The context of MiFID II is political
MiFID II is remarkable legislation in many ways. It is linked to the 2015 Paris Accord with the ambition to generate (large amounts of) investment committed to 'support transforming Europe's economy into a greener, more resilient and circular system' and 'follows global efforts towards a more sustainable economy.' 'One of the objectives of that Action Plan is to reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth."1
Another interesting aspect is that current MiFID consultation recognises a potential conflict of interest. What if relative loss occurs as a result of ESG based selection of funds? The answer is likely to emerge with the introduction of the concept of 'sustainability risk', which will be the duty of the adviser to explore with the client and therefore remain the liability of the adviser. The legislation also recognises the risks of firms using ESG as an excuse to sell more expensive or own brand products, churning portfolios or most egregiously, 'greenwashing', where products are misrepresented as to their ESG credentials.
It is important to note that the ESG rules relate primarily to suitability
Article 12 couldn't be more succinct and the following should be read without paraphrasing:
'Under the existing MiFID II framework, firms providing investment advice and portfolio management are required to obtain the necessary information about the client's knowledge and experience in the investment field, their ability to bear losses, and objectives including the client's risk tolerance to enable the firm to provide services and products that are suitable for the client (suitability assessment).
'The information regarding the investment objectives of the client includes information on the length of time for which the client wishes to hold the investment, his/her preferences regarding risk taking, risk profile, and the purposes of the investment.
'However, the information about investment objectives generally relates to financial objectives, while non-financial objectives of the client, such as environmental, social and governance (ESG) preferences, are usually not addressed.
'Existing suitability assessments generally do not include questions on ESG preferences of clients, while the majority of the clients would not raise the ESG issue themselves. As a result, investment firms consistently do not give appropriate consideration to ESG factors in the selection process.
'[Article 3..] In addition, Article 1 requires investment firms to prepare a report to the client that explains how the recommendation to this client meets his investment objectives, risk profile, capacity for loss bearing and ESG preferences (ex-post information disclosure).'
Where does ESG morph into SRI?
ESG identifies environmental, social and governance components within an investment but frames them alongside traditional technical valuation to help identify risks and opportunities that will impact investment outcomes.
SRI research extends the ethical dimension and seeks to recognise a wider motivation for investors along political, religious or personal convictions, beyond technical valuation.
The nuance is thus: ESG investing seeks investment returns but recognises the ethical dimension to successfully seeking returns. SRI investment promotes the ethical selection over investment returns.
How to conduct research
As always from a research perspective, suitability reigns. An example of a typical Synaptic grid is shown below, underlining the system's ability to combine technical research with ESG negative and positive and thematic screening. My client in this instance requires a portfolio made up predominantly of global equities with a focus on environmental credentials. Here are some candidates identified by the research.
The research grid admits ethical funds with the following research criteria overlaid: RSMR SRI Rated / Negative criteria: Environmental Abuse, Nuclear Energy / Positive criteria: Climate Change, Environmental Management, Sustainable Development / Signatory to European SRI Transparency Code.