European Commission Issues Proposals on Sustainability for Financial Services Firms

February 26, 2019

The proposals pave the way for the integration of environmental, social, and governance considerations into the day-to-day thinking of financial services firms.

The European Commission (the Commission) published a draft regulation under the MiFID umbrella on 4 January 2019 on how portfolio managers and financial advisers should take sustainability issues into account when assessing suitability (the January 2019 Draft). This notable development represented a significant milestone in the European Union’s (the EU’s) march towards the integration of environmental, social, and governance (ESG) considerations into the day-to-day processes of financial services firms. That march has been steady and deliberate, springing from global efforts towards a more sustainable economy represented by the 2015 Paris Agreement on Climate Change and the United Nations 2030 Agenda for Sustainable Development. The Commission has made sustainable finance an express initiative within its overall plans to strengthen capital markets in the EU. More recently, the International Organization of Securities Commission (IOSCO) has been following the increasingly intense focus on global sustainability and published its consultation report on 1 February 2019 on sustainable finance in emerging markets and securities regulators’ role. Before we remind ourselves of the wider context, let us first examine further the January 2019 Draft in relation to the integration of ESG considerations and preferences into investment advice and portfolio management.

Under MiFID II, investment firms must act in the best interests of their clients. Investment firms providing investment advice or portfolio management are required to provide suitable personal recommendations to their clients or make suitable investment decisions on behalf of their clients. Suitability has to be assessed against clients’ knowledge and experience, financial situation, and investment objectives. To achieve this, firms must obtain the necessary information from clients and must conduct a suitability assessment at the on-boarding stage. For example, firms should understand the investment objectives of their clients. However, ESG issues are not normally considered under the current suitability regime. The January 2019 Draft would require firms to identify their clients’ ESG preferences so that their advice and investment decisionmaking reflects the clients’ financial objectives and ESG preferences. In addition, firms will be asked to ensure ESG considerations are properly reflected in their policies and procedures required under MiFID II in order that they understand the nature, features, costs, and risks of financial instruments selected for their clients.

The January 2019 Draft seeks to make concrete the concept of ESG with some helpful definitions, including one for “ESG preferences”, which is defined as “a client’s choice whether and which environmentally sustainable investments, social investments or good governance investments should be integrated into their investment strategy”. In short, the draft regulation clarifies that MiFID firms providing financial advice and portfolio management should

  • carry out a mandatory assessment of their clients’ ESG preferences in a questionnaire sent to them;
  • take their clients’ ESG preferences into account in selecting financial products; and
  • for retail clients only, prepare a report to the client that explains how the recommendation to the client meets his investment objectives, risk profile, capacity for loss bearing, and ESG preferences.

The draft regulation helpfully states that there will not be a requirement for existing sustainability assessments to be revisited and contemplates a 12-month transitional period following its commencement. Both these steps will sweeten the pill for the industry as it prepares for yet another step-change.

In a related development, the European Securities and Markets Authority (ESMA) published its “Guidelines on certain aspects of the MiFID II suitability requirements” in May 2018. ESMA took the opportunity to recommend as good practice that firms should currently consider ESG factors when gathering information on a client’s investment objectives, paving the way for investment firms to volunteer to include ESG preferences in their suitability assessments ahead of becoming obliged to do so.

Although the January 2019 Draft has MiFID investment firms in its crosshairs, the EU’s ambitions for sustainable finance touch most areas of financial services: UCITS managers, AIFMS, insurers, MiFID investment firms, occupational retirement schemes, and European venture capital, social entrepreneurships and long-term investment funds. The Commission wants to address an ongoing lack of transparency in how institutional investors, asset managers, and financial advisors consider sustainability risks in their investment decisionmaking or advisory processes. This is despite the progress already made in the occupational retirement sector where the relevant updated and recast directive, which was required to be implemented locally by EU countries by 13 January 2019 and is colloquially known by the acronym “IORP”, took the first step towards a more concise disclosure framework for financial services in relation to ESG factors. The mischief being that clients stand never to receive the full information needed to inform them properly about the sustainability-related impact of their investments.

The January 2019 Draft is part of a continuing effort by European lawmakers to lay the foundations for an EU framework that puts ESG considerations at the heart of the financial system to help transform the EU’s economy into a greener, more resilient, and circular system. It follows the more far-reaching draft legislation consulted on by the Commission in May 2018 on disclosures that relate to sustainable investments and sustainability risks (the May 2018 Draft) under which there are three categories of covered firm:

  • Financial market participants, defined as AIFMS, portfolio managers, UCITS managers, an IORP qualifying occupational retirement scheme, a provider of a pension product, an insurer which makes certain products available, EuVECA, and EuSEF managers
  • Insurance intermediaries advising on certain products
  • Investment advisers under MiFID

Broadly, all obligations under the May 2018 Draft would apply to financial market participants and most obligations would apply to the other two categories. The document proposes that covered firms

  • publish and maintain written policies on the integration of sustainability risks in the investment decisionmaking or advisory process on their websites;
  • provide investors/clients with the following pre-contractual disclosures:
    • the procedures and conditions applied for integrating sustainability risks in investment decisions;
    • the extent to which sustainability risks are expected to have a relevant impact on the returns of the financial products made available; and
    • how their remuneration policies are consistent with the integration of sustainability risks and are in line where relevant with the sustainable investment target of the financial product.

Additional transparency requirements would apply to a firm that offers its investors/clients a sustainable financial product, such as a fund or managed account. The May 2018 Draft also provides for a 12-month transitional period.

The EU’s wider package of regulatory change follows global efforts to tackle climate change and achieve a sustainable economy, acknowledging the role that the private sector must play if governments from around the world are to meet their ambitious sustainability targets under the Paris Agreement and the United Nations 2030 Agenda.

The Commission established a High-Level Expert Group (HLEG) in December 2016 with the goal of developing a comprehensive EU strategy on sustainable finance, which concluded that ESG had to be considered as part of the drive towards sustainable finance. Specifically, the HLEG set out recommendations including that a technical classification system should be established at the EU level. This is part of the EU’s efforts to achieve clarity on what is considered to be a “green” or “sustainable” investment.

The recommendations of the HLEG form the basis of the Commission’s Action Plan on Financing Sustainable Growth, published in March 2018. To be clear, final versions of the May 2018 and January 2019 Drafts are not expected in the short-term and await agreement of an appropriate taxonomy governing ESG and sustainability. The Commission has chosen to publish proposed legislation earlier than it might otherwise have done in an effort to encourage voluntary development of existing sustainability standards.

In the United Kingdom, the Financial Conduct Authority (FCA) issued a discussion paper on Climate Change and Green Finance in October 2018, noting that the “FCA must consider all major risks that have an impact on the markets and institutions we regulate including those posed by climate change”.

Specifically, the FCA is developing policies under four headings:

  • ESG and climate change regarding UK workplace pension schemes
  • Enabling competition and market-growth for green finance to assist in the United Kingdom’s transition to a low carbon economy
  • Disclosures in capital markets
  • Public reporting by financial services firms on how they manage climate risks. For example, a report prepared by an asset manager would describe how it manages the risk to long-term investments created by climate change.

We are closely monitoring the area of sustainable finance and its regulation at both EU and UK levels. Morgan Lewis will continue to publish regular updates as the regulatory framework evolves.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Simon Currie
William Yonge
Steven Lightstone