Financial Services Ireland

FINANCE DUBLIN ARTICLE

The new EU ESG regulatory framework and its implications for asset managers

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The European Commission has put together a sustainability package embracing a regulatory framework for securities and investment funds built around three principal components. In the latest issue of Finance Dublin, EY’s Muntasir Khaleik assesses a package that is of fundamental significance for asset managers.

As many asset managers predicted, EU financial services regulation is leading the way with bold and ambitious reforms that support climate change goals and commitments. The European Commission has put together a sustainability package that includes three components: Taxonomy, Disclosures, and Benchmarks Regulation. This new EU ESG regulatory framework is expected to have profound ramifications for asset managers within the EU and beyond.

Taxonomy Regulation
This regulation establishes the conditions and the framework to gradually create a unified classification system (‘taxonomy’) for determining whether an economic activity is environmentally sustainable. It applies to financial market participants (FMPs) making available financial products. FMPs include a broad range of investment funds, product manufacturers and asset managers, including insurance undertakings, pension funds, AIFMs and UCITS management companies.

The key obligations of the Taxonomy Regulation
The regulation sets out six environmental objectives and is to be implemented through delegated acts which will be developed in two phases. The first phase comprises two objectives; 1) climate change mitigation and 2) climate change adaption to be adopted by the Commission by 31 December 2020 and applicable from 31 December 2021. The second phase relates to the remaining four objectives: 1) sustainable use and protection of water and marine resources, 2) transition to a circular economy; 3) pollution prevention and control and 4) protection and restoration of biodiversity and ecosystems. The phase should be adopted by the Commission by 31 December 2021 and apply from 31 December 2022.

The Taxonomy imposes three key obligations on member states at the EU, FMPs, and large public-interest entities:

  • EU Member states should apply the Taxonomy when regulating environmentally sustainable financial products or corporate bonds;
  • FMPs need to make statements about the alignment of investments with the Taxonomy when making available financial products;
  • Large public-interest entities to include information about how their activities align with the Taxonomy in the non-financial disclosure part of their financial statements.

Disclosure Regulation
This regulation introduces disclosure obligations on how institutional investors and asset managers integrate ESG factors into their risk management processes. It applies to all FMPs and investment firms authorized under MiFID providing portfolio management services. It also applies to financial advisers (FAs), including certain insurance intermediaries and providers of investment advice (unless employing less than three employees). It can also apply to non-EU asset managers.

The key obligations of the Disclosure Regulation
The new transparency requirements include disclosures on internal policies through the website about the integration of sustainability risks in the investment decision-making and advice process, the consideration of principal adverse impacts of an investment decision on sustainability factors, and information on how remuneration policies are consistent with the integration of sustainability risks.

It also requires disclosure of information through pre-contractual documents on how sustainability risks are part of the investment process. If deemed not relevant a clear and concise explanation of why not and the adverse sustainability impact of the investment decisions is required.

At product level (UCITS, AIFs, and separate accounts), FMPs will be expected to describe how sustainability risks are integrated into their investment decisions, the likely impacts of sustainability risks on the returns of the financial products made available, and how the financial products consider principal adverse impacts on sustainability factors.

Financial products which promote environmental characteristics, and which invest in an economic activity that contributes to an environmental objective will need to disclose in pre-contractual or offering memorandum detailed information on how those characteristics are met and if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics.

The annual reports of ESG focused UCITS, AIFs and separate accounts will need to provide details of how the relevant ESG objectives are being met in their annual report.

The Regulation will apply from 10 March 2021, with certain obligations taking effect later. Obligations related to the provision of first annual reports delayed until 1 January 2022.

Benchmarks Regulation
The regulation was created by an amendment to the existing EU Benchmark Regulation. It introduces two new climate-related benchmark classifications, EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks, as two distinct categories of low carbon benchmarks. The aim is to ensure consistent understanding among benchmark users. It focuses on benchmark administrators but can also have some indirect impacts for benchmark users such as asset managers.

There is a grave risk that dangerous climate change will occur that will endanger the lives, welfare and living environment of many people all over the world. This new EU ESG regulatory framework is being developed to address climate change risk and asset managers must embed ESG factors in their decision-making process and act now to be compliant with regulations.

This article was written by EY Director Muntasir Khaleik for the July issue of Finance Dublin