‘All funds to be ESG in 5 years’

A) Sustainable Finance developments

1. SFDR “Level 1”: no reply from EC; CSSF issue local reminder

With the 10 March 2021 deadline looming, the funds industry continues to await the European Commission’s reply to the European Supervisory Authorities (ESAs) recent letter seeking clarity on ‘priority issues’ related to the initial legal application of the Sustainable finance disclosures regulation (SFDR).

Presumably, the EC’s response will be used to enable ESAs to issue their public supervisory statement “…before the application date of SFDR …to achieve an effective and consistent application of the SFDR’s requirements and consistent national supervision”.

Meanwhile, ESMA’s constituent national competent authorities (NCAs) seem to have been left to their own devices to issue (variable) SFDR guidance to their local asset managers.

• In Luxembourg, the CSSF sent a communication reminding UCITS management companies and alternative investment fund managers of their SFDR fast track procedure(expiring 28 February) to enable their initial (level 1) SFDR compliance before 10 March 2021.
• The French AMF has also recently updated their local Disclosure advice (which includes the need to review and update specific UCITS KIID content).

2. SFDR “Level 2”: ESAs issue draft RTS

Shortly after sending their letter to the EC, the ESAs delivered to them a Final Report including a substantially revised level 2 RTS.   Here is a short summary of the ESA’s finalised proposals (194 pages in total).

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As before, there are 2 x levels of sustainability disclosure:

1. A) Entity-level

i.e. principal adverse impacts (PAIs) that investment decisions have on sustainability factors. These have to be disclosed on the websites of financial market participants, in the form of a statement with set indicators in relation to:

• climate and environment
• social and employee matters, respect for human rights, anti-corruption and anti-bribery aspects.

The ESAs have reduced PAI disclosure to 14 x mandatory indicators (from the revised ‘climate and environment indicators table), with at least 2 x additional indicators selected from other tables.

The SFDR entity-level reporting is based on the principle of “proportionality” – i.e. for companies with fewer than 500 employees, the PAI reporting applies on a comply-or-explain basis.

The “mandatory reporting template” for the principal adverse sustainability impacts statement can be found in Annex I (pages 52- 81).

1. B) Product-level

Where products are deemed to be in scope of SFDR, sustainability characteristics or objectives of financial products are to be disclosed in an annex to the necessary pre-contractual documentation (e.g. Prospectus) and periodic reporting (e.g. Annual Statements) and made available on providers’ websites.

Details are outlined in a further set of “mandatory templates”:

Annex II  (pages 82- 85): Pre-contractual disclosure for Art. 8 financial products [i.e. environmental and / or social characteristics]

Annex III (pages 86- 89): Pre-contractual disclosure for Art. 9 financial products [i.e. sustainable investment objective]

Annex IV (pages 90- 93): Periodic Reporting disclosure for Art. 8 financial products [i.e. environmental and / or social characteristics]

Annex V (pages 94- 97): Periodic Reporting disclosure for Art. 9 financial products [i.e. sustainable investment objective]

The ESA’s highlight that “…the same disclosures are required for a very broad range of products attached as annexes to existing sectoral disclosure documents that have different levels of granularity and length.”

The ESA’s state their final Report and RTS takes into consideration respondent feedback supplied during the public consultation (launched in April 2020) and include results from consumer testing exercises of their pre-contractual and periodic product templates (conducted by the Dutch financial regulator and Warsaw School of Economics).

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With the EC expected to endorse the RTS within 3 months, the proposed legal application date (level 2) is 1 January 2022.

Meanwhile, the ESAs will publish a consultation on additional Taxonomy Regulation-related product disclosures (e.g. climate change-related Key Performance Indicators) currently scheduled to commence within a similar timeframe to SFDR (level 2).

3. ‘All funds to be ESG in 5 years’

Finally, a reminder why all of this now matters.

Latest market research of 200 professional fund buyers (Nov-Dec 2020) has gained widespread media coverage.  Current findings indicate 73% of UK respondents (and 72% based in Europe) are now predicting all investment funds will incorporate ESG within five years. By contrast, only 50% of North America fund selectors share this sentiment.

NB: these latest findings indicate a significant shift from last year’s study, which found:

“Fund selectors attach surprisingly little significance to sustainability considerations. Just 7% say sustainability/ESG factors are one of the most important fund selection drivers… they highlight a gap between perceived and actual levels of ESG engagement.”

Elsewhere, 80% of global respondents now fear increased greenwashing as ESG demand increases, while 28% are currently sceptical that sustainable investment “represents a market bubble that will eventually burst”.

Other regulatory happenings

1. Goodbye UCITS KIID?

“The recommendation of the ESAs is to avoid the coexistence of the PRIIPs KID and the UCITS KIID. This is expected to mean that that the UCITS Directive would need to be amended so that UCITS managers no longer have to provide a UCITS KIID to retail investors. At this stage, the ESAs have not provided a recommendation on which document, if any, should be provided to professional investors, instead of the UCITS KIID …more time is needed to reflect on this issue.”

– European Supervisory Authorities, June 2020

“The UCITS KIID is and has always been a retail-investor document…it is also no longer fully MiFID-compliant and would require extensive revisions in the near future. Having two diverging different key information documents would be a recipe for disaster.” – EFAMA Feb 2021

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The European Supervisory Authorities (ESAs) have recently sent another letter to the European Commission (EC), this time confirming a qualified majority approval of their draft PRIIPS KID RTS (i.e. left unratified in June last year).  This approval is given on the understanding there will be a wider examination of continued areas of concern in the EC’s forthcoming level 1 review of the entire regime (currently pencilled to commence in H1-2022).

Recent press speculation (based on referral to a key quotation in the RTS last year) speculates that the UCITS KIID’s days are now numbered.  As always, it is a matter for the EC to decide.

A removal of the current obligation to supply a UCITS KIID to retail investors, or an outright abolition of the KIID, would probably require a level 1 amendment to the UCITS IV Directive (published in 2009). This would take a significant amount of time to implement and (until now), is a course of action the EC has avoided.

With no formal response from the EC (at the time of writing), the default outcome remains that the revised PRIIPS Key Information Document and extended regime application (to UCITS products) requires implementation by 01 January 2022.

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Meanwhile, the European Fund and Asset Management Association (EFAMA, which includes Kneip as a member) issued a 4-page press statement which included reminders of the current issues that need to be addressed, i.e. “…once and for all, to settle the dilemma at the heart of the PRIIP KID”, including:

• A pronouncement that “Time has already run out to allow for proper implementation”
• Their extensive synopsis of key difficulties associated with the “massive operational undertaking” of a coordinated UCITS KIID -> PRIIP KID switchover
• Their insistence of a further twelve month extension of the UCITS exemption (once the RTS is published in the EU Official Journal), i.e. until end-Dec 2022.
• Their demand that the “UCITS KIID must go” once the switchover to the PRIIPs KID regime is completed.

EFAMA’s commentary has gained extensive media coverage (incl. Funds Europe, Investment Week, Asset Servicing Times and FT Ignites) following its publication.

2. AIFMD consultation now closed

Changes to the Annex IV Reporting template would have significant costs implications – including data sourcing, aggregation, editing XML for both the managers, and the NCAs consuming the data. Those costs and adaptations should not be underestimated due to the interconnection of the various IT systems.” – EFAMA 29 Jan 2021

The European Commission’s AIFMD consultation closed at the end of January.

• The EC’s detailed post-consultation results are expected sometime in Q2, 2021.
• Revised legal proposals (AIFMD II) are expected to follow in Q4, 2021.
• The current anticipated AIFMD II legal application date is Q4 2023 / Q1 2024 “at the earliest”.

Meanwhile, EFAMA also recently publicly issued a 79-page response, including a central plea: “Don’t fix something that is not broken”.

Recommendations include resisting significant changes to the existing AIFMD framework (“which would divert resources and disrupt the current balance”), while avoiding additional product-level rules and client categories.

While the current supervisory reporting requirements (Annex IV) are adjudged as “mostly appropriate”, EFAMA acknowledge and welcome “further consistency in reporting requirements across Member States”. However, before introducing any changes at this stage, they advise the EC to “undertake a gap analysis” together with technical experts from the funds industry and national regulators.

Finally, they state their members are not in favour of the proposal to merge AIFMD with the UCITS directive (into a single EU funds regime).

Once again, EFAMA’s response to the AIFMD consultation gathered significant press coverage.

3. ESMA launch MiFID II common supervisory action

Last month, the European Securities and Markets Authority (ESMA) initiated a common supervisory action (CSA) with their national competent authorities covering the supervision of UCITS costs & fees across the EU.

This month, ESMA launched another CSA, this time to address the application of MiFID II product governance rules.  Throughout 2021, ESMA will co-ordinate analysis of how manufacturers:

• ensure that financial products’ costs and charges are compatible with the needs, objectives and characteristics of their target market
• identify and periodically review the target market and distribution strategy of financial products
• exchange specific information with their distributors (incl. content, frequency).

NB: a reminder that ESMA’s previous MiFID II Product Governance Guidelines and Investor Protection Q&As include numerous referral / alignments to PRIIPS regime factors.