Roundtable: In Pursuit of Value, not Values

Fiduciary duty is driving the growth of sustainable investing in the US.

In early November, with both COP27 and the US midterm elections looming, a group of sustainable investment experts joined ESG Investor in New York to consider the evolving US regulatory landscape for sustainable investing.

Domestic political issues cast a long shadow, not least due to anti-ESG actions in a number of Republican-run states over recent months, included a blacklisting of asset managers for factoring ESG risks into their investment decisions. But global events were also front of mind, not just the outcome of the climate-focused negotiations which concluded last weekend in Egypt, but also the COP15 summit, convened in Montreal next month to finalise the Global Biodiversity Framework.

And in a year that has seen social issues gain almost as much attention as environmental ones, not least in the resolutions proposed by investors at the AGMs of large US-listed firms, roundtable participants were keen to build consensus, starting with the areas where common ground already exists.

Above all, there was a focus on the drivers of value to end-beneficiaries of investment decisions and a rejection of the idea that values were being imposed on an unwilling customer base.

“Integration of ESG risks and opportunities are so necessary to active management that we would be remiss in carrying out our fiduciary duty if we did not do it. If you constrain me from doing these things, then I am not going to be able to deliver a service to you,” said Marina Severinovsky, Head of Sustainability, North America at Schroders.

Climate disclosure baseline

This month was widely expected to see the release by the US Securities and Exchange Commission (SEC) of its finalised rule on climate risk disclosures, following a consultation process in the early summer.

But a well-publicised technology glitch put paid to established timelines for the rule, alongside almost a dozen others. This means both investors and corporates must wait until Q1 2023 to find out the detail of the requirements, including on unfamiliar and contentious areas such as the reporting of Scope 3 emissions.

Following a high number of feedback submissions, opinions vary on the chances of significant change to the initial draft released in March, not least due to the extensive groundwork put in by the SEC.

“The SEC rule is going to create a standardised baseline. There will always be companies that exceed expectations, but it will at least give it a floor. Disclosures up until this point have been voluntary and variable. The market has been using estimates from third parties, when we would much rather obtain that information from companies directly,” said Caitlyn McSherry, Director of Investment Stewardship at Neuberger Berman.

“The SEC’s proposed rule has done a good job of leveraging existing frameworks where there is strong international consensus, for example leaning on the Task Force on Climate-related Financial Disclosures framework and coordinating with the International Sustainability Standards Board. That is a benefit to investors and companies.”

For Andrew Otis, Partner at law firm Kramer Levin, discussions around Scope 3 liability and materiality had diverted attention from some critical issues of risk management.

“There may be more compliance and litigation activity around risk disclosures, i.e. identifying and characterising risks in ways that are supportable, disclosure of those risks, and the extent to which such disclosures interact with other disclosures,” he said.

Once the details are known, corporates can ramp up their efforts to meet their new disclosure requirements and develop the underlying programmes and policies to support them. But the political context means there is likely to be a greater period of uncertainty and adjustment than normally follows a new rule.

SEC guidance and enforcement following initial disclosures will inform the efforts and approaches of regulated firms, noted Otis, but with a wider range of stakeholders also taking an interest. Investigative hearings in Congress and legal challenges around the SEC’s authority could muddy the waters for some time, he suggested.

“While the frameworks proposed by the SEC are really good starts, the regulatory landscape is going to be uncertain for the next two, three, four years. There will be opportunities for litigation on both sides, pushing firms to disclose through shareholder litigation and SEC enforcement, but also state-level efforts to challenge ESG disclosures,” said Otis.

Nevertheless, for US-based asset owners, the rule marks a necessary, if insufficient milestone. “Asset owners have been looking for consensus and guidance from the regulatory agencies. It’s important to have that push from the regulatory side. And generally, the more information we have at our disposal to inform our decision-making the better,” said Han Yik, Senior Stewardship Advisor to the CIO at the New York State Teachers’ Retirement System.

Anti-ESG backlash

The likely challenges to SEC’s climate risk disclosure rule reflects a wider anti-ESG backlash, partly fuelled by the scepticism that accompanies greenwashing scandals, but also driven by the culture wars between conservatives and liberals that have characterised US politics in recent years.

This has manifested itself most markedly at state level, with some states withdrawing business from asset managers, imposing anti-ESG requirements on suppliers and investigating banks’ climate-related policies, while others have gone in the opposite direction, for example by setting their own net zero policies. Although the midterm elections altered the overall political balance less than expected, use of ESG factors in investment decisions will continue to be viewed through a politically partisan lens.

“Investors are going to have to navigate the relationship between the anti-ESG programmes that are picking up momentum at the state level and the disclosure requirements of the SEC. And asset management companies will have to decide how they are going to respond to being targeted by Republican attorneys-general,” said Otis.

Asset managers acknowledged a certain level of discomfort and bewilderment in being caught in the culture-wars crossfire. But they also felt a strong sense of duty to clients.

“We’re doing it because we’re fiduciaries who work to meet our clients’ financial expectations, but do not want to destroy the world in the process,” said Tanya Svidler, Director of Institutional Business Development and Client Portfolio Management, Trillium Asset Management & Perpetual Investments.

But roundtable participants also accepted the need for an adjustment on the part of managers. “What we can do is step up our efforts to educate investors on what sustainable investing is and what it is not, and start clarifying the reasons why it is important for investors to look at material ESG risks and opportunities,” said Svidler.

Schroders’ Severinovsky agreed with the need for asset managers to better articulate the rationale for incorporating sustainability considerations into investment decisions, as well as the systemic risks this approach seeks to ameliorate.

“Some of this [backlash] is political, but some of it is driven by real human concerns,” she said. “Change is hard; transition is challenging. What happens to the workers and the communities and customers? We should have been talking louder about the just transition earlier. It’s up to us to be respectful and empathetic, talking about transition financing and engagement, and not leaving folks behind.”

Stakeholder expectations

As Director of sustainability-focused NGO Ceres’ Policy Engagement Investor Network, Ben Tabor liaises closely with many asset managers. He suggested being targeted by politicians has left its mark. “With the climate-related regulatory regime that’s coming in, I think most managers would consider it very important that asset managers move together. There has been an effort to scare the group into moving backwards. But when asset managers move together, with the asset owners, there’s a lot of power in the group,” he said.

The resolve of asset managers is likely to be stiffened, roundtable participants suggested, by the demands and expectations of stakeholders. NYSTRS’ Han noted the strong appetite of his funds’ beneficiaries to take account of climate risks, while McSherry at Neuberger Berman said investee firms are taking an increasingly proactive approach.

“We have found corporates prefer to have long-term planning strategies that are not going to diverge dramatically from one administration to another,” McSherry said.

“That’s why, even though the climate disclosure rule has not been finalised, a number of corporates have looked to shift their reporting cycles in preparation, working on their internal controls etc, to bring them up to a different standard.”

This perspective was backed up by Shaibal Roy who, as Sustainability Strategy Leader at Momentive Performance Materials, represents the specialty chemicals firm on a number of cross-industry fora focused on sustainability challenges.

“I study the ESG and CSR reports and disclosures of our peers, customers, and suppliers. In the corporate world, I don’t see an ESG backlash. If anything, in the corporate world I move in, we are planning for more aggressive disclosures, and plans to achieve ESG-related targets,” he said.

Kramer Levin’s Otis agreed that effective communication with stakeholders would continue to be important, in light of an evolving regulatory picture, both domestically and globally, adding that adaptability would be key to meeting compliance requirements, both for corporates and investors.

“Multinational corporations have found that the most efficient response was to develop an environmental policy, implement that policy in a continuous improvement mode, and make sure they were dealing with the specific compliance regimes in each area. I think there’s a decent analogy between that approach and this area of climate disclosure compliance,” he said.

Curbing greenwashing

Climate risk disclosures might be the most high-profile aspect of the SEC’s programme to enable sustainable investment choices, but it is flanked by a range of other measures which will soon take force. From the point of view of investor protection and confidence, perhaps the most significant is its two-pronged approach to curbing greenwashing. This extends the existing ‘Names Rule’ to strategies with ESG characteristics, while also creating three categories of ESG fund, with concomitant new disclosure requirements.

Ceres’ Tabor noted that these steps toward creating a green fund-labelling regime had split opinion, with roughly a third of consultation responses backing the proposals, a third seeking amendments and a third opposing them.

“We pushed for more of an ‘opt-in’ framework, to simplify and de-risk the determination of which funds may be marketed as ESG funds and therefore must make additional disclosures,” said Tabor.

“Our view is that if you want to use terms like ‘ESG’ and ‘climate’, you have to disclose the information to back it up. We also would like to see concise and visually engaging summaries of key ESG disclosures designed for retail investors, akin to the SEC’s recently adopted fee disclosure requirements.”

Trillium’s Svidler reflected the mixed broader market sentiment when suggesting the SEC’s proposals were much-needed, if not perfect. “In the classification proposed by the SEC, there may be a small disagreement over the nomenclature in the marketplace, but differentiating between ESG as a process versus ESG as a product is the key,” she said.

“If ESG is central to the investment process, the strategy could be eligible to be considered ESG focused; if there is an impact outcome, then it may be appropriate to call the fund as such; if the ESG issues are considered in the fund’s investment decision-making process, and the fund is disclosing on those issues, then it’s an ESG integrated fund. Whilst we in the industry have specialised knowledge, there is a wide world out there in which not everybody means the same thing.”

The Silent ‘S’

If we are currently some way from market consensus on how to distinguish between different funds informed by ESG factors, there is perhaps even further to go in agreeing how best to identify and measure social risks and opportunities in investment portfolios, let alone setting mandatory disclosure frameworks.

In terms of regulatory action, the SEC has signalled its intent to increase disclosures around human capital management as well as diversity, equity and inclusion (DEI), as part of a broad agenda to provide investors with more detailed, transparent and comparable data.

Jamila Abston Mayfield, Partner, Financial Services Risk Management at EY, who is also a member of the SEC’s Investor Advisory Committee, says the regulator is still shaping its own views ahead of proposing requirements for regulated firms.

“With the SEC looking to enhance workplace diversity and human capital disclosures, there is a need for greater alignment and most firms don’t have it right yet. At present, commissioners are still looking to gauge where the market is and understand how to better align with international consensus,” she said.

A point often made is that translating global climate goals and risks into plans and targets for investors and companies is a challenge which can at least be guided by science, whereas measures of social-related practices and performance are more subjective. Further, attempting to quantify or rank firms via metrics such as gender balance can lead to accusations of ‘managing by numbers’ and an imposition of quotas, leading us to an extension of the aforementioned culture wars.

Closer scrutiny by roundtable participants showed that these concerns or barriers can be overcome, often with the help of a change of perspective.

“With investors, the idea of diversification is one that resonates. As investors we’re all used to diversification because it reduces correlation risk in our portfolios. In a DEI context, diversification of thoughts and ideas among managers can similarly be additive for a portfolio,” said Han at NYSTRS.

EY’s Mayfield agreed that the positive case had not been made sufficiently strongly for why companies and investors should take greater account of social factors. “For a long time, there has not been value associated with diversification, but risk. People typically see differences as risks, rather than opportunities, particularly in terms of bringing insights to the table that might otherwise be missed,” she said.

Positive and proactive

Roundtable participants suggested that recent developments, from #MeToo to Black Lives Matter to the unequal impact of the pandemic, showed firms that a positive and proactive approach to social issues is critical to maintaining strong relationships with multiple stakeholder groups, including employees and consumers.

“In terms of S issues being perceived as ‘woke’, one approach is to discuss headline or reputational risk. If firms don’t have certain structures in place, and end up having to pay out on discrimination lawsuits, it can have a material impact on their business. So it behoves us to engage with them on how to do better, in terms of related governance and practices. A little reframing can take the political aspect out of it,” said Han.

Neuberger Berman’s McSherry said a growing appreciation by firms of the importance of wider stakeholder relations was driving change in their approach to social issues. “Outside of investors, companies have a number of other stakeholders. We’ve heard from senior management teams that they’re being asked to opine on a variety of topics, more so than they ever have in the past,” she explained.

“So it’s helpful for companies to ground themselves, defining their values, purpose and place. They can develop a proactive framework, so that when the next unforeseen topic comes up, they can respond, depending on relevance.”

But operationalising awareness of social inequalities remains a challenge for investors and corporates, requiring policies and practices to be guided by common principles that are calibrated to local circumstances.

“Diversity means different things in different markets. So how do we define it? We have global operations and every different country has their own definition,” said Momentive’s Roy.

Acknowledging these difficulties, Schroders’ Severinovsky noted efforts by organisations such as the Human Capital Management Coalition to build consensus around areas of common ground, pointing out that protection of human rights and promotion of supportive human capital management policies were “bread-and-butter” operational issues for many firms.

For many, best practice and voluntary guidance can be sufficient to ensure firms take full account of their responsibilities to workers, supply chains, customers and communities. But complexities can often arise, as demonstrated by the withdrawal of firms from Russia in the aftermath of its invasion of Ukraine, while systemic social risks often require legislative remedies. In this context, rules and disclosures around the social-related policies and practices of corporates are hard to avoid.

Voluntary and mandatory

Mayfield cited examples of firms that were taking positive voluntary action through reform of their own operations in areas such as procurement selection criteria. “Something we can all agree on is that we should be creating more opportunities for small minority-owned businesses to be vendors to the big players,” she said.

But she also noted that increased regulatory scrutiny of social-related metrics would pose multiple challenges for corporates, not least in data collection, given that this relies heavily on self-reporting of ethnicity and gender, for example.

“If you don’t have access to the data, you are under-representing (to regulators) the true extent of diversity at your firm. Intersectionality is not being considered, with regard to diversity as it’s very linear, which is concerning, because there is no way to bifurcate all the pieces of us,” said Mayfield.

Data and disclosure challenges also exist in an area where the SEC has not yet explicitly begun to develop regulatory requirements, but one in which it is already liaising with international counterparts. In Montreal next month, governments will meet to finalise the Global Biodiversity Framework, a global policy initiative that aims to protect nature, partly through the alignment of public and private finance flows to its goals. As with climate, voluntary disclosures are expected to give way to mandatory requirements over time.

Roundtable participants admitted that awareness of the potential implications for investors and corporates was currently low, but recognised that managing nature-related risks, opportunities and dependencies was already becoming an integral element of sustainable investment.

“It’s important to tie climate and nature together: climate is the problem and nature can be the solution,” said Severinovsky. “Our approach has been to start with quantifying the value of nature and the cost of destroying it, then building engagement, particularly with portfolio companies around deforestation, and then creating product that has a strong investment case, through characteristics such as diversification or inflation protection. There are a lot of ways to frame why this will be an interesting opportunity for investors for decades to come.”

Ultimately, she observed, investors will need to make their own choices on how to factor such opportunities and risks into their decision-making processes.

“It is not for us to say that every investor should care about putting capital towards biodiversity, for example. It’s important to make a distinction between those things that are critical and necessary for long-term durability of returns versus those things we can deliver to asset owners if they align with their investment beliefs.”