European Fund Comment: European Regulators Continue to Focus on Sustainability

14 February 2020

Preparing for new sustainability regulations in Europe – many of them effective from March 2021 – will be high on the list of compliance tasks for European firms this year. GPs themselves will face additional disclosure obligations and changes to internal rulebooks. And many European LPs are also in scope of the new rules, meaning that environmental, social and governance (ESG) issues will be increasingly relevant for any international firm that wants to attract European investment. It is, however, also clear that the focus on sustainability is not going to end there: European policymakers have an ambitious agenda – confirmed by the regulatory strategy laid out by the European Securities and Markets Authority (ESMA) last week.

ESMA is a key player, and has an important role in defining the obligations that have been mandated in the sustainability focused initiatives that are already on their way. In particular, detailed public and investor disclosure rules will apply to European private fund managers and advisers from next March and, at the moment, it is not clear what firms will need to do to comply. The industry urgently needs to see the detailed technical standards – to be drafted by ESMA and approved by the European Commission – that will define their obligations. ESMA says that these rules are a priority.

ESMA has also given advice to the Commission on ESG-related changes to the AIFMD and the MiFID rulebooks. It is not yet clear whether the Commission will want to make more specific provision for ESG in those rulebooks than ESMA has recommended, but ESMA’s approach so far has been sensible and proportionate. ESMA also has a role in the Taxonomy Regulation, an initiative to classify “sustainable” activity and prevent greenwashing.

All of these ongoing initiatives certainly need urgent attention if the industry is going to have enough time to adapt. A rushed, last minute implementation will help no one, so ESMA’s commitment to prioritise them is welcome.

However, in what could be seen as a fundamental shift in approach, the pan-European securities regulator has signalled an intention to go much further: its ambition to incorporate ESG considerations into its work is not confined to specific sustainability initiatives brought forward by lawmakers. Instead, it will incorporate ESG into all areas of its supervisory remit.

ESMA justifies that new approach on two distinct but overlapping grounds: it says that investor preferences are shifting towards products that incorporate ESG factors, and that such factors are increasingly affecting the “risks, returns and value of investments”. ESMA regards these changes as justifying a different approach to its rulebooks in order to “enhance investor protection and promote stable and orderly financial markets”.

What does this mean in practice? First, ESMA’s focus on investor preferences implies that it should help investors to understand an asset manager’s approach to ESG factors – presumably, climate change and other environmental risks and opportunities, as well as a range of human rights and governance topics – and ensure that it keeps any promises that it makes to them. The forthcoming Disclosure Regulation and Taxonomy fit well with that objective. On the other hand, ESMA’s assertion that ESG factors often affect value and risk means that its rules should require a thorough and informed assessment of financially material ESG factors. That is, after all, what any rational investor would expect. The proposed changes to AIFMD and MiFID can be seen through this lens.

But ESMA’s stated objectives go further. It says that it will take account of ESG factors in all its rule-making activity, including when it reviews existing rules as part of its normal processes. It intends to make ESG a permanent part of its approach to regulation and risk assessment in the financial sector, and to work to make sure that national supervisors converge in their approach to ESG.

Private fund managers are not being singled out: on the contrary, much of the European sustainability agenda is targeting other parts of the asset management industry – particularly regulated investment products, pension funds and insurance companies. For example, the European Banking Authority (EBA) published an action plan on sustainable finance in December setting out a timeline for investigating the integration of ESG issues into the prudential framework for banks and investment firms. The European Insurance and Occupational Pensions Authority (EIOPA) is engaged in a similar project, including a review of investment, risk management and the prudential capital requirements of insurance companies. But private fund managers are certainly not immune and will also have to adapt to these changing regulatory priorities.

That isn’t necessarily a problem: the nature of the private funds industry means that accommodating investor preferences – and taking proper account of financially material risks and opportunities – is part of its DNA. Private funds are very well adapted to conform to the sustainability agenda and, indeed, to take full advantage of it. While getting to grips with the complex, and (so far) rather unclear, technical rules will be painful, practitioners may take some comfort from knowing that an ability to respond to emerging ESG priorities could ultimately prove to be one of the industry’s core strengths.