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Please see below, a European political and regulatory outlook from Invesco – received late yesterday afternoon – 13/01/2022

Key takeaways

Covid-19 continued to present a threat to European economies in 2021 and revealed deep fissures in the political landscape. The pandemic didn’t just leave its mark on the political scene but also in the regulatory sphere — a trend that will continue in 2022.

We expect key political drivers to include the recent German election and the upcoming French presidential vote, which comes amid concerns over Russia and China’s influence. The cost of the green transition, inflation and Brexit will also be major themes this year.

On the regulatory side, policymakers will make further refinements to ESG frameworks; roll out initiatives to enhance retail investor participation; increase their focus on financial stability; and turn their attention to the supervision of digital financial services.

Covid-19 continued to present a threat to European economies in 2021 and revealed deep fissures in the political landscape. The pandemic isn’t just leaving its mark on the political scene but also in the regulatory sphere, where regulators are grappling with the lessons to be learned from the market volatility and so-called ‘dash for cash’ at the start of the pandemic in March 2020.

We turn our gaze to 2022 and seek to highlight what we see as the major political and regulatory risks on the horizon.

Section 1: Political outlook

  1. Our analysis identifies 8 key themes that will influence the political landscape:
  2. The outcomes of European elections in France (this year) and Germany (in 2021) are likely to colour approaches to further EU integration, opening the field for a triumvirate with Italy.
  3. Battles over the rule of law in Hungary and Poland will raise questions about the nature of the EU and its members, as well as fears regarding Russia’s intentions.
  4. The EU’s strategic autonomy to act against a backdrop of increasing global polarisation between the US and China will influence trade, defence and economic thinking.
  5. Reviewing the fiscal rules that govern the eurozone will shape the EU’s ability to invest in the green and digital transformations.
  6. Implementing the UK and EU’s climate commitments will finally turn promises into action, with fights expected on the pace, and who should bear the cost, of the transition.
  7. With above-target inflation likely to persist in both the euro area and the UK, the cost of living will likely re-emerge as a political battleground.
  8. Further antagonism between the UK and the EU over the implementation of Brexit will continue to weaken incentives to build cooperation in other areas, such as financial services.
  9. Opposition to UK planning reforms could undermine Boris Johnson’s election pledge to ‘level-up’ the UK outside London and the South East.

 European leadership and integration

France and Germany are the traditional motors of European integration, and it’s often difficult to get anything done in Europe without the endorsement of these two states. It is therefore significant that Germany has a new government that will start to reach cruising speed in 2022 while France will head to the polls in April 2022.

In Germany, the so-called “traffic light” coalition made up of the Socialists, Liberals and Greens took office in December 2021. This was a watershed moment that brought to a close the stability and statesmanship that Angela Merkel brought to Germany and to Europe more widely.

In France, President Macron will face voters in April 2022, along with a fragmented field of candidates. While current polls indicate that Macron remains the favourite to win the election, the campaign has been marked by increasing populist sentiment, particularly from the right and far-right that are hoping to capitalise on anti-immigrant attitudes.

The outcomes and consequences of these elections will have a strong impact on what can get done in Europe in 2022, as well as the years to come. Although the new German government is likely to be closer to France in terms of European integration, the ability of a new and untested coalition to bring key European partners with them is likely to be weaker than under Merkel. France may have less appetite for grand integration projects for fear of it triggering heightened populist sentiment at home.

The Franco-German axis may be weakened, but it may also to include the Italians as Mario Draghi brings stability and statesmanship that has been absent in Italy for some time and gives it a strong voice in European matters. The recent Quirinale Treaty between France and Italy could be a first step in building a strong triumvirate at European level that would be pro-European integration.

 Threat from the East

While not new, the battle over the rule of law in the Eastern bloc, and in particular in Poland and Hungary is likely to continue simmering in 2022. For many member states and the European Parliament, the values on which the EU is built are at stake due to the issues presented in Poland and Hungary. These challenge the EU’s ability to advocate about democratic values abroad if they can’t keep their own members from backsliding.

For Poland and Hungary, the issue is as much about domestic politics as it is about the financial incentives on offer from the EU, with Poland having threatened to bring the EU decision-making process to a standstill if EU funds are withheld. It’s not only about Poland and Hungary. Czechia, Slovenia and Bulgaria are also at risk of breaches of rule of law.

But there is division within the remaining member states on how to respond. Although the European Parliament is urging the European Commission to invoke the rule of law provisions in the EU budget — which enables the Commission to withhold funding until steps have been taken to address rule of law issues— Germany and others have called instead for dialogue.

The one glimmer of hope on the horizon is that there are elections in Hungary in May 2022 and recent polls indicate that the opposition candidate that aims to unite all opposition parties against Prime Minister Viktor Orban has a realistic prospect of unseating the incumbent. With Prime Minister Andrej Babis of Czechia having also recently lost elections, is the tide turning on populism in the East?

Even if the debate over the rule of law is primarily an internal issue within the EU, it also has geopolitical dimensions given the increasing assertiveness of Russia and pressures on the EU’s Eastern border from Belarus. As a result, some countries such as Germany have been wary of a direct confrontation with wayward Eastern states for fear of alienating those countries and driving them into the arms of Russia.

 Strategic Autonomy and National Security

The EU’s focus is often internal but increasingly the theme of “strategic autonomy” is discussed within EU circles. In part a response to former US President Donald Trump’s exposure of EU reliance on the US and growing Chinese assertiveness on the world stage, the question of the EU’s place in the world — squeezed in between the US and China, as well as its ability to act independently — continues to be actively discussed.

The EU is increasingly eager to review its dependence on the US for defence and its reliance on the dollar clearing, which has limited the EU’s ability to run an independent foreign policy. The strained relationship with the Trump Administration and the Biden Administration’s recent missteps including the disorderly withdrawal from Afghanistan and the recent AUKUS nuclear submarine deal have raised questions about EU-US relations within European policy circles. In particular, the EU fears being forced to choose between the US and China, which it is loath to do.

The EU’s relationship with China is equally complex. It branded China a negotiating partner, economic competitor and systemic rival in 2019 — and the EU continues to struggle to define a clear China strategy. While the commercial imperative remains strong, with China having become Germany’s top trading partner, the stalled investment treaty negotiated at the end of 2020 shows that the economics cannot be fully divorced from the politics, with voices increasingly urging the EU to use its influence to address the human rights issues and other security threats in China. For example, a recent motion by the European Parliament called for the EU to get tougher with China when it comes to human rights violations; spreading disinformation; assessing the origins and spread of Covid-19; and banning companies from 5G and 6G networks that do not fulfil security standards, all while continuing to work together on climate change and other areas of mutual interest.

Concerns regarding the US, China and strategic autonomy are likely to continue to exert a strong influence across several areas, including trade and defence but also economic topics such as the internationalisation of the euro and work on central bank digital currencies where the EU fears falling behind the US and China.

Instinctively closer to the US, the UK is confronting many of the same questions as the EU regarding China – seeking to maintain access to the commercial opportunities of the Chinese market while being increasingly vocal on human rights issues; taking steps to protect its critical infrastructure from Chinese influence; and pursuing a more active role in scrutinising the takeover of British companies in sectors deemed sensitive for national security. The (non-retrospective elements of the) National Security and Investment Act came into force from 4 January 2022, increasing the risk that certain takeovers and mergers could be significantly delayed due to increased government scrutiny.

Reviewing the Stability and Growth Pact

The rule governing the EU and eurozone fiscal policies, known as the Stability and Growth Pact (SGP), was suspended when Covid-19 hit and remains suspended until 2023. However, 2022 is likely to be dominated by debates as to how to re-introduce the rules and whether the SGP needs to be overhauled given the significant budget deficits and debt overhangs that many countries suffer from due to the pandemic.

With the EU average debt-to-GDP ratio above 100%, there is concern that a strict re-introduction of the rules[1], could force a significant number of countries to introduce austerity measures. This would potentially plunge the EU back into recession and prevent member states from undertaking the necessary investments in climate change and digital to reform their economies for the future. There is also concern that the rules have become increasingly complex and hard to monitor adequately. However, a number of the so-called “frugal” member states consider the current rules sufficiently flexible and have limited appetite to reform the framework.

The success, or otherwise, of the Covid Recovery Fund, could also play a role here as many see it as a potential blueprint for a more permanent EU-level fiscal capacity that might serve as a bridge between the current SGP rules and the need to invest in the green and digital transformations across the EU.

The review of the fiscal framework comes at a time when Europe is suffering from high inflation. While the European Central Bank considers current inflation rates transitory and has so far resisted calls from hawks to increase interest rates, it remains to be seen how long this view will prevail, particularly if other central banks start to consider higher inflation is here to stay and start raising rates.

Net Zero and EU Green Deal

If 2021 and COP26 was the year of climate promises, then 2022 is set to be the year of climate delivery. Both the UK and the EU have committed to ambitious carbon reduction targets of 68% and 55% respectively by 2030.

The debate in 2022 will be focused on how we get there. In the EU, the European Commission published in July 2021 a package of proposals known as “Fit for 55”, which will amend a range of EU law, including the Emissions Trading Scheme, the Renewable Energy Directive and the Energy Taxation Directive with the aim of aligning the EU regulatory framework with the EU’s climate targets. However, the cracks are already starting to appear. The EU Taxonomy, which aims to classify which activities are “green” has already run into the buffers as various members seek to protect their own industries — such as France on nuclear or the Scandinavian region on forestry — which risks rather fraught negotiations across the package to ensure that EU states feel that the burden of achieving net zero is fairly distributed across countries and sectors.

In the UK, following a flurry of government strategy papers in the run-up to COP26, attention will also turn to implementation of the Prime Minister’s 10-point plan and the cross-government Net Zero Strategy. With ambitious decarbonisation targets to achieve by the end of this decade, political debate will centre on the cost of ‘going green’ to consumers, as the government seeks to switch energy levies from electricity to gas; to incentivise the take-up of domestic heat pumps to replace gas boilers; and to finance further new nuclear generating capacity. Against this backdrop, further Government-mandated corporate climate disclosures will be rolled out and the Treasury will unveil the UK’s version of the EU’s Green Taxonomy (expected to include nuclear) before the end of the year.

Brexit

The second anniversary of the UK’s exit from the European Union will be marked on 31 January. While day-to-day cooperation at working level between the UK and EU remains strong across a range of areas, the post-Brexit political relationship is characterised by a lack of trust and accusations of bad faith on both sides.

The Northern Ireland Protocol, agreed as part of the original Withdrawal Agreement, is an area of contention. The UK’s challenge to the terms and the implementation of the Protocol has further eroded trust – but also yielded some movement from the EU on goods inspections. However, fundamental UK objections to the role of the European Court of Justice and the application of EU state aid rules are unlikely to be reconciled, meaning antagonism over the Protocol, as well as other sensitive issues such as fisheries, will likely persist. This will continue to weaken EU incentives to enhance cooperation in areas such as migration, scientific research and financial services – continuing to put at risk items such as the Joint UK-EU Financial Regulatory Forum, which was envisaged in the Trade and Cooperation Agreement. 

Cost of living

Rising energy prices and above-target inflation brought cost-of-living issues back into political focus across Europe at the turn of the year. In the UK, the immediate effects are being felt in the retail energy supply market, which is being redrawn with the collapse of a significant number of smaller suppliers, further concentrating the customer base in the hands of the largest providers. If inflation persists, greater political scrutiny is likely to be applied to the costs to households of ‘going green’, resulting in the continuation of the long-run UK fuel duty freeze (potentially delaying the switch to electric vehicles), a delay in the government’s ambition to switch the costs of subsidising green energy from electricity bills to gas bills and pressure to delay the Government’s timetable for encouraging homeowners to replace gas boilers with low-carbon heat pumps. The debate may also weaken enthusiasm for committing to additional new nuclear generation, given the pass-through of part of the costs to consumers.

Similarly, the EU is also concerned about the rising energy prices, triggering conversations about whether such pressures are transient or more long-term and therefore warrant a structural response through reform of EU energy market regulation. The current backdrop of high energy prices and record high carbon prices could also bleed into negotiations on the EU Green Deal where the spectre of the French “gilets jaunes” protests continue to haunt politicians.   

Levelling up

Alongside “Get Brexit Done”, “levelling up” was Boris Johnson’s other 2019 Election refrain. Following the Covid hiatus, the Prime Minister is now under pressure to outline a coherent levelling-up strategy that can deliver benefits to communities – focused outside London and the South East – ahead of the next general election.

With a relabelled a government department to lead the charge, a major policy paper to define the agenda and a set of Government actions is expected soon. However defined, building more homes is likely to be both central to the agenda and one of the toughest political challenges the PM faces next year. The government backed down on previous reforms to liberalise planning rules in the face of a rebellion from Conservative MPs, so a new approach is being devised. Given the impossibility of the government being able to significantly increase the number of new homes being built, in areas where demand is high and while only building on brownfield sites, there is a risk that the new proposals follow the path of their predecessor and the housing agenda remains stuck on the status quo. 

Section 2: Regulatory outlook

  1. Our analysis identifies 5 key themes that will influence the regulatory landscape in EMEA:
  2. Refinement of the framework governing sustainable finance and environmental, social and governance (ESG) issues to address the climate transition.
  3. Continued focus on the resilience and supervision of the non-bank sector and the stability of financial markets more broadly following the March 2020 period of volatility.
  4. New initiatives to enhance retail investor participation in financial markets and continued focus on retail investor disclosures.
  5. Improving the functioning, effectiveness and transparency of financial markets.
  6. Developing the framework governing the regulation and supervision of digital financial services and operational resilience. 

Sustainable Finance and ESG

The continuing development of sustainability- and ESG-related requirements applying to supervised entities will continue to be a priority for policymakers globally. For example, policymakers will continue to commit significant resource to refining the frameworks governing sustainability-related disclosures for products and financial market participants across jurisdictions.

The data required by firms to meet such disclosure obligations will also be a focus as they take forward initiatives seeking to enhance the availability of, and access to, reliable ESG data. In this regard, the development of ESG taxonomies will continue apace, with focus moving beyond “climatemetrics” towards defining the broader environmental social component of such taxonomies.

Additionally, from August 2022, intermediaries in the EU will be required to consider investors’ ESG preferences when distributing investment products, with a significant impact on their activities as well as those of product manufacturers. 

Financial stability

The impact of the Covid-related market volatility experienced in March 2020 has drawn significant attention from policymakers over the last 18 months or so and we expect this to continue in 2022. Indeed, we anticipate policymakers’ analyses to evolve into proposals for regulatory reform to enhance the resilience of the non-bank sector, in particular with respect to the functioning of short-term money markets and money market funds (MMFs), as well as liquidity risk management within open-ended funds more generally.

The European Commission has already put forward amendments to the EU frameworks governing the operation and supervision of retail and alternative investment funds, with the aim of finalising proposals clarifying rules on fund liquidity risk management, loan origination and delegation over the course of 2022. Likewise, in the UK, we expect the Bank of England and the Financial Conduct Authority (FCA) to take forward their joint initiative on enhancing the resilience of the non-bank sector, with a particular focus on finalising a regulatory approach to asset liquidity classifications and swing pricing.

 Retail investing

In the continuing low interest rate environment, and with more responsibility being placed on individuals to plan for their financial futures, improving retail investor participation in financial markets will be a key theme in 2022. For example, the European Commission is expected to bring forward an EU Retail Investment Strategy with the aim of addressing this theme by, in part, enhancing the effectiveness and transparency of the current EU inducements regime. In the UK, the FCA will continue to develop its cross-sectoral Consumer Duty, reinforcing firms’ obligation to consider their retail clients’ best interests when undertaking activities on their behalf. Final rules are expected in Q3 2022.

Policymakers also see improving the usefulness of retail investor disclosures as key to enhancing retail investor participation in financial markets. We expect regulators in the EU and the UK to make changes to the content of packaged retail investment and insurance products’ (PRIIPs) Key Information Document (KID) template in 2022, with EU authorities requiring Undertakings for the Collective Investment in Transferable Securities (UCITS) funds to produce a PRIIPs KID by the end of the year. Separately, work undertaken by ESMA in collaboration with EU national competent authorities last year on UCITS costs and charges, and the ongoing review of the implementation UK value assessment requirements, will increase regulatory scrutiny on the transparency, cost and performance of retail products.

 Functioning of financial markets

Over the last year, EU and UK policymakers have undertaken several consultations assessing the potential effectiveness of proposals to improve the regulatory framework governing financial markets. Looking forward to 2022, we anticipate that policymakers will prioritise initiatives that seek to ensure the emergence of a privately provided consolidated tape (CT) of record for market data, alongside a reduction in complexity of pre- and post-trade transparency regimes. Indeed, the European Commission has already suggested rule changes to this effect.

Moreover, current market-wide reforms seeking to enhance the effectiveness of investment and market infrastructures, such as activities in respect of the London Interbank Offered Rate (LIBOR) benchmark’s cessation or the implementation of the EU’s settlement discipline regime, will also continue in 2022.

 Digital Finance and Operational Resilience

In the year ahead, policymakers in the EU and UK will continue to encourage innovation and the emergence of digital products and services. While significant resources will continue to be put towards existing regulatory sandboxes and pilot regimes, we expect EU-wide and UK rules governing markets in crypto assets to be finalised alongside separate frameworks for the operation of market infrastructures based on distributed ledger technology (DLT). We also expect exploratory work on central bank digital currencies to continue next year, as well as initiatives relating to Open Finance and e-IDs; artificial intelligence; and the development of common data standards.

Finally, there will be a continuing focus, in 2022, on the implementation of EU rules governing cloud outsourcing while, in parallel, policymakers seek to finalise the EU’s new Digital Operational Resilience Act (DORA) within the first half of the year. In the UK, firms across the financial sector will likewise be focusing on implementing the regulatory changes necessary to comply with new rules relating to operational resilience which will apply from March 2022.

Please continue to check back for a range of blog content from us and from some of the world’s leading fund management houses.

David Purcell

14th January 2022