As we have reported before, private fund managers – along with all parts of the financial sector – will be affected by European initiatives that aim to deliver the EU’s commitments under the Paris Agreement on climate change. Further progress has been made on those initiatives in recent months, and we now know more about how, and when, changes will be made to existing regulation.

Pressure to invest responsibly is not only coming from regulators, of course. Indeed, European legislators are, if anything, behind the private funds market. LPs and GPs have already responded to a growing realisation that future changes to regulation, shifting consumer preferences, and state-sponsored financial inducements will have a meaningful impact on asset values in the not-too-distant future. Those risks and opportunities are increasingly considered as part of any investment process. Add to that a growing demand for impactful – or at least not harmful – investments from perennial investors who are responding to the ethical preferences of their ultimate beneficiaries, and private equity fund managers have clear reasons to respond.

However, emerging European regulations will both underpin and further develop this inexorable trend. They will affect all regulated EU-based asset managers, including private fund managers, and a wide range of regular investors.

Two recent developments are particularly worthy of note: political agreement on a Regulation that will require disclosure of the way in which “sustainability risks” are taken into account in decision-making, and related proposals from the European regulator, ESMA, for amendments to the operational requirements laid out in the Alternative Investment Fund Managers Directive (AIFMD).

At a political level, there has been some debate about the types of sustainability risks that should be within the scope of regulation. Should asset managers consider all material environmental, social and governance (ESG) risks, or only those that might affect value in the portfolio?

In this respect, the agreed text of the European Directive is something of a compromise. As expected, there will be an obligation for fund managers to explain how they have considered “sustainability risks” – which are defined as value items (“an actual or a potential material negative impact on the value of the investment”). But there will also be a requirement to explain whether – and, if so, how – “adverse sustainability impacts” are taken into account in decision-making. These impacts are not defined, but are clearly wider – and need not go to value. Furthermore, that “comply or explain” approach will not be available for very large asset managers (broadly, those with more than 500 employees) after a transitional period: those managers will be forced to explain how such impacts have been taken into account.

Since these new rules will apply to all EU asset managers, including most regulated European LPs, any investment fund that wants to attract such investors will have to anticipate their additional due diligence requirements.

Related to that, ESMA’s final report includes specific proposed amendments to the AIFMD (as well as the UCITS Directive, and a separate report covers MiFID II). These changes focus on the requirement to integrate sustainability into a firm’s organisation and decision-making processes. As suggested in its initial consultation at the end of last year, the industry will be pleased to note that these remain principles-based and treat sustainability risks in a similar way to other risks that need to be assessed as part of a due diligence process. ESMA embraces the concept of proportionality, which will be comforting to the many smaller AIFMs that will be affected by these changes, and will not mandate the appointment of a specific individual to be in charge of sustainability risks. However, the management of a firm will be responsible for the “integration of sustainability risks”, and processes will need to be put in place to ensure that such risks are properly managed. Conflicts of interest will need to be specifically addressed in a firm’s conflicts policy, and (“where applicable”) managers will have to develop engagement strategies to reduce adverse sustainability impacts of investee companies.

Neither the Regulation nor the proposed amendments to AIFMD explain exactly what is meant by sustainability risks, other than “an environmental, social or governance event or condition” – leaving open questions as to the quality of disclosures addressed to investors, “greenwashing”, and inconsistent and incorrect use of the ESG label. For now, ESMA indicates this as future work for the European Commission – although the Regulation mandates ESMA to work on various technical standards, including the content, methodologies and presentation of information on disclosures.

These rules will be phased in, and firms probably have until early 2021 to prepare for them. However, their publication certainly represents important progress towards regulation of ESG in the financial sector, and firms would be well advised to take note.