Sustainable investing: rooting out conduct risk and why MiFID II matters

20 November 2019

The appetite for sustainable investing shows no sign of letting up anytime soon. The asset management industry clearly recognises this, with a wide range of products launched in recent years to accommodate investor demand. Even for funds without a specific Environmental, Social and Governance (ESG) mandate, new regulatory initiatives including the EU Sustainable Finance Action Plan and the UK Stewardship Code 2020 are prompting asset managers to consider and disclose how they integrate ESG risks and opportunities into their investment decision-making. But as the sustainable investment market continues to grow and firms rush to meet demand, there may be greater scope for conduct risk. Firms should not neglect the need to meet their existing conduct obligations in the context of their ESG activity, including those stemming from MiFID II.

One of the most likely sources of ESG-related conduct risk stems from information asymmetries. For example, corporate issuers may have information advantages over the asset managers investing in their securities, driven by inconsistent company disclosures and wider challenges in accessing good quality ESG data. This may compromise the completeness and accuracy of due diligence assessments carried out by asset managers before making an investment decision, and their ability to assess ESG risks and opportunities robustly. What’s more - particularly in a primary market context - feedback on the corporate issuer from asset managers could suffer, compromising the efficiency of price formation. Ultimately, these types of issues could translate into less favourable outcomes for the clients of asset managers, including through weaker investment performance.

Another information asymmetry could exist between fund managers and their clients. ‘Greenwashing’ is one example of the misclassification or mis-selling of products which has garnered regulatory scrutiny recently. Initial work carried out by the FCA has identified a number of cases where sustainable labels have been applied to a wide range of products, some of which appear to hold broadly similar assets to products which aren’t classified as sustainable. If investors are unable to validate whether a fund is genuinely promoting sustainable outcomes, they risk purchasing products that are unsuitable for their investment needs. The FCA has indicated that it will be examining greenwashing in further detail, noting that it will take action where necessary.

In this context, firms should consider the application of their obligations under MiFID II to any ESG activity they carry out. Central to this is the overarching obligation to identify and manage any conflicts of interest, so that firms are not using any information advantages to advance their own interests in a way that compromises those of their clients.

Suitability and product governance requirements will also be of critical importance. As part of the suitability assessments carried out when providing investment advice or individual portfolio management services to clients, firms will need to be proactive in collecting information on clients’ ESG preferences, and be transparent on the ESG profile of funds being offered. On product governance, manufacturers and distributors will need to consider, at a meaningful level of granularity, any ESG preferences of clients when identifying the target market for funds. They will also need to determine whether the ESG characteristics of a fund are consistent with the identified target market and, more broadly, ensure these factors are considered throughout the product lifecycle, with the ultimate objective of obtaining good outcomes for clients.

Related to this, relevant firms should test themselves on whether their investment approach to ESG is embedded in their assessments of fund value when implementing the FCA’s new rules in this area, particularly when thinking about what value means for different groups of clients.

There are, of course, a wider range of MiFID II obligations that will need to be met in the context of sustainable investing activity. For example, what does greater integration of these factors mean for achieving best execution? Are you reflecting the ESG profile of financial instruments in your assessments of execution price and cost? This is likely to be particularly challenging when assessing execution quality for instruments such as green bonds, where market data on prices and pricing benchmarks are still evolving.

Conduct risk has long been at the forefront of the regulatory agenda, but a growing industry focus on ESG presents a new environment in which such risks can emerge. Firms would be sensible to prepare themselves for greater scrutiny from regulators in this area going forward. In fact, the FCA’s current supervisory agenda on MiFID II implementation will present the regulator with an opportunity to review how firms are approaching relevant investor protection measures in the context of ESG activity. With work on product governance now underway, firms need to be on top of this and ensure their approach is robust enough to withstand interrogation from their supervisor.

Lucas Penfold

Lucas Penfold | Manager, PwC United Kingdom
Profile | Email | +44 (0)7483 407581

Leo Donnachie | Senior Associate, PwC United Kingdom
Profile | Email | +44 (0)7483 329595

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