Risks and Factors of Sustainability in UCITS and AIFMD
Back in July 2018, ESMA and EIOPA received a mandate from the EU Commission to provide technical advice to supplement the existing package of proposals and assist in the development of potential amendments or delegated acts to integrate sustainability risks and factors in UCITS and AIFMD.
ESMA issued accordingly a first consultation paper in December 2018 (please find the document here and after a round of responses from industry participants, as part of the EU law making process, the final report was released at the beginning of May 2019 (please find the document here).
In this post, we aim to discuss the importance of the concept of sustainability and how integration of sustainability risks and factors in UCITS and AIFMD will take place.
The Concept of Sustainability
Recently the concept of sustainability and sustainable finance has gathered particular interest at European level. This consultation from ESMA comes in tandem with a package of measures, already adopted by the European Commission in May 2018, on sustainable finance. The aim of the package was mainly to define a taxonomy of sustainable economic activities at European level with a view to offer investors a way to benchmark and compare the carbon footprint of their investments by enhancing the disclosure of how the environmental, social and governance elements are factored in the overall risk process of finance activities.
The idea underpinning the endeavour is that sustainable growth can be achieved when capital flows to sustainable investments and a long-term view is encouraged in the investment decision process. And whilst there is consensus that the market is not mature yet on all the issues involved in sustainability, the development of the market starts with identifying a clear and robust taxonomy of all the green assets, projects, categories and sectors. Of course, the need for a regulation at European level of these issues is clear in that regulatory fragmentation has the downside of generating regulatory arbitrage when best practices instead should be spread around Europe. More coordination will also happen at global level.
Definition of Sustainability Risk
As per the consultation paper, integration of sustainability risk factors in UCITS and AIFMD shall take place via high-level principles, following the approach adopted for other types of risks. Bearing in mind that one of the aims is to avoid at all costs regulatory arbitrage, it makes sense to avoid strict prescriptions that could still be adopted differently across Europe.
The idea is that authorised fund managers, whether regulated by UCITS or AIFMD, will have to be able to evaluate also the sustainability risk of their investments, amongst other risks. Similar to other risks, they will have to incorporate sustainability in their due diligence and risk management to a different extent depending on the size and complexity of their operations as well as the relevance of the sustainability risk factor.
However, integration of sustainability risk factors under UCITS and AIFMD proceeds from a clear identification and definition of sustainability risk first. So far, no such definition under both directives exists for risks of this type. For the purposes of ESMA consultation paper and in anticipation of a more definitive legislative definition, a definition of sustainability risk is inferred from the concept of sustainable finance, which refers to environmental, social and governance factors (ESG factors).
Given that sustainable finance means taking into account those broader ESG factors in the investment decision making process, sustainability risk can be understood as the risk of fluctuation in value of an investment or position in a portfolio due to those ESG factors.
Organisational requirements, operating conditions and risk management
Of course, not all strategies are affected the same way by ESG factors, nor all firms have the size to be able to implement with no effort each and every new requirement. ESMA’s approach in its final report is to ensure that appropriateness and proportionality are taken into account when dealing with the integration of sustainability risk factors in UCITS and AIFMD. Below the list of the main areas that will be tackled by amendments to delegated acts for both UCITS and AIFMD, along with an indication of the general approach adopted by ESMA.
- Organisational requirements – no need for an ad hoc qualified person in charge of integration of sustainability risk factors in UCITS and AIFMD. This measure doesn’t necessarily allow per se the attainment of the objectives of the EU Commission on this issue. ESMA’s conclusion is that the requirement would be disproportionate and at this stage it is sufficient that senior management is collectively involved in the process.
- Operating conditions – here the concept of appropriateness and proportionality, which as we will see is one of the main takeaways in terms of integration of sustainability risk factors in UCITS and AIFMD, starts to surface in its importance. ESMA’s conclusion is that the due diligence requirements in terms of sustainability risks shall be applied in a way that is appropriate to the specific strategy (sustainability is in fact more relevant to certain strategies than it might be for others) and that realistically at this stage, where the market is not mature yet on these topics, it makes sense to stick to a more principle based approach without embarking into more detailed and prescriptive descriptions.
- Risk management – here the concept of proportionality takes over. ESMA’s conclusion is that a more holistic approach should be adopted in dealing with sustainability risk factors in the risk management process and that no additional legislative measures or definition are required at this stage.
The main takeaway is the one of proportionality when dealing with integration of sustainability risk factors in UCITS and AIFMD. It is a very positively welcome approach. Whilst ESG factors are not all relevant in the same way for all strategies, imposing more stringent requirements of organisational or operating nature, as well as creating more detailed definitions will not help in achieving the goals of the European Commission, rather would create some distorted and unnecessary consequences. For instance, imposing blanket requirements, without a proportional approach, will result in unnecessary additional costs for smaller firms or for other firms which, for nuisances of their investment strategies, for instance, are less impacted by ESG factor.
The way for full integration of sustainability risk factors in UCITS and AIFMD is paved and requires for the time being a coordinated approach at European level. However, there is need for coordination at a more global level on sustainable finance and therefore it is more appropriate to implement changes at this point that are not highly detailed or prescriptive, but principle-based, in order not to conflict with other measures proposed at more global level in the near future.