ESG investing is a term that covers various investment-related choices that blend environmental, social, and governance factors into traditional investment appraisal. People often use the term interchangeably with 'socially responsible investing' (SRI) and 'sustainable investing.' The European Union is planning to inject this concept into its existing financial laws, as this article explains.

Broadly speaking, we can define the word 'sustainable' as anything that is good for the environment, good for society and good for governance.

The aims of the EU

On 3 May, the European Securities and Markets Authority issued two reports that contained technical advice to the European Commission (the nearest thing that the EU has to an executive branch) about "sustainability risks [i.e. things that might make things less sustainable] and factors" that relate to considerations regarding the environment, society and good governance with regard to investment firms and investment funds. The two reports envisaged the integration of these risks and factors into the second Markets in Financial Instruments Directive (MiFID II) (investment services), the Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings in Collective Investment in Transferable Securities (UCITS) Directive.

ESMA published its technical advice to help the EU amend its law. If the other organs of the EU endorse these texts (which ESMA has revised), they might come into force in 2020. Both reports contain proposals to make investment managers responsible for sustainability risks. The way in which any new EU rules that spring from these proposals might apply to British fund managers will depend on whether the UK wishes to adopt them after Brexit.

These ideas stem from the EU’s intention to make people's fiduciary duties clearer and to allow various people (including HNW investors) to know more about financial firms' sustainability risks and the opportunities they have to make sustainable investments. It aims to:

• reorient capital flows towards sustainable investments and help businesses grow;
• assess and deal with relevant financial risks that stem from global warming, the depletion of the Earth's resources, environmental degradation and social issues; and
• foster long-term financial and economic activity and allow various people to see more information about such investments.

The appearence of rules before the appearence of a regime

The text of the amendments that ESMA wants the EU to make amounts to no more than an insertion of the words “sustainability risks” in various articles in the three directives, but just two words mask some important challenges ahead. ESMA acknowledges that it would be difficult for the EU to force its member-states to take a uniform and detailed approach to imposing sustainability until an EU-wide taxonomy is in place. The super-regulator is working towards this as part of the European Commission's Sustainable Finance Action Plan, which the commission hopes will be complete by mid-2022. This plan contains comprehensive proposals for guidelines and disclosures about the decisions that people might make, and the marketing materials that they might publish, regarding ESG investments. It is to apply to UCITS, AIFMs, insurance undertakings, occupational pension funds and fund managers and venture capital. Ultimately, the European Commission intends to develop EU 'ecolabels' for financial products.

Investment managers could therefore end up being responsible for handling sustainability risks that are enshrined in EU law while the EU's sustainability regime is still under construction. Indeed, the amendments to the AIFMD, the UCITS Directive and MiFID II, if they follow ESMA's blueprint, will not even contain a definition of the phrase "sustainability risks."

The European Parliament, however, defines such risk as “an uncertain environmental, social or governance event or condition that, if it occurs, could cause a negative material impact on the value of the investment.” With this form of words in mind, we might expect the proposed changes to require MiFID, AIFM and UCITS managers to:

• establish organisational arrangements and decision-making processes that take account of ESG factors, where appropriate, when they are servicing clients;
• include sustainability risks in their investment and risk management arrangements and risk management policies;
• spot conflicts of interest that may emanate from the design and distribution of sustainable investments, particularly the risks of green-washing services and products (see below), mis-selling, misrepresentation and the unsuitable churning of investments;
• ensure that their compliance officers, internal auditors, boards and senior fund managers consider sustainability risks when carrying out their various duties and have enough resources and skills on hand to do so;
• include ESG preferences in the determination of target markets for product design and service distribution (and, of course, monitor these); and
• establish strategies, including the exercise of voting rights, to encourage the companies in which they are investing to take account of sustainability.

A tangled skein of problems

Investment strategy, therefore, is likely to be vital - not just for a mandate or a fund, but also for the house that manages it. Regulators might take a management firm that manages more than one mandate with inconsistent 'sustainability' objectives to be running against the objectives that underpin the EU’s proposals, especially if that firm does not claim to be making sustainable investments (and especially if it does not seem to want to). How will these investment managers fare in a market whose regulators presume that they ought to be taking account of sustainability risks?

Then there is the risk that firms will try to deceive investors into thinking that their investments are sustainable. Even if they are sincere, there is also the risk that they will find it hard to measure their success in achieving sustainability and will come to inconsistent conclusions. With no EU-wide taxonomy or standardised approach to help firms measure things, investors may have to rely on their own resources to establish and monitor firms for signs of sustainability. Retail investors, who rely on representations made through financial promotions, will of course not be able to do this.

Greenwashing - the practice of making an unsubstantiated or misleading claim about the environmental benefits of a product, service or company practice - is bound to take place. Will high-net-worth individuals only be able to spot it when they have already made some good or bad returns on their investments? Or will they be able to predict that greenwashing is about to take place because ESMA (or the market) has evolved good ways of spotting the right signs?

Product governance

Product governance is a concept that the UK's Financial Conduct Authority embraces in PROD, its rulebook on the subject. PROD 3.2.1R dictates that each 'manufacturer' must maintain, operate and review an approval process for each financial instrument (or a significant adaptation thereof) in each case before marketing it or distributing it to customers. Indeed, the rulebook applies to both to manufacturing firms and distributing firms. Each distributor (according to PROD 3.3.1R) must understand the financial instruments that it distributes to clients, assess their compatibility with the clients' needs and distribute them only in the best interests of the clients.

Firms should use product governance techniques to hold their fund managers to account for the claims and objectives that they set for their funds and services. They should also use such techniques to stop themselves from distributing those funds and services (and products) outside their allotted markets and to ensure that products remain fit for their intended objectives throughout their lifecycles.

Here and there

Unsuitable turnover and unsuitable times for making investments are also problems for sustainability. Clients may say that they want fund managers to consider sustainability risks but this may not be their primary objective. When is the right time, suitable for the underlying investor or consistent with the investment mandate, to switch to a more sustainable investment? Or, as the EU wants to force fund managers' investment strategies to take sustainability into account, would it be more suitable to 'hold' the investment and wait for new rules to appear?

This is also an opportunity for firms to consider how to use the requirements of the imminent EU Shareholder Rights Directive to demonstrate to investors that they are doing sustainable things.

Lastly, there are resources. ESMA wants to make the usual suspects accountable for enforcing its new rules – namely senior fund managers, compliance officers and internal auditors. Training, competence and capability will all require consideration and support, not least because accountability requires capability and competency.

Investment strategy, financial promotion, suitability, disclosure, reporting and capability have often been the subject of new rules. While the EU rolls out its Sustainable Investment Action Plan over the next three years, firms that want to promote their own worth in the ESG sphere should use sound product governance, high standards of conduct, robust systems and controls and effective governance and they should do so (excuse the pun) on a sustainable basis.

* Jonathan Wilson can be reached on +44 (0)20 3146 1869 or at jon@elliswilson.co.uk