Last year, the European Commission published the final version of the new suitability rules to MiFID II.[1] With this new regulation, investment services providers are obligated to take their clients’ environmental, social and governance (ESG) preferences into consideration when making investment decisions. While this will enable investors to make a more objective and sustainable investment choice, it poses certain challenges to the financial services industry. Each financial institution will need to develop or revaluate their inhouse ESG strategy, and their client offering in investment products will need to be expanded or at least modified.

The new regulation

The existing MiFID II rules require those providing investment advice and portfolio management to obtain information on clients’ financial objectives, risk profile, and knowledge and experience in investment products. The changes to the MiFID II suitability rules ensure that investors’ ESG preferences are taken into consideration during the investment advice and portfolio management processes as well.

These ESG requirements need to be captured by investment firms from their clients, while also integrating it into their product governance requirements. The ESG changes to MiFID II have a big impact on banks and investment firms that manufacture and distribute investment products. The financial institutions have until the 2nd of August 2022 to comply to these new ESG regulations.

Investment services providers are confronted with several challenges to incorporate these new ESG requirements.

Challenge 1 – Incorporating new requirements

Investment services distributors and providers will face big challenges to incorporate these ESG requirements in their current processes, regulatory framework, and product offer.

They will have to analyse on how they want to educate the client concerning the importance of sustainable investing. The term means something different to each investor, so it will be important to capture the correct and relevant information from the client. Asking the right questions, and the interpretation and analysis of these questions will be critical to serving the customer correctly.

They will also have to consider how to get the relevant information from the client (i.e., which questions to include in the MiFID questionnaire), how to store this new information, and how to operationalize it in the impacted investment processes. All this implies important changes in the investors’ profile per client, while financial institutions also have to decide which products they will offer to clients who wish to invest in companies with high ESG ratings. Currently, most banks don’t have a specific ESG product offer. Some banks already have SRI (Socially Responsible Investment) products in their offer, but these funds don’t capture the whole picture, since ESG investing considers a broader set of due diligence questions. Current offers from different banks are not yet aligned to these preferences.

Challenge 2 – Strict deadline

There is an obvious discrepancy in time between the deadline of ESG in MiFID regulation and other regulations linked to sustainable finance, resulting in a lack of the required market data for the distributors of investment products to fulfil their obligations under ESG in MiFID.

The distributors of investments products face the difficult task of advising their customers based on their sustainability preferences, without having the tools & data to determine whether their offer meets the customer’s ESG preferences. While they must comply by the beginning of August 2022, companies are not yet sharing enough information about their sustainability policy. This results in a mismatch between the imposed regulations and the information currently available for investment services distributors and providers. Resolving this mismatch will take some time, making the deadline even more challenging. Many of them find that the deadline is too strict and will be asking for it to be extended to early 2023. From a political and regulatory angle, there seems to be little response to this request for postponement at this stage.

Challenge 3 – Data issues

As mentioned just before, a third issue is related to (the lack of) data. Investment services providers are confronted with missing and insufficient raw data inputs in order for them to analyse the current investment products on ESG suitability. More and more companies are providing ESG data themselves through their annual reports, but since this is not obligated, not every company does this, making it even harder to compare those companies based on ESG criteria. Also, there are no universal guidelines on how to differentiate between ESG suitable and non-ESG investment products. Several external agencies (e.g., Bloomberg and Morningstar) specialize in the analysis of this data, but due to the lack of a regulatory framework, all of them use a different rating system. This could lead to a greenwashing risk, where the product development team exaggerates the relevant ESG credentials of the firm or products.

Conclusion

With this new MiFID II ESG regulation, the European Commission has sent a clear signal on the importance of sustainability in the future. However, these new ESG regulation comes with several challenges. While compliance will likely be difficult, the scope of the regulation will be a breakthrough for the industry worldwide. Although all financial institutions face the same issues, they will come up with different solutions to implement these ESG requirement in their own specific processes and product offer. As the deadline to comply comes closer and closer, financial institutions will need to prioritize accordingly and dedicate time, resources, and expertise to ensure the maximum degree of compliancy possible under these challenging circumstances. Sufficient expertise in sustainability, regulation, and data management will play a crucial role in this.

Dynafin

At DynaFin, we have a team of highly dedicated and specialized consultants in the domains of Invest and Regulation. We are happy to have a noncommittal discussion on the status of MiFID and ESG compliancy of your organization, or any related topics in our core business domains.

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