Consumer demand and new regulation are driving sustainability up the agenda. Financial advisers must be ready to respond, says James Tothill.
It seems that not a day goes by without a story about ESG (environmental, social and governance) issues in the financial press. It might be news of an ESG scandal, or a firm launching a new ESG-focussed fund, or the latest ESG initiative from government or regulators.
The ESG wave is fast becoming a tsunami. But what is driving it, and how should advisers prepare?
Many factors have led to the increased prominence of ESG in investment and financial planning; but two of the most important are consumer demand on one side and regulation on the other. This leaves financial advisers as the filling in a sustainability advice "sandwich".
The power of the individual
Start with the consumer demand. Individuals are increasingly concerned about environmental issues such as climate change and biodiversity loss, and social issues such as inequality and diversity. They are also becoming aware that when it comes to answering the question, "But what can I do?", the potential impact of savings and investments could be significant.
Appetite for sustainable investment is undoubtedly growing. A UK government survey finds that 68 per cent of UK savers want their investments to be responsible and carry a positive social or environmental impact1. But many people do not know how to find the products that match their preferences for sustainable investment. A wave of upcoming regulation will help to put this right.
Regulation driving change
As well as the increase in bottom-up demand from the public, there is an unprecedented level of top-down regulation relating to sustainability issues.
Two of the most significant are the Sustainable Finance Disclosures Regulation (or SFDR) and changes to the suitability test in MiFID II.
SFDR: Shining a light on sustainability
The first requirements of SFDR will come into force from March 2021 for EU countries. It is not certain how the UK will treat these rules, as Brexit means that they are not automatically part of the UK rulebook, but the UK government has said it intends to "at least match the ambition of the EU".
The rules require disclosures about how firms manufacturing products integrate sustainability risks into their investment decisions; how they consider the impact of their investments on people and the planet; and how the remuneration of senior management aligns with these things. This is going to be a big change: manufacturer firms are going to need to be clear about how they incorporate ESG into their investment processes and this will shine a light on the seriousness of their commitment.
There are additional disclosures for products claiming to have "green" or sustainable credentials, with much more information required of the product providers to prove that they are delivering on any claims made and that the product's investments align with the sustainable objectives.
Advisers are also subject to equivalent requirements to disclose how sustainability risks and the impact of investments are factored into the advice they give to clients and if not, why not.
Bringing preferences into advice conversations
Ross Liston, Managing Director of Bankhall, which supports over 800 financial advisory firms, believes the impact of ESG will present new challenges for the profession. Ross commented: "Currently, suitability chiefly relates to the risk appetite of clients, their investment objectives, and how long they're aiming to invest for. Sustainability issues are not often discussed, but that's about to change. Advisers will be required to find out if a client has any sustainability preferences they want factored into the recommendation they receive. If they do, the adviser will have to make sure that, as well as being appropriate to the client's risk and investment objectives, the recommendation also suits their sustainability preferences."
Ross continued: "Advisers need to be able to discover and understand what preferences a client has. Working through the differences between firms and products regarding their sustainability commitments will also be important, along with the huge amounts of information available as a result of SFDR, in order to match the right products to the client's preferences. This is all in addition to the existing requirements about understanding each client's risk and return objectives, and the need to make suitable recommendations."
A virtuous circle
These are significant changes in the regulatory requirements as regards information and conversations relating to sustainability and ESG. The relationship between the demand from individuals for products, the advice that takes account of the issues that are important to them, and the changes being imposed by regulators will form a virtuous circle.
As more information about the sustainability outcomes of products and advice comes to light and conversations that embed sustainability preferences become the norm, clients will better understand how they can ensure their preferences are reflected in their investments. This should lead to richer, more informed advice conversations and long-term relationships, a better understanding of products and more demand for a focus on sustainability.
To take advantage of the changes and incorporate them into the way they serve their clients, advisers will need a deeper understanding of both their clients' priorities and the different ways that firms and products approach ESG.
That is why Aviva Investors is launching "ESG Know How", an initiative designed to meet the rising demand for better adviser knowledge of ESG investing and how these regulatory changes will impact advisers and the wider industry. It will provide an opportunity to learn more about the fundamentals of ESG and the pending regulatory changes, and how they will affect the advice process.
While these new rules are important, they are only part of a wider reshaping of the whole investment industry. However, the fundamentals for advisers are not changing: the rules are still about understanding clients' priorities for their investments and the product options that best match them. But from now on, clients' sustainability preferences will be right at the heart of that process. That's as it should be.
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