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Reforms Needed to Free Investors to Consider ESG Factors

Australia-focused report is part of wider effort to give asset owners greater certainty over pursuit of sustainable outcomes.

Sweeping reform of the laws governing relationships among asset managers and owners, trustees, and beneficiaries are urgently needed, according to a new report.

At issue is the extent to which the concept of ‘fiduciary duty’ is an obstacle to ESG-based investment.

The report focuses on the position in Australia, but similar work by the same organisations is under way in the UK, European Union, Canada and Japan.

It was carried out by the UN-supported worldwide body, Principles of Responsible Investment (PRI), the UN Environment Programme Finance Initiative and the Generation Foundation, which promotes an equitable world in which climate change is confronted.

Those handling other people’s money have a fiduciary duty always to act in those people’s best interests. But there is disagreement and a lack of clarity as to how those interests are defined.

The issue is longstanding, but has been thrown into sharp relief by the sharp rise of ESG-related investing in recent years, with existing regulatory frameworks increasingly requiring fiduciaries to consider whether to simply pursue maximum returns for clients and trustees, or take into account wider issues, typically related to sustainability.

The share of investments managed via sustainable strategies rose by 15%, accounting for more than a third (36%) of global AUM, according to the Global Sustainable Investment Review 2020, published last year.

Figures published by the Responsible Investment Association Australasia this week estimated that responsibly invested assets accounted for 43% of the Australian market in 2021 (A$1.54 trillion).

Need for comprehensive framework

The report sees no contradiction between the two. “Investors’ ability to generate financial returns depends on the stability and viability of environmental and social systems, on which the economy relies.” But the legal position, in Australia and elsewhere, has yet to catch up with this, it added.

Under its current legal and regulatory framework, some institutional investors in Australia have more freedom than others to mitigate system-level risks by shaping sustainability outcomes, notably general insurers. But, the report notes, few insurers currently target sustainability impact through investments, as the law “is not explicit” on the scope of this discretion.

“Similarly, existing standards for superannuation funds … direct trustees to focus narrowly on idiosyncratic risks, do not require them to consider system-level risks and fail to identify such risks as material,” It added.

David Atkin, chief executive of the PRI, said: “Fundamentally, fighting climate change and building a prosperous and resilient future start with reform of the law: of how investors’ duties are understood by market participants; of how active ownership is facilitated, and how beneficiary interests are understood and managed.”

To this end, the PRI proposed five major changes to Australian policymakers.

The first is to update standards and guidance in order to state clearly that fund managers and trustees have a duty to address sustainability-related system-level risks.

Second is to adopt “a comprehensive corporate sustainability reporting framework”.

“Outdated interpretations”

The third recommendation is that financial regulation should be reformed so as to support effective stewardship by investment managers.

Fourth is the implementation of a classification system, a ‘taxonomy’, to guide investment managers as to which activities are sustainable, similar to those being introduced in Europe and elsewhere.

Finally, it says, the authorities should address the effects of heatmaps – sector and/or country rankings based on a wide range of ESG metrics – and financial performance tests on investors’ actions.

Beyond Australia, similar uncertainty prevails. Sonal Mahida, Senior Consultant to the PRI in the US, said: “Outdated interpretations and limited understandings of materiality have led to the misconception that addressing ESG factors falls outside the scope of fiduciary duty.

“As a result, incompatibility with fiduciary duty has often been given as a reason by asset managers and advisers for not incorporating ESG factors into the investment decision-making process.”

She added: “Fiduciary duty is not an obstacle to addressing ESG.”

Consideration of non-financial factors

While regulatory frameworks need to evolve to allow institutional investors to consider sustainability-related system-level risks, there are also internal barriers to a broader, sustainability-led investment remit.

In February, Pensions Expert, part of the Financial Times, published a poll showing 60% of respondents had experienced resistance in trustee meetings to sustainable investment, noting: “It is inevitable there will be some opposition to sustainable investments because of the inherent conflict between two competing strands – the compatibility of ESG-friendly investments with trustees’ fiduciary responsibilities to deliver investment performance.”

This report takes forward work published last year by the PRI, UNEP FI and the Generation Foundation which looked at the position in 11 jurisdictions, including the UK. It found that life assurance companies in Britain “can offer policies with sustainability impact objectives, provided that the applicable consumer protection requirements are satisfied”.

It added that the regulatory regime for life assurance “specifically contemplates products that target specific environmental or social objectives”. The report goes on: “In the UK, there is a well-supported view that pension fund trustees can, to some extent, consider ‘non-financial’ factors on the basis of beneficiaries’ views.

“Beneficiaries’ views could conceivably include their preferences to have investment powers used for sustainability impact. Regulatory guidance provides that non-financial factors may be taken into account where: a) pension fund trustees have good reason to think that beneficiaries would share the concern; and b) the decision does not involve a risk of significant financial detriment.”

The partners behind the report are now developing roadmaps for reforms in five jurisdictions – Australia, Canada, the EU, Japan and the UK.

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