Sustainable investment experts predicted an even greater emphasis by investors on public policy, at a recent roundtable held by S&P Global Sustainable1 and ESG Investor.
Just over a month ago, as UK and European policymakers packed up their briefing notes ahead of the summer recess, a group of sustainable investment experts joined S&P Global Sustainable1 and ESG Investor to consider the suitability of evolving regulatory and legislative frameworks for the urgent task of steering capital to ‘green’ assets.
Since then, heatwaves across the northern hemisphere, gathering energy and food security crises, and climate policy actions across the globe, notably in the US, have raised new questions about the path to a net zero economy – alongside concerns about the impact of inflation, disruption and transition on existing economic and social inequities.
With a busy schedule taking shape across the final four months of 2022, including critical inter-governmental meetings in Egypt, Indonesia and Canada, we have outlined some of the key themes discussed at our sustainable investment and regulation roundtable, held at ESG Investor’s London offices in late July.
Sustainable investment professionals are focused primarily on understanding and managing the ESG risks, opportunities and impacts in their portfolios, using the available tools, data and disclosures. But they increasingly see the need to engage with policymakers, particularly on measures to reform the real economy, as they look to drive investment to sustainable assets and projects.
First, our roundtable participants surveyed the existing regulatory landscape for sustainable investing. This landscape is far from fully formed, but is gradually acquiring solidity, according to Jason Mitchell, Head of Responsible Investment Research, Man Group.
“We’re still putting the building blocks in place, but they look remarkably different from two or three years ago. The legislation being introduced in Europe and the UK lends significantly more permanence to sustainable investing,” he said.
In the first half of 2022, Europe witnessed a number of telling developments, including: a high-profile row about the inclusion of gas and nuclear energy in its environmental taxonomy; a painful compromise over the introduction of updated sustainability reporting requirements for corporates; and grindingly slow progress on proposals to increase transparency on environmental and human rights risks along supply chains.
Meanwhile, the UK pursued its climate-first approach, rolling out disclosure rules for financial institutions and corporates in line with the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD). And although the UK government doubled-down on climate by instituting a Transition Plan Taskforce, its plans for a Sustainable Disclosure Requirements regime – intended to broaden disclosures and set rules for ESG funds – and a UK green taxonomy made little obvious headway.
While progress was uneven, it was achieved against a radically changing geopolitical backdrop, and reinforced by moves in the US to mandate climate risk disclosures by corporates and discourage greenwashing by fund providers. It might not be perfect, but perhaps we should not expect it to be.
“This is one of only a few times in the history of the financial system that we will be regulated on the impact, and in this case, the sustainability impact, of our investments, in addition to their financial performance,” said Will Martindale, Co-head of Sustainability, Cardano Group.
“After 400 years of financial regulation, that’s quite a shift. So, it’s not really surprising if the regulators get a few things wrong, but the overall trajectory is positive.”
Among roundtable participants, attention focused most closely on the Sustainable Finance Disclosure Regulation (SFDR), which sets Europe’s rules for the information that financial service providers must provide to customers about sustainable finance products, such as ESG funds.
Now in operation for almost 18 months, SFDR is the primary framework globally for determining what fund managers must say about the sustainability credentials of their funds. As a pioneering piece of legislation, it has been subject to revision and clarification, with tougher obligations due to be added next year, including the requirement for funds to report in more detail on taxonomy alignment.
Further, SFDR’s provisions have been quickly embedded in market practice, with ‘sustainable’ funds and strategies launched or rebadged in line with its Article 8 and 9 classifications, some even switching between the two, reflecting internal tussles between compliance and marketing departments.
“SFDR is moving from being a disclosure to a labelling regime. This is how it is being interpreted by the market. Whenever you’re trying to create any kind of sustainable fund, the market perception is that it has to meet Article 8 criteria as a minimum,” noted Imane Kabbaj, Sustainable Investments Specialist, Pinebridge Investments.
Despite some reservations, roundtable participants generally welcomed the greater discipline and transparency SFDR has begun to bring to the market for sustainable investments. Mitchell said the language used to describe funds’ attributes was now “more systematic, rigorous and contractually binding”. Anastasia Petraki, Investment Director, Schroders, said such positive impacts of SFDR had come at the cost of “confusion” to clients, due to regulators “moving the goalposts during its implementation”.
Petraki added that, although client demand remained dominant, the widespread introduction of disclosure regulations across jurisdictions could impact product design. “Where regulators use different criteria to define what makes a sustainable fund, it might work as a barrier for cross-border distribution,” she said.
“Client demand, in my view, can influence product design a lot more. For example, we’re seeing increasing demand for thematic and impact products,” Petraki added.
A ‘point-in-time’ assessment
SFDR’s influence can be seen in the shift in assets to Article 8 and 9 funds, and the ongoing scrutiny of their underlying components and philosophy for evidence of greenwashing, intensified by an uptick in enforcement action, notably by the US Securities and Exchange Commission (SEC).
“The irony is that the US SEC, while a comparative laggard on regulation, is proving to be tougher on greenwashing through old-fashioned mis-selling rules,” said Mitchell.
Soňa Stadtelmeyer-Petru, Lead Sustainable Investing Strategist, EMEA, JP Morgan Asset Management, asserted that asset owners typically regard funds’ SFDR status – whether Article 8 or 9 – as providing just the starting point for an assessment.
“Institutional clients tend to have questions regarding how we can help them achieve particular sustainable investing objectives, such as meeting their net zero commitments and understanding the role of different levers, such as engagement,” she said.
Roundtable participants broadly agreed that SFDR’s disclosure requirements provided a useful but incomplete guide to the institutional investor about the sustainability profile of an ESG fund.
“SFDR is about ‘point-in-time’ assessment rather than reflecting the ongoing role of investors with companies,” said Daisy Streatfeild, Sustainability Director, Ninety One. “We invest in things that might not be considered fully sustainable currently, but we engage with companies over time to improve that performance and reach sustainability goals.”
Focus on policy
Whether from corporates or financial institutions, disclosures about ESG risks and impacts are critical to the growth and credibility of sustainable investment. For this reason, progress on reporting standards, though widely welcomed and closely monitored, is understood to be only a pre-requisite for meaningful action.
“So far, the focus has been on reporting, which might become an expensive exercise in the absence of reliable data. But we’re not spending enough time talking about the real economy and industrial policies that are needed to take us to a sustainable future,” said Petraki.
This applies to investors and politicians. It has long been recognised that the path to net zero and the achievement of the UN Sustainable Development Goals requires the public and private sectors to move forward in parallel, with the former providing the policy direction for the latter to follow.
Even in periods of stability and growth, it is challenging to get politicians to look beyond the electoral cycle to address long-term, systemic issues. It is even harder when a combination of post-pandemic supply and demand imbalances and military aggression by a fossil fuel-rich authoritarian regime gives rise to an energy crisis with potentially severe and long-lasting economic consequences.
Undoubtedly, many politicians and investors have reassessed their assumptions and priorities during the first half of 2022, if not their overall trajectory.
“As we’ve seen in Europe already, there will be some short-term changes to the direction of transition,” said Streatfeild. “But so far the politics is holding up reasonably well, in terms of the energy crisis reinforcing the need to transition to renewables, diversify energy sources and improve energy efficiency. Similarly, investors are telling us that this doesn’t change the fundamentals of where we’re going, just the course of how we get there.”
According to Stadtelmeyer-Petru, tactical reassessments of energy sources by governments in light of Russia’s invasion of Ukraine are being weighed by investors in the context of their strategies for decarbonising their portfolios.
“We even see some clients considering increasing their investment into coal-based business models to help prevent these businesses going private, which could result in less disclosure and transparency regarding their net zero ambitions,” she explained.
“And where some of these clients may have exclusionary policies in place that incorporate coal and net zero targets, they’re now also increasingly considering including certain high-emitting sectors in their portfolios, to help play an active role in decarbonising these businesses.”
Searching for signals
Jessie Wilson, a Professional Trustee at Dalriada Trustees, suggested asset owners needed to closely monitor all aspects of policy reactions by governments to the ongoing energy and food price crises.
“If trustees believe geopolitical developments are financially material to the risk and return profile of their investments then, under fiduciary duty, they should be engaging with managers and consultants to act accordingly,” she said.
It is highly likely that the need for close monitoring of policy developments by investors will only intensify over the rest of 2022, as governments seek both short- and long-term answers to their energy security and climate change commitments.
“There is a direct correlation between the right signals from governments and where investments are going. Conversely, when the signals are wrong, it can be hugely damaging,” said Oscar Warwick Thompson, Head of Policy and Communications at UKSIF.
“If you’re looking to invest in the UK, and you read that the government’s energy security strategy is going to recommit to investment in North Sea oil and gas, that will send the wrong signals to many sustainable investors looking to invest in projects across the UK.”
For Martindale at Cardano, the importance of political decisions to investors’ ability to allocate capital sustainably is so high as to require a reassessment of priorities and resources.
“Think about the impact of investment activities: integrating ESG issues in portfolio construction is essentially a risk management activity; buying and selling will not have a huge influence on a firm’s ability to prosper; stewardship is more impactful, but not as much as policy engagement on real economy issues,” he noted.
“But we spend lots of time and money on designing portfolios, with only a bit of time on stewardship, albeit not as well funded, and policy engagement is done in free time and weekends!”
In the coming months, investors are likely to be monitoring policy and regulatory developments with particular reference to commitments made at COP26. These include rich nations making good on climate finance promises to developing countries, binding obligations by all parties to revisit nationally determined contributions (NDCs) ahead of COP27 in Egypt, and progress on pledges made by smaller groups on issues such as methane, deforestation and electric vehicles.
As Warwick Thompson suggested, investors will be looking above all for detail, including coherent plans for a just transition to a net zero economy which provide clear signals to investors and map out a future for the industries, employees and communities most affected.
The NDCs of Group of 20 countries were criticised in the run-up to Glasgow for their scant detail on how to reduce the amount of greenhouse gas produced by their agricultural sectors, despite these accounting for almost a third of global emissions.
This is unlikely to be the case this year, not only due to historic heatwaves in the northern hemisphere and food security worries globally, but also due to the clear links between climate goals and nature protection firmly underlined in Glasgow last November.
“It’s often forgotten that investments in climate adaptation and the prevention of the loss of biodiversity and marine life can have substantive impacts in the real economy, when you consider issues such as coastal communities, tourism, fishing and beyond,” said Kabbaj at Pinebridge Investments.
Another factor keeping nature front and centre is that COP27 in Sharm El Sheikh will be followed in a matter of weeks by UN Conference on Biological Diversity’s long-delayed COP15 in Montreal.
COP15 will see the finalisation of the Global Biodiversity Framework – dubbed the Paris Agreement for plants – which will commit signatories to align financial flows with its objectives to protect and conserve nature. This will have wide-ranging implications for the firms and investors involved in the global food system, but it reaches well beyond to all involved in the use of natural resources for commercial gain.
Getting to grips with nature
Many investors admit that getting to grips with nature-related risks, impacts and dependencies is a daunting task, the complexity of which is reflected in the challenges facing the Taskforce on Nature-related Financial Disclosures (TNFD) as it builds a reporting scheme on the framework developed by TCFD.
Streatfeild says the challenges around quantifying nature-related risks demands a more holistic approach to disclosures.
“The TCFD focused on risk before the impact side of double materiality, but TNFD should jump straight there, given the limitations there are in defining the data and metrics to calculate the financial risks,” she said.
Further, she argued that, even more so than for climate-related risks, non-engagement by investors is not a credible or creditable response.
“The fact that a firm is operating in a protected or high-risk area tells us almost nothing. Rather than simply avoiding any investment in particular regions on biodiversity grounds, it is important to support the economic development of such emerging markets while managing any nature-related risks and fostering positive impacts,” Streatfeild added.
Wilson conceded that many asset owners are at the start of their understanding of how to factor nature-related risks and impacts into their investment processes, relying on guidance from service providers at this early stage.
“For now, most trustees are taking a relatively high-level approach to nature-related risks, expecting high standards from managers, partly by monitoring implementation statements, but there are insufficient disclosures on specific nature-related issues at present,” she said.
Before they are required by law to consider nature-related risks, trustees of UK pension schemes will need to demonstrate how they account for social risks. Following a consultation, the Department of Work and Pensions has established a task force to help trustees understand social risks and identify reliable and accurate data and metrics.
The latter will not be the biggest challenge for asset owners and their service providers in investing to achieve positive social outcomes, according to Cardano’s Martindale.
“It’s not just a matter of a lack of data. We’ve got data on issues like pay gaps, supply chain policies, labour rights, CEO-to-average-worker wage ratios, etc. The challenge is the perception that social issues are inherently political,” he said.
Roundtable participants agreed that disclosures on pay gaps, and other workforce-related data, were already helping investors to improve their understanding of practices and processes at investee companies, thus informing engagement priorities. However, the mixed success of shareholder resolutions aimed at closing such gaps and improving pay levels, during this year’s AGM season, suggests a lack of consensus.
One high-profile example was the failure to secure majority backing for a resolution requiring food retailer Sainsbury’s to pay an externally-calculated living wage to all employees and contractors, partly due to concerns over the lack of flexibility it may leave the retailer during a time of economic uncertainty.
“The fact that the issue really split the investment community, with some high-conviction sustainability-led investors deciding not to support the resolution, shows that there is not currently a clear view on how to address social issues in voting and stewardship,” said Martindale.