A major player in the fight against climate change is the capital market. The transformation to a low-carbon, more sustainable and resource-efficient and circular economy needs capital, lots of capital. The European legislator’s declared goal is to redirect capital flows into sustainable investments. To do this, it uses two approaches: taking into account customers’ sustainability preferences and disclosing how sustainability risks are managed. While sustainability preferences are on everyone’s lips today, sustainability risks currently lead to a rather shadowy existence. Reason enough to take a closer look at this topic.
Consideration of sustainability preferences
From August 2022, financial service providers will no longer only ask investors about their investment objectives, risk preference and risk-bearing capacity and the intended investment period. They will also determine whether and, if so, to what extent a proportion of the investment amount should be invested in financial instruments that are in particular ecologically sustainable. What is to be understood by ecologically sustainable is defined by the so-called Taxonomy Regulation, which has recently been the subject of heated debate as a result of the inclusion of nuclear and gas-fired power plants.
Interface between SFDR and MiFID II
The reason for this is the Delegated Regulation (EU) 2021/1253, which is intended to further promote the idea of sustainability in the financial industry and forms a kind of interface between MiFID II and the Sustainable Finance Disclosure Regulation (SFDR) from 2019.
Accordingly, the entire industry is currently preparing to supplement its client suitability questionnaires forms and to obtain the corresponding client information. If the investor decides to specify sustainability preferences, these must be strictly adhered to in discretionary portfolio management. Within the scope of investment advice, a financial instrument may be recommended even if it does not match the individual sustainability preferences. However, the financial service provider must clearly point out the lack of this match.
With the instrument of sustainability preference, the legislator places bets on investors’ sense of responsibility. It assumes that a sufficiently significant proportion of investors either regard sustainability criteria as an indispensable prerequisite for the long-term profitability of an investment or do not only invest according to pure return criteria, but also want socio-political aspects to be taken into account in the form of sustainability criteria.
Dealing with sustainability risks under the SFDR
The European legislator defines sustainability risks as environmental, social or governance (ESG) events or conditions, that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment (Art. 2 No. 22 SFDR). With this definition, it links the topic of sustainability to the financial performance of a specific investment.
Disclosure obligations and inclusion in risk management
Financial service providers must, according to the SFDR include relevant sustainability risks – like all (other) relevant financial risks too – “in their procedures, including their due diligence processes, and assess them on a continuous basis (recital 12)”. In pre-contractual disclosures, they must explain the way in which sustainability risks are integrated into investment decisions in the context of portfolio management or investment advice and the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products offered (Art. 6). If a financial service provider does not consider sustainability risks to be relevant, it shall explain this “clearly and concisely”.
In practice, these obligations are currently being tackled rather half-heartedly. More than spiritless flat rates for the fulfilment of disclosure obligations are rarely found. The legislative goal, namely to enable investors to make informed investment decisions, to promote the consideration of sustainability factors in this context and ultimately to increase the resilience of the real economy and the stability of the financial system (recital 19 SFDR), is thus unlikely to be achieved.
Obligations to provide advice on sustainability risks
The real leverage comes from somewhere else. Almost hidden and disguised as a matter of course, the legislator of the SDFR points out in the recitals that financial service providers must consider and include sustainability risks in their advisory processes (recital 6).
Here at the latest platitudes are at their end; now it’s time to talk clear language!
Investment-appropriate advice requires investment-specific explanations, especially with regard to risk disclosure. The investor must be made aware of the risks he is about to take with the financial product presented to him.
Old wine in new bottles?
Strictly speaking, it is a matter of course that sustainability risks are included in risk management, are taken into account in portfolio management and made the subject of proper investment advice. Nothing else applies to them as to all other financial risks.
Nevertheless, the European legislator raises sustainability risks to a higher level with the regulations discussed here. With the explicit definition as investment-specific risks and the obligation to take them into account within the framework of the investor-protecting regime of MiFID II, the legislator also expresses their special significance as financial risks.
Sustainability risks in the suitability questionnaire
It therefore seems consistent to ask not only about sustainability preferences, which may be perceived as purely altruistic, but also about the investor’s willingness to bear sustainability risks. Especially the latter is suitable to make him realise that the consideration of sustainability factors is not (only) purely altruistically motivated, but rather (also) in his very own financial interest.
From the perspective of the financial services provider, a survey of the willingness to bear sustainability risks not only serves to ensure compliance with regulatory requirements. It is also suitable for preventing liability risks within the framework of proactive legal risk management. An investor who is asked about this will hardly be able to argue later that she had no (altruistic) sustainability preferences, but that she did not want to accept such risks under any circumstances.