MiFID misses mark: ESG motivations matter

MiFID should require financial firms to ask about consumers’ sustainability objectives instead of preferences. Because what motivates most consumers about sustainable investments is having impact.

A couple of weeks ago, there was some good news for those who believe that ESG investing, or sustainable investing, should be even higher on the agenda than it already is: the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, is consulting on suitability requirements under the Markets in Financial Instruments Directive (MiFID II), in order to update its guidelines relating to sustainability.

Under the proposed rules, financial firms will need to collect information about their clients’ “sustainability preferences” and recommend only financial products that fulfill those preferences.

What are ESMA’s aims with this new rule? As we’ve come to expect with ESG or sustainability-related regulatory initiatives, there is a whole laundry list: facilitating the transition to a low-carbon, more sustainable, resource-efficient, and circular economy in line with the Sustainable Development Goals (SDGs); strengthening the response to climate change by, among others, making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development; giving clear signals to investors that they should avoid stranded assets; raising sustainable finance to reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth; ensuring sustainability factors are taken into account by investment firms as part of their duties. And last but – we would argue – certainly not least, investor protection and countering greenwashing.

Worthy goals and laudable steps, no?

Yes, but the MiFID proposal misses the mark by a wide margin on two points: First, it is based on a rather technocratic understanding of sustainability preferences, focusing entirely on alignment with existing, complex regulation, instead of straightforwardly asking what investors expect from sustainable investing products. Second, it rests on opaque and largely unrealistic notions of how sustainable investment products, today, actually contribute to solving societal problems.

On the first point: over the last few years, academics, investment firms, and sustainability professionals have come round to the view that consumers have different motivations to engage in sustainable investing. Basically, there are three: (1) ‘impact’ – contributing to a better world through investments; (2) ‘values-alignment’ – avoiding association with ‘bad’ or ‘amoral’ companies through investments; and (3) ‘performance’ – optimizing financial risks and returns by considering sustainability aspects.

A 2020 study, “A Large Majority of Retail Clients Want to Invest Sustainably” (2° Investing Initiative), shows rather convincingly that, yes, about 2/3 of consumers are interested in sustainable investing, or have ‘preferences’. But in that group, most consumers are driven by the first motivation. That is, they are drawn to sustainable funds because they hope that this allows them to have impact, in other words, to contribute to a better world. To be sure, the second and third motivations also play a role, but a smaller one.

The study is based on a survey asking probing questions about consumers’ specific preferences and reasons why they decided to buy, or not to buy, sustainable funds. The answers are revealing. When offered sustainable funds, about half of respondents said they wanted more information, in particular to “know more about the potential consequences on my profits; know what exactly are the activities and how they help with addressing these social and environmental issues; see hard evidence of their effectiveness in addressing these issues.” When asked why they decided not to invest in impact funds, about half of respondents said, “It looks like a marketing trick, not sure those funds have any concrete impact.”

Another study by the 2° Investing Initiative, “EU Retail Funds’ Environmental Impact Claims Do Not Comply,” shows that – while over half of a sample of 230 ESG funds make environmental claims, most claims remain entirely vague. And hardly any fund provides evidence backing up the impact claims that are made. So why do consumers who, if probed in-depth, say they are mainly interested in real-world impact still flock to such funds that do not provide it?

The explanation can be found in the pivotal role that social norms play in responding to questions such as “are you interested in investing sustainably?” When asked, consumers usually respond affirmatively and  even seem willing to sacrifice thousands of euros for ‘green’ products, even if those do not deliver any substantial evidence for their green credentials. In fact, most consumers may never have dedicated any time and brain space to the topic or may have never considered this arguably complex issue before. And when faced with complex new questions, they tend to adhere to the social norm: what is ‘the normal thing’ to do? In these situations, financial firms may be able to sell anything that looks remotely green to consumers who want to make the world a better place.

Instead of protecting consumers in such situations by forcing financial firms to clarify clients’ motivations and to be transparent about how their products satisfy them (or not), the MiFID proposal makes things easier for financial firms, and more difficult for consumers. If the aim is to protect consumers, MiFID should require discussing “sustainability objectives” in easily understandable terms, instead of “sustainability preferences” defined with reference to complex regulatory initiatives such as SFDR and the Green Taxonomy. This may seem like a subtle difference, but it would be a much better way of framing the issue, and would likely lead to better conversations with clients.

But how difficult would it be to go slightly further and to include in MiFID the requirement to discuss the three motivations of sustainable investing? Asking consumers whether they want to a) have impact, b) align their portfolios with their personal values, or c) use ESG factors to optimize risk and return would be much more effective in teasing out their true motivations. These objectives were first mentioned in research years ago and have by now been widely accepted by sustainability professionals, academics and financial firms.

This leads to our second, and perhaps more important, argument: the fact that the MiFID rule appears to assume that inflows into sustainable investment funds, as they currently are, will make a substantial contribution to fixing societal problems. In contrast, various studies have shown that most “ESG,” “impact,” or “sustainable” funds, in fact,  contribute very little to solving those problems.

Firstly, this is because asset management firms currently have few incentives to structure funds for them to have a meaningful impact. Asset management firms need to up their game in this area, and having discussions triggered by MiFID – at least if it follows our recommendation above – would help them see that this is what their clients demand. What we would hope for is a market that competes for risk, return, and real-world impact – instead of merely finding the easiest ways to get products classified ‘sustainable’ in line with Article 8 or 9 SFDR.

Secondly, this is because many of society’s significant problems, like those captured in the SDGs, do not yet come with simple solutions that can be implemented by listed companies or easily packaged in conventional investment strategies and sustainable funds. Most require highly complex financing solutions involving governmental agencies, development banks and NGOs. Today, institutional investors like pension funds and insurance companies, let alone retail investors, hardly ever cooperate with these actors.

If ESMA and the EU want to reach all those laudable goals mentioned in the MiFID proposal preamble, it will take much more than mapping investment customers’ sustainability preferences or objectives, as important as that is. It requires the facilitation of complex public-private partnerships in order to structure solutions to these problems and finance them, at scale. And we don’t have to argue here that this work is urgent: every day, we are reminded that the 2030 deadline for the SDGs is coming closer and closer and that we are nowhere near meeting the Paris climate goals.

ESMA should focus on investor protection and the countering of greenwashing and bring MiFID in line with emerging best practice by referencing the three investor motivations for sustainable investing. This should also incentivize asset management firms to expand their impact offering. But ESMA should also be more transparent and realistic about what this will do to solve society’s problems – and that much more is required. EU agencies and national governments should establish collaborative platforms to solve urgent problems and find workable solutions to fund them.

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