ESMA consults on sustainability in suitability and product governance

The call for evidence is a natural element of ESMA’s functioning to ensure that financial regulation is being properly implemented. Nevertheless, it serves as a reminder of the fact that the Sustainable Finance Disclosure Regulation (SFDR) has extremely wide-ranging consequences that apply throughout the legislative framework and impact the entire industry.

How SFDR impacts MiFID II

SFDR made certain changes to MiFID II, which have applied since November 2022. Since that date, product manufacturers and distributors, such as wealth managers or asset managers, must consider sustainability factors and sustainability-related objectives at every stage of the MiFID product governance process chain.

The provisions go further still, to drive additional investment towards sustainable investments. To ensure that financial instruments with sustainability factors “remain easily available also for clients that do not have sustainability preferences”, the provisions state that: “investment firms should not be required to identify groups of clients with whose needs, characteristics and objectives the financial instrument with sustainability factors is not compatible.”

In practice, this means that, when no sustainability preferences have been given by a client, on the proviso that there is no difference to acceptable risk for the client in question, an Article 8 or 9 product can be deemed to be suitable for that client. However, the converse is not the case, which inevitably steers more capital of MiFID clients towards sustainable investments and creates an incentive for product manufacturers to meet the minimum requirements of Article 8.

The push of investor capital

In March 2018, the European Commission published its ‘Financing Sustainable Growth’ action plan. The plan was intended, in part, to reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth. So, by design, the Commission wanted to ensure that investor capital was driven towards sustainable investment.

To satisfy this, it needed to create a sustainable investment framework, which led to the development of SFDR. Rather than simply leaving it to investors to make their own choices and do the right thing, the EU has ended up with a set of wide-ranging rule changes to meet this objective of reorientation of capital flows towards sustainable investments.

The package of legislative measures under SFDR made amendments to the MiFID, the 2009 Undertakings for Collective Investment in Transferable Securities (UCITS) Directive and the Alternative Investment Fund Managers Directive (AIFMD) delegated regulations to entrench the position established SFDR into the wider asset management ecosystem. These measures intended that investment firms manufacturing and distributing financial instruments considered sustainability factors throughout the entire fund and client lifecycle.

ESMA’s call for evidence

Six months on from SFDR’s implementation, ESMA’s new call for evidence will gather industry feedback that will help it better understand the evolution of the market and provide answers as to how firms apply the new MiFID rules on sustainability. In particular, ESMA aims to:

• develop a better understanding of how MiFID II requirements are being implemented and applied by firms across the EU and the challenges firms face in their application;
• gain a better understanding of investor experience and reactions to the inclusion of sustainability factors in investment advice and portfolio management services; and
• collect information, views and data on main trends on aspects related to the provision of sustainable investment products and services to retail clients.

SFDR's shortcomings

Given the other shortcomings of the design of SFDR, including the way that it can encourage greenwashing or even ‘green-bleaching’ - when funds choose not to claim that their produces are sustainable in order to avoid extra regulation and potential legal risks - the original intention to forcibly reorientate capital flows might be considered to be sinister. However, the core text of SFDR was rushed, so perhaps Hanlon's razor applies better here: "Never attribute to malice that which is adequately explained by stupidity."