Q&A: Everything you need to know about the MiFID II sustainability preferences test

The regulatory landscape in Europe has been moving at a very fast pace. From the introduction of the Sustainable Finance Disclosure Regulation (SFDR) in 2021, we now turn our attention to some of the upcoming regulations, and in particular, the new requirement to assess sustainability preferences as part of the existing MiFID II suitability assessment, which comes into effect in August.

In this article, we will examine the following key areas around this regulation: The new sustainability preferences assessment requirements and how they sit within the broader sustainable finance agenda across Europe; how the sustainability preferences assessment might work in practice; what the main implementation challenges are, and what  advisers might do.

What is the MiFID II sustainability preference assessment?

Elisabeth Ottawa, Schroders’ Deputy Head of Public Policy, said: “The gist of the MifId sustainability preferences are that any client, existing and new, must be asked about their sustainability preferences.

“There are three options to choose from: a Taxonomy alignment (read below for an explanation of EU Taxonomy), a percentage in sustainable investments as defined by the SFDR, or a quantitative or qualitative consideration of principal adverse impact (PAIs). As a reminder, PAIs aim to capture any material negative effects that investments have on the environment and/or society.

“Once the client chooses one or a combination of these options, the adviser must make sure that the product offered matches the client’s sustainability preferences. If not, then the product cannot be sold unless the client changes their sustainability preferences.”

How does the sustainability preferences requirement sit within the broader sustainable finance agenda across the EU?

Elisabeth Ottawa said: “The ultimate goal of the EU sustainable finance agenda is to channel more investment into sustainable assets and hence, to green the EU economy. The way this is intented to work across the investment chain is as follows:

”Companies report non-financial, ‘sustainability’ information and the Taxonomy alignment of their economic activities. Financial market participants would then use this information to disclose information on the sustainability level of their products, and also to report how they integrate sustainability considerations altogether.

“In the next step, advisers would have to ask clients about sustainability preferences and match products accordingly. Then the investor would be confident that they invest in a financial product that matches their preferences. And since all sustainable products would need to comply with these disclosure rules, there's more comparability and, hence, more competition between those products.”

What are the first steps for advisers when addressing sustainability preferences?

Anastasia Petraki, ESG Investment Director at Schroders, said: “There are two things that advisers would have to do. The first thing is business as usual, as in, they would still need to collect all information to assess the client situation, where they are financially, what their level of knowledge and experience is, and their investment objectives.

"Then the next step would be to explain to the client what the ESG (environmental, socal and goverernance) factors are and the different ways in which they can be expressed.

“Advisers should also outline the difference between products with sustainability focus and products that do not have such a focus. Having thus set the scene, advisers would then go to the actual question: ‘Do you have sustainability preferences? Yes or no’. If a client says no, then the adviser is still allowed to recommend the sustainability product, as long as that product is deemed suitable based on the client's knowledge, financial situation and investment objectives.

“If the client says ‘yes’, which we expect most clients to do, then the client would have to talk about whether their preference is for that taxonomy alignment, or the percentage of sustainable investment, or principal adverse impact considerations.”

What about picking multiple options?

 Anastasia Petraki said: “The guidelines were a bit silent on what happens if a client chooses a combination of options, but this is something where perhaps we will see more guidance later this year. If the client chooses the Taxonomy alignment, then the next step would be to identify a range or the minimum percentage of that alignment. If the client goes for percentage in sustainable investment, then again, the idea is to identify that minimum percentage, but also to discuss whether the focus should be on the E, the S or the G. If the client goes for principal adverse impact considerations, it's a matter for the client to discuss whether they want to focus more on the E, or the S or the G.”

What if the client’s preferences don’t match with a product on offer?

Anastasia Petraki said: “If the client expresses preferences in a way where no product is immediately identified as suitable for recommendation, a quite iterative process will probably follow. There will be a question to what extent the client is willing to adapt the way that they express their sustainability preferences.

"If they do adapt those preferences, then this iterative process starts again. If not, it is pretty much the end of the discussion. We think is actually quite important for advisers to record and document everything independently of what the outcome is. We would expect specific focus on the cases where a client adapts their preferences."

What tools are there for advisers?

Nathaële Rebondy, Schroders’ Head of Sustainability, Europe, said: “One of the key tools at advisers’ disposal to help them filter out and choose relevant products based on the preferences expressed by their clients is the European ESG Template (EET). It pulls together all of the ESG data that is useful and required to make sure that distributors can take into account and respond to the regulatory requirements.

“While the EET is voluntary, it is likely to be the primary means through which product manufacturers can report on the three sustainability preference options across their products.”

What are the challenges of the implementation?

Anastasia Petraki said: “By looking at the timeline of the regulation we can identify at least four problems.

1. The final guidelines on how to do the sustainability preferences assessment, will be available from the regulator later in the year, that is a couple of months after the changes come into effect in early August.

2. The actual detailed disclosures for Article 8 and 9 product that will help this sustainability preferences assessment, will appear within the SFDR Level 2 disclosure templates that come into effect in January 2023.

3. The Taxonomy, which is one of the key options for the sustainability preferences assessment, is still work in progress.

4. Companies will only report the necessary non-financial data, with the Taxonomy Regulation currently only applying to a small number of companies and the Corporate Sustainability Reporting Directive (CSRD) not kicking in before 2024.

What is the EU Taxomony?

Anastasia Petraki said: “The EU Taxonomy is a classification system to help us identify which economic activities are environmentally sustainable. For an activity to be environmentally sustainable, it needs to do four things. It needs to significantly contribute to at least one of six environmental objectives[1]."

"It needs to not do significant harm to any of the other objectives. It needs to comply with quite detailed technical screening criteria, and it also needs to comply with minimum social safeguards. With only two of the six environmental objectives specified, currently, only a very small number of EU economic activities (estimated between 1% and 5%) qualifies as ‘green’.”

What is the current status of the Taxonomy Regulation?

Anastasia Petraki said: “At the moment, the Taxonomy Regulation is incomplete, it remains politically contested, and the corresponding company reporting is missing. This means that we have substantial data gaps. There is guidance from European regulators that says, use of estimates is not allowed, but where there is no data from companies, firms can use “equivalent information” either directly from companies themselves or third-party providers. It is not clear how “equivalent information” would differ from estimates.

“Where those estimates are available in the market, we see large variation across third-party providers.

Moreover, clients are not really familiar with the concept of the Taxonomy. So advisers would need to understand what data is out there, whether it comes from companies directly, or based on estimates. Then, if the data is based on estimates, are they done in-house or by a third party provider? How are they done? And so on.”

Must the assessment around preferences focus on those three options?

Anastasia Petraki said: “Regulators were actually quite explicit in how they framed sustainability preferences, meaning that the actual assessment will have to revolve around those three options. I think in the context of trying to explain the framework to clients, there can be a broader discussion around ESG, the different investment approaches, and how they aim to achieve sustainability. Understanding the investment approach is perhaps more important than understanding the single numbers, because the numbers in isolation and out of context will not tell you much about how a fund is managed.”

Elisabeth Ottawa said: “I would take the analogy of browsing a restaurant menu. The conversation could go in a direction that you start by explaining, ‘what is usually a starter? What is usually a main dish? What is usually a dessert?’ You don't have to come up and explain the exact recipe of each dish, but you need to explain a little bit, what is the concept of each of those groups of dishes and what is maybe the main feature of it.

“Is it a vegetarian dish? Is it something with meat or is it fish? In a next step, your client would voice what category of dish he/she wants and what his particular taste preference is. And then you need to see if you have a dish on offer on the category chosen. You will then hopefully start a conversation, which doesn't go completely off the regulatory requirements, because you don’t start and stop by solely serving the dishes you have.“

[1] The six environmental objectives are: climate change mitigation, climate change adaptation, transition to a circular economy, sustainable use and protection of water and marine resources, pollution prevention and control, protection and restoration of biodiversity and ecosystems.