Disclosure Regulation);
- where these risks are deemed not to be relevant, participants must provide a clear and concise explanation of the reasons (Article 9 (2) of the Disclosure Regulation); and
- the methodology used to asses and measure the impact of sustainable investment including data and screening (Article 10 of the Disclosure Regulation).
Participants will have to disclose the following information on their periodic reports (i.e. annual and/or interim) in accordance with Article 11 of the Disclosure Regulation:
- the overall sustainability-related impact of the financial product by means of relevant sustainability indicators; and
- if an index is designated as a reference benchmark, a comparison between the overall impact of the financial product with the designated index and a broad market index in terms of weighting, constituents and sustainability indicators.
The ESMA’s proposed amendments will compel participants to designate a senior person within the company who will consider sustainability risks when making investment decisions. The current legal framework does not oblige participants to consider those risks relating to sustainable investments and this has resulted in participants being passive on considering the impact that a sustainable investment may have on their products as well as poor engagement policies. The EU seems to encourage and force participants to engage more with companies they invest in to make them consider environmental, social and governance factors.
The Disclosure Regulation adds more obligations on managers and advisers of UCITS and AIFs who must disclose whether sustainability risks have been considered and if not, provide valid reasons for not doing so. These new obligations and requirements will enhance transparency and prevent managers from offering funds which are not de facto green and do not have clear benefits to the environment or climate change. Although the Disclosure Regulation provides more transparency for investors to make well informed decisions, there is still a lack of definition, in particular, what activities are to be considered sustainable investments. This gap should, in theory, be filled by the Taxonomy Regulation which will define and outline the criteria for an investment to be considered as environmentally sustainable. This will create the unified classification system the EU intends to establish. Furthermore, the definition of sustainability risk set out in the Disclosure Regulation seems to be too vague and ambiguous as the word “potential negative impact” could lead to different interpretations. This may create confusion for participants who will have to spend more time and resources to assess potential impacts on their investment portfolios.
More importantly, ESMA has also indicated that the proposed changes should all be applied by managers of UCITS and AIFs with the principle of proportionality in mind, taking into account the size, nature, scale and complexity of their activities. Smaller firms are very likely to struggle from a cost perspective with the impact of the new rules (access to resources, training, documentation, disclosures, controls and testing). Regulators and supervisors are advised by ESMA to be particularly cautious that smaller independent firms are not driven out.
An analysis of the EU’s proposal on the Taxonomy Regulation can be found in the following article The European Commission proposals on “Green” finance and the financial regulators’ initiatives on sustainability, EU Law Analysis, December 2019
Report ESMA’s technical advice to the European Commission on integrating sustainability risks and factors in the UCITS Directive and AIFMD
 The European Commission proposals on “Green” finance and the financial regulators’ initiatives on sustainability, EU Law Analysis, December 2019
 ESMA’s technical advice to the European Commission on integrating sustainability risks and factors in the UCITS Directive and AIFMD
 The European Commission proposals on “Green” finance and the financial regulators’ initiatives on sustainability, EU Law Analysis, December 2019