Policy reform, best practice and legal judgments are redefining the relationship between fiduciary duty and sustainable investment.
In late April, the UK High Court ruled that charity trustees can consider climate change factors when making decisions over their investments, even if it means making lower returns. The ruling reinterpreted a 1992 judgement when the Bishop of Oxford challenged the Church Commissioners for England over their investment policy. In that ruling, a judge found that trustees should maximise return on their investments except in circumstances where it conflicted with the charity’s purpose or mission.
The question of whether an investor’s fiduciary duty takes precedence over sustainability – potentially excluding large parts of the investment universe which could generate positive environmental (and social) outcomes – is attracting increased attention as the role of the financial sector in tackling climate change becomes more crucial.
The recent court case might offer greater freedoms to the trustees of charities, but the decision forms part of a long-established continuum.
“The UK ruling is in perfect alignment with our findings that investors can pursue sustainability as it is permitted by existing legal frameworks,” says Margarita Pirovska, Director of Policy at the Principles for Responsible Investment (PRI).
This explainer looks at how attitudes and guidelines around the relationship between fiduciary duty and sustainable investing are changing.
What are fiduciary duties?
Fiduciary duties exist to ensure that those who manage other people’s money act in their beneficiaries’ interests, rather than serving their own. The Principles for Responsible Investment (PRI) notes that fiduciary duties are “of particular importance in asymmetrical relationships; these are situations where there are imbalances in expertise and where the beneficiary has limited ability to monitor or oversee the actions of the entity acting in their interests”. As such, these duties flow from one party to another along extended and complex value chains.
The PRI, which has engaged in a multi-year study of fiduciary duty regulations globally, cites two important aspects: loyalty and prudence. Loyalty requires fiduciaries to “act in good faith” in the interests of their beneficiaries, impartially balance the interests of different beneficiaries, avoid conflicts of interest, and not act for the benefit of themselves or a third party. Prudence requires fiduciaries to act with “due care, skill and diligence” and invest as would an ordinary, prudent person.
How does fiduciary duty relate to sustainable investment?
In 2005, a group of investment managers organised under the UN Environment Programme Finance Initiative (UNEP FI) commissioned law firm Freshfields Bruckhaus Deringer to publish a report, ‘A Legal Framework for the Integration of ESG Issues into Institutional Investment’. The report argued that “integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions”. This suggested that incorporation of ESG factors was a prerequisite of fiduciary duty.
In 2015, UNEP FI and PRI followed-up the report with ‘Fiduciary Duty in the 21st Century’, which analysed investment practice and fiduciary duty in eight countries: Australia, Brazil, Canada, Germany, Japan, South Africa, the UK and the US. Noting that during the decade asset owners had made increasing commitments to responsible investment, the report stated that failing to consider long-term investment value drivers, including ESG issues, in investment practice “is a failure of fiduciary duty”.
When evaluating whether or not an institutional investor has delivered on its fiduciary duties to beneficiaries, both the outcomes achieved and the process followed are of critical importance, it added. For example, a decision not to invest in a high-carbon asset because of financial concerns about stranded assets is likely to be seen as consistent with fiduciary duties, providing that the decision is based on credible assumptions and robust processes.
UNEP FI and PRI noted that despite “significant progress”, many investors had yet to fully integrate ESG issues into their investment decision-making processes.
How are attitudes changing?
The role of ESG factors in institutional investment best practice was revisited in 2021 in a report, ‘A Legal Framework for Impact’ commissioned by The Generation Foundation, PRI and UNEP FI and produced by Freshfields Bruckhaus Deringer. The 500+ page report focuses on sustainability impact in investor decision making. In a foreword, Al Gore and David Blood, Co-Founders of Generation Investment Management, wrote that “too many investors” still approach ESG investing from a “defensive posture”. Risk management alone is “not enough” and investors should make decisions on the basis of risk, return and impact in order to take full advantage of the opportunities provided by the “sustainability revolution”. The implication was that investors should be free to pursue positive environmental or social impact even if it compromised return.
Pirovska says over the years the interpretation of fiduciary duties and of investors’ obligations has evolved in different markets around the world. “But overall, we can say that fiduciary duty requires investors to incorporate all value drivers in investment decision making.” These drivers increasingly comprise systemic ESG issues – not just climate, but other factors such as human rights.
The PRI’s research pointed to the conclusion that incorporating ESG into investment decision-making alone is not sufficient to reallocate the capital required for the transition to a net zero economy, adds Pirovska. Examining whether legal frameworks allow the alignment of portfolios with net zero and sustainability goals was the next step.
Pirovska says there are two driving forces that are increasing awareness among investors that they can do much more to achieve sustainable outcomes than was understood a decade ago. First, there is an increasing number of policy reforms and regulatory updates taking place in Europe, the UK and elsewhere. These reforms are clarifying the way fiduciary duties are defined in the law, enabling investors to consider sustainable objectives.
Second, investment practice itself is leading to greater understanding of the relationship between fiduciary duty and sustainable investment. An increasing amount of assets under management are committed to climate and ESG goals. Pirovska points to the number of industry alliances and initiatives where asset owners and managers are committing to sustainability goals and alignment of portfolios with net zero. “There is a deliberate commitment to sustainability objectives that is driven by long-term considerations.”
Are returns no longer first among equals?
The overall conclusion of the 2021 report, which studies 11 different jurisdictions, is that while a primary objective for investors is financial return, that is not the “end of the story”, says Pirovska. Investors are “usually permitted” to pursue sustainability and ESG goals in parallel with their fiduciary duties. This is a “new aspect to the way we understand fiduciary duty”, she adds.
In economies where governments have committed to net zero transition, investors need to consider these macro goals, as long as they inform beneficiaries of this intention.
The report states: “There may have been a time when it was possible to approach the goal of earning a financial return largely in isolation from the others. In reality, however, financial and economic systems are part of wider social and natural ecosystems, the health of which is vital to broader goals. Financial and economic systems can help these ecosystems flourish, particularly in their social dimension. However, they also depend upon and can adversely affect them. They can both strengthen and undermine the systems on which they rely.”
A report by the Network for Greening the Financial System (NGFS), which represents central banks and securities regulators, also raises the issue of risks and their relation to fiduciary duty. It argues that regulators must act to ensure financial institutions are taking full account of financially-material climate and sustainability risks. Asset managers should view management of such risks as integral to the execution of their fiduciary duties, the report noted.
Which jurisdictions are leading the way on policy reform?
The PRI is currently analysing the policy framework in five jurisdictions and in April released an analysis of EU rules and policy recommendations to encourage a wider pursuit of environmental and social goals. Pirovska says the EU is leading in policy reform, while other markets are “catching up”.
The EU Taxonomy Regulation, for example, provides a “practical tool to bridge the gap between international sustainability goals, like the Paris Agreement, and investment practice”, says PRI. The taxonomy’s technical screening criteria performance thresholds, helping investors assess whether the economic activities in which they invest meet robust environmental sustainability standards and are aligned with high-level policy commitments, such as the European Green Deal and EU climate law. Pirovska notes that jurisdictions elsewhere are emulating the Taxonomy Regulation.
While the EU is leading the way, the reforms “are still not sufficient to bring the EU significantly closer to its environmental and social goals, be it through increased capital flows towards sustainable activities or stewardship driven by sustainability concerns”, says the PRI.
Overall, investors in the EU can pursue sustainability as a key objective but there are many different regulations that need to be clarified and greater guidance produced for investors. For example, within the “prudent person” principle, the PRI report said EU lawmakers should clarify when sustainability impact goals must or can be considered and develop implementation guidance. Beneficiaries’ “best interest” should be clarified to consider sustainability impact goals and the relationship between financial and sustainability objectives also should be clarified.
How should asset owners and investors view fiduciary duty today?
The PRI says investors with fiduciary duties need to address fundamental questions including:
- Should I take account of ESG issues in my investment processes and decision-making?
- Should I encourage higher standards of ESG performance in the companies in which I invest?
- Do I have a responsibility to support the integrity and stability of the financial system?
- How should I respond to wider systemic risks – and opportunities – such as those presented by climate change?
While the conceptual debate around whether ESG issues are a requirement of investor duties and obligations is over, according to UNEP FI, further work is required. “As currently defined, the legal and regulatory frameworks within which investors operate require consideration of how ESG issues affect the investment decision, but not how the investment decision affects ESG issues.”
Policy reforms on disclosure, taxonomies and fiduciary duty should be “coherent” across jurisdictions, says Pirovska. “It is important to make sure that different rules all work in the same way and support sustainability strategies and clarify investor duties.”