ESG Regulation for the Buy-Side

**Quarterly European Sustainable Fund Flows (EUR Billion)**

Flows into European sustainable funds have more than doubled in Q2 of 2020 to €54.6bn, following growth of investor interest in Environmental, Social and Governance (ESG) investments. This has, encouragingly, been helped by the initiatives to “build back better” in the wake of COVID-19, and consequent restructuring of investments.[ii]

Clients moving towards ESG investments will be looking for funds and investment strategies that show clarity and responsibility in sustainability principles when formulating and marketing their products. The EU has begun the process of drafting and implementing a number of new disclosures and regulations to ensure that Sustainable Risks are integrated throughout the buy-side investment process and being the first movers in implementing the upcoming regulations will help asset and fund managers gain a competitive advantage in the exploding ESG marketplace.

This article aims to discuss what the new regulations mean for the buy-side, in terms of obligations and structural changes, and the necessary steps stakeholders can begin to take for their eventual implementation.

Regulatory Background

0 (1).png — “The EC’s goal is to *‘Clarify Institutional Investors’ and Asset Managers’ duties’* by achieving transparency on how firms consider Sustainability Risks in investment decision making.”

The European Commission’s (EC) action plan[iii] aims to channel private financial flows towards investments that support the Paris Agreement Target of a carbon-neutral economy by 2050. The EC’s goal is to ‘Clarify Institutional Investors’ and Asset Managers’ duties’ by achieving transparency on how firms consider Sustainability Risks in investment decision making. This is done mostly through obligations on managers to disclose, by ‘complying or explaining’, the efforts they have taken to integrate Sustainability Risks into their portfolio and investing processes.

What does this mean for Asset Managers and Hedge Funds?

The EU Disclosures Regulation imposes new disclosure obligations on Financial Market Participants (FMPs) which includes AIFMs, UCITS Management Companies (MANCOs), and MiFID investment firms that provide portfolio management services, making it easier for investors to make sustainably informed decisions[iv]. The regulation means firms will need to start the internal integration of Sustainability Risks in their investment process and external considerations of the adverse impact that investments may have on Sustainability Factors.

These will need to be disclosed in pre-contractual disclosures, such as:

the UCITS fund prospectus
AIFMD Article 23 disclosures for AIFs
MiFID required regulatory disclosures

As well as periodic disclosures which covers:

UCITS fund annual reports
AIF annual reports
periodic reports of services under MiFID

Importantly, if a firm decides that it does not need to consider such adverse impacts, it must explain why.

The Disclosures Regulation has a wider application to Insurance and Pension sector firms. These firms should look toward the Insurance Distribution Directive, Investment Firms Regulation and Investment Firms Directive which take effect next year.

The Suitability Delegated Regulation will alter how MiFID firms must assess the suitability of their products and services for clients, ensuring that the client’s ESG preferences are considered. ESG standards must be observed when marketing or recommending a financial instrument, as well as throughout the selection process. A client’s investment objectives must include the client’s ESG preferences and firms must state in reports how ESG preferences are incorporated, and if not - then why. Firms selling MiFID II products are obliged to integrate Sustainability Risks throughout their governance and organisational frameworks, as well as their risk management policy.

The Delegated Acts amendment is a UCITS Directive and aimed at AIFMD and MiFID firms. UCITS and AIFMD Firms will have to incorporate Sustainability Risks across their organisational and governance structures when selecting and monitoring investments, establishing Due Diligence Policies and while complying with the fund’s objectives and strategy. They must ensure that they have the expertise to integrate Sustainability Risks effectively and that third parties have the required knowledge to monitor these Sustainability Risks. Sustainability as a type of exposure must be assessed as part of the fund’s risk management policy.

Finally, the Framework Regulation aims to establish a taxonomy for determining whether an economic activity is environmentally sustainable. Most of the framework only applies to products expressing an environmental sustainability focus, however all FMPs will need to include a short negative disclosure in financial products which do not follow the taxonomy.

How can Asset Managers and Alternative Investment Managers prepare for compliance?

MiFID firms will need to take ESG considerations into account, where relevant, in establishing and implementing risk management policies and procedures and setting the level of tolerable risk. Considerations must be made when assessing products and services it provides, whether the product meets the target market’s identified needs and when identifying an initial target market. The European Securities and Markets Authority (ESMA) have stressed that these requirements should be applied proportionately, while firms should assess the size, nature and complexity of their activities[v].

Firms will need to make significant business and policy decisions in relation to how sustainability impacts their investment procedures. They should assess whether its products lie within the scope of the regulation and therefore, whether to prepare the necessary disclosures explaining the processes made taking into account Sustainability Risks and Factors. For each non-complying product, they will have to prepare the necessary negative disclosure.

Organisational and Governance Changes for the Buy Side

(Based on guidelines from the Principles for Responsible Investment (PRI) [vi] and the Alternative Investment Management Association (AIMA)) [vii]

[viii]

Asset Managers and Hedge Funds should look to establish a responsible investing policy, alongside changes to governance structures, investment processes and its monitoring and reporting practices to ensure it satisfies investor expectations. This will be particularly important for investment decision makers, compliance and risk teams, and they should also check their external agreements with Traders and Brokers, for implementing exclusion lists, and with Administrators to extend agreements to include monitoring portfolios for non-compliant positions.

Comprehensive Approach to ESG Integration

Hedge Funds should begin with conducting an analysis of the existing rules and procedures, determine the changes which are required, and begin the internal organisation process with reviews and updates to internal policies and procedures. Focusing on data, integration, and transparency across governance and operational structures to ensure ESG and Sustainability Risks are considered throughout the investment decision process.

A few suggestions include:

A “Top to Bottom” and “Front to Back Office” integrated approach; Relevant procedures and oversight by board members and directors to ensure client preferences are incorporated and staff training and education to implement ESG considerations across risk calculations and the portfolio management process
Governance by an internal governing body or compliance function; monitoring and implementation might be outsourced
Data - Institutional Managers will need to make changes to improve the quality of their data supply chains to ensure they have the relevant data to make decisions on whether a potential investment meets their client’s ESG requirements. The rise of big data and machine learning is improving the quality and timeliness of information from data vendors, but asset managers will need to engage better with vendors to ensure their specific data needs are met
Transparency on ESG integration – Communication including statement of investment policy, links to international standards, and the data sources used. Changes to marketing products, including updates to the firm's website

Adapting the Investment Process

Choices over which adaptation is best will depend on the overall strategy of the Fund. This will vary greatly between different strategies but should start with the initial screening process and considering the portfolio turnover, investment strategy, time horizon, and position size. Hedge Funds will have to choose whether they prefer to pick from an unconstrained universe with tilts to ESG or restrictions on securities issuers involved in ‘sin’ activities.

Other options for Hedge Funds will include:

Disclosing the active ownership processes that they are involved in to ensure that their clients’ demands are being met. This would involve discussing their proxy voting methods and signalling that private discussions are being held with board members, eventually reporting the impact of this
Engage in promises with clients and security issuers to divest from an investment if they feel like adequate steps are not being taken to incorporate Sustainability Risks
Report on the non-financial impact of their investments helping clients to understand where and what their money is doing. This could be done through custom metrics or using PRI standards and frameworks
Align interests via fee and incentive structures, changing reward structures for both financial and non-financial performance. Showing a clear alignment of interests will lead to a competitive advantage against non-fee-aligned funds seeking ESG-centric clients

Conclusion

All Asset Managers and Hedge Funds should be aware that this is an on-going process, and that there is no one-size-fits-all approach when it comes to implementing ESG considerations. FMPs should look to learn over time and through experimenting to see which processes are best for their firm, strategy, and clients’ wishes.

Mid to large firms, with ESG processes already focusing on these matters, should be looking to understand where the European Commission and FCA are on their roadmap to be able to tailor business changes around this. Starting with the Disclosures regulation, the first to come into force, from March 2020.

Firms without a formalised approach to ESG need to start making strategic decisions based around time and resources. These need to be discussed before working on compliance with the Draft amendments and SFDR disclosures.

How can Pico Analytics help?

At Pico Analytics we research and implement how Sustainable Finance can deliver clients benchmarked returns on investments and look at what companies can do to ensure they are compliant with sustainable financing directives. We aim to ensure that all organisations and firms are able to meet their ESG commitments while ensuring stake-holder interests are surpassed through transparency and data analytics, covering UCITS, SICAVs, AIFM products and alternative investment portfolios.

We are currently developing our product in which you upload your portfolio to be analysed using big data, informing you how sustainable it is against a number of global climate transition scenarios. This will allow you to make informed strategic decisions integrating sustainability into your portfolio management and organisational structure and to comply with relevant regulations.