Risk & Compliance

Eligibility test and sustainability preferences.

Date:September 21, 2021

Earlier we wrote about the plethora of terms on risk and sustainability, and how you can deal with them. We would have liked to take you further into the level 2 of the Sustainable Finance Disclosure Regulation (SFDR) this month, but in the absence of a published version of it, that is not yet possible.

As we mentioned in the previous article, delegated regulations/directives for MiFID II, IDD/SOLV, AIMFD and UCITS following the SFDR were published in the Official Journal of the European Commission (EC) on August 2, 2021. This month, we bring to your attention the suitability test component of Delegated Regulation (EU) 2021/1253.

Pursuant to this Delegated Regulation, the suitability test must be expanded to include client sustainability preferences as of August 2, 2022.

What are sustainability preferences?

The Delegated Regulation defines what is meant by sustainability preferences:

“sustainability preferences” is the choice of a client or potential client as to whether, and if so to what extent, one or more of the following financial instruments should be integrated into her or his investment strategy:

  1. a financial instrument for which the client or potential client determines that a minimum percentage should be invested in environmentally sustainable investments within the meaning of the Taxonomy Regulation;
  2. a financial instrument for which the client or potential client determines that a minimum percentage should be invested in sustainable investments within the meaning of the SFDR;
  3. a financial instrument that takes into account the main adverse effects on sustainability factors where the client or potential client determines the quantitative or qualitative elements that must show that these effects are taken into account (within the meaning of the SFDR).

Financial product versus financial instrument

Perhaps you noticed something while reading the definition? Wasn’t it that the SFDR assumes a financial product and that this is not the same as a financial instrument?

The Delegated Regulation states whether and, if so, to what extent the sustainability preferences of certain financial instruments should be integrated into the client’s investment strategy. And the financial instruments in question are linked to the Taxonomy Regulation (TR) and the SFDR, which thus assume a financial product.

Implementation example

We will show you by example how this can play out; and what you can do to manage the implementation of this Delegated Regulation. Because before you know it, no model portfolio will soon be suitable for clients.

We assume an investment firm with a number of gray, light green and dark green model portfolios. It is September 2022 and your client enters in the new suitability form in the first box (sub a) that at least 40% of financial instruments must be invested in an environmentally sustainable investment in accordance with the TR.

The investment firm in question has neatly filled in the pre-contract templates for all the (model) portfolios that qualify as Article 8 or 9 SFDR, and so you can easily look up what is the planned/intended asset allocation based on the investment/selection policy.

You soon find out that only one of your Article 8 SFDR portfolios has any taxonomy aligned activities at all. Only 30% of this model portfolio includes taxonomy aligned activities.

You are looking at your Article 9 SFDR model portfolio. In line with the European Commission’s Q&A on the SFDR and the AFM’s report on the SFDR, this model portfolio consists almost entirely of sustainable investments. However, this model portfolio sees sustainable investments in the sense of the SFDR (without ecological sustainable investments in the sense of the TR). And so this model portfolio also does not meet (any of) the client’s completed preferences.

This example shows that when the client fills in the first box of the sustainability preferences, your investment firm’s model portfolios already fail to meet the client’s preference. This is even though you offer a number of light green and dark green model portfolios in addition to your gray model portfolio.

In this example, the client filling in a minimum percentage at the second box (sub b) would most likely not lead to “unsuitability” of the Article 9 SFDR model portfolio(s), but a similar problem as outlined above is not inconceivable in practice.

In short, once a client enters a minimum percentage under the sustainability preferences, a model portfolio that qualifies as Article 8 and 9 SFDR may be “unsuitable” as a result.

Mismatch between supply and demand

What this example shows? With the arrival of the Delegated Regulation and the accompanying changes for the suitability test, a mismatch can easily arise between supply and demand.

The SFDR Q&A from the EC and the recently published AFM report on the SFDR gives (some) parties reason to take another good look at the investment/selection policy for article 8 SFDR and article 9 SFDR products.

We recommend that you also assess in advance, using various scenarios, how the sustainability preferences within the framework of the suitability test will fit in with your investment/selection policy and the asset allocation of your model portfolios. Of course, you will have to provide some guidance on the number of scenarios you use.

Want to know more?

Would you like to learn more about the rules around sustainability preferences from MiFID II, and what the implications are for investment advice and asset management? Then follow our e-learning ‘MiFID II and sustainability preferences’.