ESMA Publishes Advice on How Fund Managers and Investment Firms Should Integrate Sustainability Risks and Factors into Their Business Models

August 28, 2019

The European Commission (the Commission) has made sustainable finance an express initiative within its overall plans to strengthen capital markets in the European Union. In July 2018, the Commission sought advice from the European Securities and Markets Authority (ESMA) on potential legislation under EU directives governing fund managers and investment firms with regard to sustainability. ESMA published its advice on 30 April 2019.

Following a consultation process, ESMA published "technical advice" to the Commission on 30 April 2019 on how fund managers and investment firms should integrate sustainability considerations into their processes and procedures. This advice takes the form of two final reports targeting fund managers and investment firms, respectively.

It is notable that ESMA has decided to take a principles-based approach to integrating sustainability risks and factors within the frameworks of the EU Alternative Investment Fund Managers Directive (AIFMD), the EU Markets In Financial Instruments Directive (MIFID) and the EU UCITS Directive, similar to the approach already taken to other risks within those frameworks. In response to concerns over smaller firms struggling with implementation costs and independent firms being driven out, ESMA confirmed that all the proposed changes under the three directives would be subject to proportionality by virtue of existing legislative provisions. A substantial number of proposals take the form of recitals in the preambles to EU legislation, rather than operative articles. The recommended use of recitals represents a reasoned, balanced approach by ESMA in order not to give excessive prominence to ESG principles and to retain flexibility to adjust to future developments.

Considering that there are still several ongoing Commission legislative procedures, as referred to below under “Update on Related Measures”, prescriptive requirements relating to sustainability risks at the current stage in development could enhance the risks of regulatory arbitrage by authorised entities, create regulatory inconsistencies, and subsequently result in legal uncertainty.

Fund Managers

The Final Report on integrating sustainability risks and factors in the UCITS Directive and AIFMD (the UCITS/AIFMD Report) sets out ESMA’s advice on how the relevant EU legislation should be modified to address ESG concerns. Sustainability risks in this context are the risks of fluctuation in the value of positions in a fund’s portfolio due to ESG factors.

Under the UCITS Directive, while management companies must have in place certain organisational procedures and well-documented structures and practices, they are not required to take ESG considerations into account or consider conflicts of interest that could arise from sustainability risks. Similarly, under the AIFMD, AIFMs are not expected to take into account ESG considerations.

The majority of the respondents agreed with ESMA’s principles-based approach. ESMA confirmed this approach and acknowledged concerns that a more prescriptive approach to this dynamic area of regulation could potentially stifle innovation and allow regulatory inconsistencies to emerge and take hold. Consequently, ESMA’s advice is sufficiently general and broad to allow fund managers to assess how to best take into account ESG considerations.

ESMA recommends changes in the following areas of the UCITS and AIFMD frameworks:

  • General organisational requirements: Incorporation of sustainability risks within organisational procedures, systems, and controls to ensure that they are properly taken into account in investment and risk management processes (e.g., decisionmaking, internal reporting, and monitoring). Notwithstanding that the operative wording appears after the existing proportionality clause (as opposed to before it, as is the case with the counterpart amendment to the MiFID framework), the intention is that proportionality should apply.
  • Resources: Consideration of the required resources and expertise for the integration of sustainability risks. ESMA proposes that in reaching decisions on resourcing themselves adequately, across personnel and third party monitoring, fund managers must take into account the necessary resources and expertise for the effective integration of sustainability risks and ensure that their senior management is responsible for the integration of sustainability risks.
  • Conflicts of interest: Consideration of the types of conflicts of interest arising in relation to the integration of sustainability risks and factors. ESMA proposed the use of a recital focusing on conflicts of interest arising in relation to the integration of sustainability risks. A significant number of respondents considered it necessary to single out sustainability, given current conflicts rules cover only conflicts that may arise. Some respondents either supported use of a recital or stronger measures, such as a specific provision in the body of the legislation. ESMA concluded that use of a recital is a balanced approach. In practice, conflicts of interests policies would need to address how such conflicts are identified and addressed.
  • Due diligence requirements: Consideration of sustainability risks when selecting and monitoring investments, designing written policies and procedures on due diligence and implementing effective arrangements. ESMA decided to include specific requirements on fund managers to
  • take into account sustainability risks when complying with the investment due diligence requirements and, only "where applicable", the principal adverse impact of investment decisions on sustainability factors; and

  • develop engagement strategies with a view to reducing the principal adverse impact of investee companies on sustainability factors (e.g., for the exercise of voting rights).

We note the provisions in the final version of the Disclosure Regulation (see further below under “Update on Related Measures”) relating to disclosures of principal adverse impact that are required for regulated firms with more than 500 employees and that are based on a comply or explain mechanism for regulated firms with fewer than 500 employees. These deregulatory provisions would bear cross-referencing in any revised texts.

  • Risk management: Explicit inclusion of sustainability risks when establishing, implementing, and maintaining an adequate and documented risk management policy. Again, ESMA has taken a principles-based approach to finalising the proposed legislation, given that the risk management processes of funds do need to be specifically tailored to their investment strategies, the characteristics of the portfolios, and the objectives of the underlying investors. ESMA has simply included sustainability in the list of material risks to be managed.

Investment Firms

The Final Report on integrating sustainability risks and factors into the MiFID framework (the MiFID Report) sets out ESMA’s advice on how the relevant EU legislation should be modified to address ESG issues, recommending changes in the following areas:

  • General organisational requirements: ESMA has recommended similar changes to those recommended in the UCITS/AIFMD Report but with some differences, such as using the term “ESG considerations” rather than “sustainability risks” and expressly making the new obligation contingent on where such considerations “are relevant for the provision of investment services to clients”. Some consultees considered that this amendment should be reserved for firms providing portfolio management and/or investment advice, but ESMA rejected that suggestion, while emphasising the proportionality principle that is already hard-wired into the provisions on organisational requirements and the wording specifying that ESG considerations should only be taken into account where they are relevant.
  • Risk management: ESMA decided it was appropriate to include a specific obligation to take sustainability risk into account in firms’ risk management policies and procedures. However, they decided to recommend a new recital on risk management that was not proposed at the consultation stage, but which does confirm ESMA’s view expressed in the consultation paper that both compliance and internal audit must consider sustainability risks. The recital also refers to senior management to align ESMA’s advice on UCITS/AIFMD with that on MiFID.
  • Conflicts of interest: ESMA decided to recommend a new two-pronged recital to be added to the MiFID II Delegated Regulation to ensure that investment firms
    • when identifying the types of conflicts of interest that may damage the interests of a client, should include those that may stem from the distribution of sustainable investments; and
    • establish “appropriate arrangements” to ensure that the inclusion of ESG considerations in the advisory and portfolio management processes does not lead to mis-selling practices. The recital usefully gives three examples of the types of mischief in mind: an excuse to sell own-products or more expensive ones; churning of clients’ portfolios; and misrepresentation of products or strategies as fulfilling ESG preferences where they do not (so-called “greenwashing”). One outcome will be that firms will be expected to revise their conflicts policies to include a clear reference to how these types of conflict are identified and managed.
  • Product governance with particular reference to manufacturers’ and distributors’ obligations on the definition and review of the target market: given that the target market assessment under the product governance requirements does not need to take account of sustainability factors, ESMA has decided to impose a high-level requirement on firms (allowing flexibility) to consider their clients’ “ESG preferences (where relevant)” and whether any financial instrument’s “ESG characteristics (where relevant) are consistent with the target market”. In a subtle but significant change, ESMA amended its consultative wording that held out clients’ and target markets’ ESG preferences as an example of their “needs, characteristics and objectives” in favour of characterising them as a self-standing factor. This was to differentiate between investment objectives and ESG preferences, which the Commission regards as important to do in order to avoid any mis-selling where an ESG consideration ranks above a client’s own investment objective.

Update on Related Measures

The Commission has made sustainable finance an express initiative within its overall plans to strengthen capital markets in the European Union, stating that: “Re-orienting private capital to more sustainable investments requires a comprehensive rethinking of how our financial system works. This is necessary if the EU is to develop more sustainable economic growth, ensure the stability of the financial system, and foster more transparency and long-termism in the economy.”

The Commission adopted a package of measures on 24 May 2018 on sustainable finance that included proposed regulations aimed at establishing a unified EU taxonomy of sustainable economic activities (the Taxonomy Regulation), improving disclosure requirements on how institutional investors integrate ESG factors in their risk processes (the Disclosure Regulation), and creating a new category of benchmarks to help investors compare the carbon footprint of their investments (the Low Carbon Benchmark Regulation). In addition, the Commission has been seeking feedback on amendments to the MiFID framework published in January 2019 to include ESG considerations and preferences into advice that investment firms offer to clients and portfolio arrangements. Our previous LawFlash includes further details on those MiFID proposals and the Disclosure Regulation.

Low Carbon Benchmark Regulation

Political agreement was reached on 25 February 2019 on the Low Carbon Benchmark Regulation, which, in short, amends the Benchmark Regulation framework by

  • introducing two new categories of benchmark, a low carbon one and a positive carbon impact one;
  • requiring benchmark administrators that pursue or take into account ESG objectives to provide an explanation of how the key elements of the methodology reflect the ESG factors and to explain in their published “benchmark statement” how ESG factors are reflected; and
  • setting out the key requirements governing the methodology for the two new benchmarks.

Disclosure Regulation

Political agreement was reached on 7 March 2019 on the Disclosure Regulation, which sets out how financial market participants and financial advisors must integrate ESG risks and opportunities in their processes, as part of their duty to act in clients’ best interests. It also sets uniform rules on how those financial market participants should inform investors about their compliance with the integration of ESG risks and opportunities. The regulation is built around three main pillars:

  • Elimination of greenwashing: The regulation is intended to eliminate unsubstantiated or misleading claims about sustainability characteristics and benefits of an investment product and increase market awareness on sustainability matters
  • Regulatory neutrality: The rules introduce a disclosure toolbox to be applied in the same manner by different financial market operators
  • Level playing field: The regulation covers the following financial services sectors: (i) investment funds; (ii) individual portfolio management; (iii) both investment and insurance advice; (iv) private and occupational pensions, and (v) insurance based investment products.

Taxonomy Regulation

The Commission continues to work with the co-legislators to reach an agreement on the remaining part of the package, the Taxonomy Regulation.

The European Union’s willingness to make progress on integrating sustainability in European financial services legislation by itself, and without waiting for a global converging regime, is laudable. However, the involvement of global regulators will be necessary, as sustainability is a global issue. To be critical, the EU approach to legislative proposals is uneven and somewhat back to front, given the inevitably slow progress of the Taxonomy Regulation – which will, it is hoped, provide a common set of definitions and classifications designed by experts (e.g., physicists and biologists) to determine which economic activities are or are not ESG compatible – and its lagging behind all other measures made to date.

Indeed, the Securities and Markets Stakeholder Group, which exists to facilitate consultation between ESMA and stakeholders on ESMA’s areas of responsibility, has stated its concerns in this regard and that it would have “much preferred the adoption of a clear and appropriate taxonomy and labels before investment firms, institutional investors and asset managers were requested to disclose how they integrate sustainability risks in the investment decision-making or advisory process”.

We are closely monitoring developments in the area of sustainable finance and its impact on financial services regulation across the United Kingdom and the European Union. Morgan Lewis will continue to publish regular LawFlashes as the regulatory framework continues to evolve.


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