Advisers, brace yourselves for Mifid II requirements

Morningstar's Bioy says there is still a definitional problem even for asset managers

Financial advisers should brace themselves for a confusing investment product landscape when the amended Markets in Financial Instruments Directive II (Mifid II) goes live next month.

From 2 August, financial advisers in the EU will be required to consider clients’ sustainability preferences when conducting suitability assessments. If clients express interest in making sustainable investments, advisers will have to accommodate. Depending on the specific client’s preferences, advisers will have to source products that have a minimum proportion of sustainable investments as defined by the Sustainable Finance Disclosure Regulation (SFDR) or the EU Taxonomy.

To facilitate this process, asset managers have been asked to disclose this key information for all applicable products before the August deadline.

But the adviser’s task will be no easy feat, in part because reporting a fund’s exposure to sustainable investments and classification under the taxonomy isn’t easy for asset managers. In addition to the well-known conundrum of issuer data availability, there is a definitional problem.

Do no harm

Under the SFDR, a sustainable investment is one “that contributes to an environmental or social objective, provided that such investments Do Not Significantly Harm any of those objectives and that the investee companies follow good governance practices”.

The issue is that this definition of “sustainable investment” leaves too much room for interpretation, especially when it comes to the Do Not Significantly Harm (DNSH) principle. A list of Principle Adverse Impact indicators must be considered for the purpose of the DNHS test. These indicators are a series of metrics in relation to certain matters, such as “greenhouse gas emissions” and “water usage and recycling”. But regulators haven’t specified any thresholds, so determining what these should be is currently left at the discretion of asset managers.

Another aspect left at the discretion of managers relates to the way sustainable companies are counted in portfolios. While one firm might count the entirety of a sustainable company (beyond a certain level of revenue derived from sustainable activities), another might only count the proportion of revenue attributed to those activities. These two approaches would produce opposite results: high percentages of sustainable investments in the first case, and much lower levels in the latter case.

Different interpretations of the regulation have led asset managers to adopt different approaches to the calculation of sustainable investment exposure, rendering it impossible to compare competing products directly. Products with similar mandates and portfolios will report divergent exposures to sustainable investments depending on the methodology chosen by their providers. Hence the need to go beyond headline numbers and dive into the details.

In addition to the methodological challenge, an adviser’s work will be hamstrung by the mere fact that many funds haven’t reported the required information yet or have reported zero exposure to sustainable investments.

Taxonomy alignment

According to Morningstar data collected from European ESG templates (EETs) as of 18 July, less than half (47%) of Article 8 and Article 9 funds had populated the “minimum % of sustainable investments” field. And of these, about a third reported 0% values.

The situation will be trickier if clients request taxonomy-aligned investments because options are even more limited in that corner of the market.

EET data collected by Morningstar on nearly half of the in-scope share classes reveals that the overwhelming majority (90%) of Article 8 and Article 9 funds do not target any taxonomy-aligned investments. Very few funds, only 8%, reported minimum targets of between 0% and 10% of assets. Even fewer, only 2% of funds, target exposure higher than 10%. No funds have reported a target above 60%.

Financial advisers in the EU will struggle to fulfil their new obligations in the coming months. And many will have to teach themselves while they educate their clients about the new, complex, and growing landscape of sustainable investments.

Although the recent EU Taxonomy and SFDR were designed to clarify the definition of “sustainable investment” and reduce opportunities for greenwashing, we are in the early days, and there is much work to do. Additional clarifications are expected soon, but in the meantime, caution and thorough due diligence will remain key.