In March 2018 the European Commission published an Action Plan on Financial Sustainable Growth (the “Action Plan”) to help investors identify, compare and classify sustainable investments and integrate ESG criteria into their investment processes. More recently, the European Commission began the process of amending MIFID II to ensure that in future, investment managers will be required to take into account consumers’ Environmental, Social and Governance (ESG) preferences as part of the overall suitability process. The market is already seeing growing client demand for ESG products; Morningstar data shows sustainable funds domiciled in Europe showed resilience during the recent market sell-off. Driven by continued investor interest in ESG issues, the European sustainable fund universe grew by EUR 30 billion in the first quarter of 2020 compared with an outflow of EUR 148 billion for the overall European fund universe. Advisors and Investment Managers should therefore not only be on the front foot from a regulatory perspective, but also from a commercial and strategic perspective, ensuring they are able to serve their clients’ best interests.    

The expected implementation date for the updated rules on suitability is March 2022. This might seem far away, however, given the expected challenges and all-encompassing nature of ESG, firms should be thinking ahead as to how they will address these key regulations into their existing process and control frameworks.

In this blog, we explore in more detail the operational and compliance challenges ESG will create for Advisors; specifically the risks and challenges in capturing ESG preferences of clients during the suitability assessment process.  

Regulatory background and ESG overview 

The existing MiFID II suitability rules require those providing investment advice and portfolio management to obtain information on clients’ financial objectives, risk profiles, capacity for loss, as well as knowledge and experience in relation to the specific type of financial instruments being advised on. The proposed updates to MiFID II will add clients’ ESG preferences to this list.   

The purpose of this regulation is to create demand for ESG products; to move to a more sustainable economy. Whilst clients’ aren’t obligated to provide any ESG preference, and factors like investment objectives must be assessed before a clients’ ESG preferences, if some clients provide a strong opinion on ESG and the firm does not have a suitable product available, consideration must be given as to whether the firm can still make a suitable recommendation for that client. 

Advisors will need to review the proposed changes to regulation the surrounding provision of advice and portfolio management to ensure ‘sustainability preferences’ are captured within their suitability process. To this regard, they will need to consider the wide range of ESG factors that their clients may have a preference on which will form part of their overall recommendation. 

ESG factors investors may consider:

Defining ESG issues can at first appear daunting, given for many it is unchartered territory. Fortunately, the starting point can be aided by a number of existing frameworks and principles

ESG needs to be grounded in materiality. For example, what is considered a material set of environmental issues for oil and gas companies is not directly comparable to textiles or consumer products. Identifying the material ESG issues facing underlying assets should be the first consideration for Advisors. The Sustainability Accounting Standards Board (SASB) outlines where they consider relevant ESG issues as material to different industries, including example metrics that can be used for monitoring performance. SASB is used by many as a guide for determining material ESG issues – recently a prominent institutional investor announced it would use selected SASB KPIs as a method for engagement and stewardship.

Advisors should also consider the UN Sustainable Development Goals, and their associated targets for 2030, as part of understanding definitions of ESG or sustainable. Climate change action is one of seventeen key focus areas globally agreed to achieve sustainable development. The World Economic Forum, appreciate this ‘new age of materiality’ for ESG has been working toward standardising ESG metrics used by companies, that will support investors decision making based on ESG performance.

Finally, firms should consider the key activities outlined within the EU Sustainable Finance Taxonomy to determine a variety of ESG preferences. To this end, incorporating ESG will provide a new set of product governance challenges when firms decide on the range of investments that they can advise on.  Collecting appropriate data on ESG products and monitoring this on an ongoing basis in itself will be another key challenge for firms.

Embedding ESG in the suitability process

One of the main challenges for firms will be effectively embedding ESG considerations within their suitability process. Many may argue that suitability requirements are already overly burdensome for clients, and adding further requirements on ESG preferences risk making the process overly lengthy and complex, ultimately jeopardising customer engagement. It is therefore important that firms consider the customer journey in its entirety, and, as we will explore in this blog, it is not as straightforward as one might perceive.     

Let us consider the key steps within the suitability process by taking an Advisor focused view. We will explore the key considerations and challenges that may arise as ESG is incorporated into the process, and call out some key impacts that firms and their Advisors should start to consider.

1.   Customer Fact find

Before asking a client what their ESG preferences are, Advisors will first need to ensure clients understand what is meant by ESG in clear and simple language. This may include describing the difference between the ‘E’, the ‘S’ and the ‘G’ and what sort of factors are considered under each heading. 

Firms should consider whether they would need to verify or otherwise test client responses with regards to ESG. In the same way Advisors have to assess clients’ knowledge, experience and understanding of investment risks associated with the advised products, firms may wish to consider whether they should do the same for ESG. For example, a client who misinterprets ESG might limit what products the advisor considers for them. In future years, if the Advisors recommendation has not achieved the desired outcome for the client, it could give rise to a suitability related complaint.        

Client responses could fall across a spectrum of attitudes and preferences for ESG for Advisors to consider. This could range from clients having no ESG preference to clients having very specific preferences towards achieving an impact that aligns with a particular Sustainable Development Goal (SDG), otherwise known as Impact Investing. This is illustrated below:

Advisors also need to be aware that people’s attitudes to ESG factors may change over time. Client preferences in response to world events and topical issues at the time of assessment will likely influence their responses. Striking the right level of granularity in the questions asked will therefore be key, too niche or too detailed could limit investment choice or lead to portfolio rebalances over time; too high level and firms risk not capturing a client’s actual ESG preferences.

2.   Making a recommendation

When making a recommendation, Advisors need to be clear how they have considered the client’s ESG preferences for each financial instrument recommended.  In particular, suitability letters should contain an explanation on whether, or how, clients’ objectives have been achieved by taking into account their expressed ESG preferences. To do this, Advisors need to have clear consistency between the internal categorisation of ESG products and external marketing information for ESG products. Embedding the suitability process with product governance oversight will be key to successful implementation.    

One other key concern is around fee transparency and the potential conflicts of interest that could exist between firms and clients. Many ESG products are, by nature, more costly than their non-ESG equivalents and this could create conflicts where funds or strategies are labelled as ESG in order to charge higher fees. To this end, ESMA set out in its technical advice that firms should have in place appropriate arrangements to ensure that the inclusion of ESG considerations in the advisory process does not lead to mis-selling practices or misrepresentations and do not damage the interest of the client. Or, as ESMA describe it, “an excuse [for a firm] to sell its own-products or more costly ones, or to generate unnecessary churning of clients’ portfolios, or by firms misrepresenting products or strategies as fulfilling ESG preferences where they do not”.

Firms will need to consider any limitations of how particular ESG preferences may affect uptake of model portfolios and investment strategies, and, ultimately whether the clients’ objectives can be met where the client has expressed strong ESG preferences. 

Firms also need to consider impacts to other existing processes, as discussed in the diagram below.


3.   Periodic reviews

The current process for periodic reviews of suitability requires firms to provide an assessment of suitability of any recommendations they provide to the client, where they hold an ongoing relationship. For many, periodic reviews will include ESG as a consideration for the first time, reaching a population of existing investors who might have never expressed their ESG preference.

This may present a number of challenges for Advisors, including how they obtain client engagement on a new topic when clients have had long standing relationships; or how the process would account for any portfolio transitions to more ESG friendly assets without impacting the risk exposure and objectives for the client. 

Key Takeaways 

The impact of ESG will be wide ranging and require careful planning in the run up to implementation.  Suitability is just one aspect of the ESG requirements however, other impacts to additional areas such as product governance and conflicts of interest that deserve equal attention.  Firms will look to their ESG change programmes and impact assessments to highlight these areas in further detail, however in the meantime, we have set out below some high level questions for Advisors and firms to take away and consider when implementing ESG into their suitability process.

Further reading 

Deloitte has supported the mainstreaming of sustainability within the investment system by leading and actively participating in every critical framework, taskforce and committee that is used and relied on by investors. We regularly publish thought pieces on how sustainable finance has grown and is still evolving. 

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Every day we work with investment management clients, around the world, supporting their approach to sustainable finance through six key areas: