Proactive ESG compliance by asset managers will drive value creation, says Melanie Wadsworth, Corporate Partner at Faegre Drinker.
The aims of the UN’s Climate Action Pathway for Finance, published in advance of COP26 last year, are nothing if not ambitious. By 2050, its vision is for asset managers to have adjusted their business models to ensure that every financial decision takes climate change into account. While this may seem a long way from where things stand today, there is no denying that addressing environmental concerns – and social and governance issues – is increasingly expected to be at the heart of every firm’s investment process.
In part, this shift has been driven by the regulators. If there is to be any hope of achieving the UK government’s target of net zero emissions by 2050, the carrot of the promised ‘Green Industrial Revolution’, creating jobs and business growth opportunities, will not be enough. And so, to the stick of legislation, as the important role of financial institutions in driving change is recognised and harnessed.
Europe’s example
The EU has been a leader in this area, implementing the Sustainable Finance Disclosure Regulation (SFDR) which applies to financial market participants and financial advisers, including firms providing portfolio management services and fund managers. In-scope firms are already required to publish written policies on their websites about how sustainability risks are being incorporated into their investment decision-making process and advice. They must also disclose information about how their remuneration policies are consistent with the integration of sustainability risks and will soon have to report on the ‘principal adverse impacts’ of their investment decisions from a sustainability perspective.
The SFDR applies not just to asset managers based in the EU, but potentially also to those who market products to investors based in the EU. It is possible that out-of-scope firms may ultimately decide to voluntarily comply with the SFDR as a result of investor pressure.
The SFDR is supplemented by the EU Taxonomy which classifies economic activities as ‘environmentally sustainable’ if they make a substantial contribution to one or more of the EU’s stated climate and environmental objectives. The intention is that this should help both the firms’ institutional clients (such as pension scheme trustees) and ‘end-user’ consumers (such as scheme members or retail investors) to more easily identify so-called green investments and direct their funds accordingly.
But the UK is certainly not being left behind when it comes to regulation, as the government seeks to establish Britain as a global leader in sustainability. Late last year, the Financial Conduct Authority (FCA) published Policy Statement PS21/24, aligned with the Financial Stability Board’s roadmap towards mandatory climate-related disclosures and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), the climate reporting framework increasingly accepted as a global benchmark.
At COP26, the UK government committed to working towards mandatory TCFD-aligned disclosure obligations across the UK economy by 2025. However, for now, the FCA’s rules on climate-related disclosures in PS21/24 only require firms to take “reasonable steps” to ensure their disclosures of transition plans towards a low-carbon economy are consistent with the TCFD, to the extent relevant. The FCA has also exempted firms with less than £5 billion in assets under management (on a three-year rolling average), although such firms are encouraged to disclose voluntarily where possible or start building the capability to do so.
Practical challenges
So, the impetus is there, but what are the practical challenges faced by asset managers and others seeking to embrace the climate-related disclosure regime? First and foremost is the time lag between the proliferation of legislation and the development of tools and methodologies to ensure that data is available against which performance can be measured. If disclosures are to be fair and not misleading, they must be based on metrics which are consistent and reliable. For many firms (and their investee companies), collecting, verifying and assessing the impact of the relevant data is still an imperfect process. Like-for-like comparisons remain difficult and even the FCA acknowledges that we are in a transitional period.
Recognising this, the FCA’s rules do not currently require firms to disclose information (for example, in relation to quantitative scenario analysis) if data gaps or methodological challenges cannot be addressed through the use of proxies and assumptions, or if to do so would result in disclosures that are misleading. Firms must, however, explain where and why they have not been able to make disclosure, as well as the steps they are taking towards being able to do so.
For many firms, the pressure to establish ESG programmes quickly has meant that, although some ESG expertise may be in place, the wider firm does not yet have a deep understanding of the relevant ESG concepts. Educating staff across the organisation must therefore be a priority if firms are to successfully establish the holistic ESG strategy that will be required to achieve meaningful change.
There is no doubt that responding tactically to changing customer preferences can offer a significant opportunity to develop new product ranges to address this demand. However, the risk of accusations of ‘greenwashing’ and the reputational damage that can cause is real, and firms are rightly concerned to avoid this.
Beyond the potential to benefit from the growing demand for ESG-focused products, cultural and brand benefits may be gained for firms which genuinely commit to prioritising the wider ESG agenda. For example, firms which strive to improve performance in areas such as inclusion and diversity and pay transparency – and which seek to link remuneration to management of ESG risks – should also expect to benefit from a competitive advantage in recruitment and retention of employees.
Investment due diligence is another area where ESG is making itself felt, as firms adapt their policies and processes to assess the impact of ESG risk factors. Again, obtaining reliable data remains a challenge in this area, but firms should be engaging with their investment portfolio on ESG issues and setting clear expectations for the information they expect to receive, not just to satisfy regulatory obligations, but to drive long-term investment returns.
Increasing impact
ESG considerations are set to have an increasingly significant impact on the financial services sector and the wider economy in the UK and beyond. This will require asset managers not only to provide innovative investment solutions for clients seeking to migrate capital away from high carbon products and services, but to be able to demonstrate a clear understanding of the ESG profile of the assets in which they invest.
To stay ahead of the competition, a more purposeful culture should be developed in which ESG considerations are deeply embedded in the firm’s risk management frameworks and operating models. It is all too easy to see ESG compliance as yet another box to be ticked. However, the potential for proactive ESG compliance to drive value creation should not be underestimated.
Proactive ESG compliance by asset managers will drive value creation, says Melanie Wadsworth, Corporate Partner at Faegre Drinker.
The aims of the UN’s Climate Action Pathway for Finance, published in advance of COP26 last year, are nothing if not ambitious. By 2050, its vision is for asset managers to have adjusted their business models to ensure that every financial decision takes climate change into account. While this may seem a long way from where things stand today, there is no denying that addressing environmental concerns – and social and governance issues – is increasingly expected to be at the heart of every firm’s investment process.
In part, this shift has been driven by the regulators. If there is to be any hope of achieving the UK government’s target of net zero emissions by 2050, the carrot of the promised ‘Green Industrial Revolution’, creating jobs and business growth opportunities, will not be enough. And so, to the stick of legislation, as the important role of financial institutions in driving change is recognised and harnessed.
Europe’s example
The EU has been a leader in this area, implementing the Sustainable Finance Disclosure Regulation (SFDR) which applies to financial market participants and financial advisers, including firms providing portfolio management services and fund managers. In-scope firms are already required to publish written policies on their websites about how sustainability risks are being incorporated into their investment decision-making process and advice. They must also disclose information about how their remuneration policies are consistent with the integration of sustainability risks and will soon have to report on the ‘principal adverse impacts’ of their investment decisions from a sustainability perspective.
The SFDR applies not just to asset managers based in the EU, but potentially also to those who market products to investors based in the EU. It is possible that out-of-scope firms may ultimately decide to voluntarily comply with the SFDR as a result of investor pressure.
The SFDR is supplemented by the EU Taxonomy which classifies economic activities as ‘environmentally sustainable’ if they make a substantial contribution to one or more of the EU’s stated climate and environmental objectives. The intention is that this should help both the firms’ institutional clients (such as pension scheme trustees) and ‘end-user’ consumers (such as scheme members or retail investors) to more easily identify so-called green investments and direct their funds accordingly.
But the UK is certainly not being left behind when it comes to regulation, as the government seeks to establish Britain as a global leader in sustainability. Late last year, the Financial Conduct Authority (FCA) published Policy Statement PS21/24, aligned with the Financial Stability Board’s roadmap towards mandatory climate-related disclosures and the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), the climate reporting framework increasingly accepted as a global benchmark.
At COP26, the UK government committed to working towards mandatory TCFD-aligned disclosure obligations across the UK economy by 2025. However, for now, the FCA’s rules on climate-related disclosures in PS21/24 only require firms to take “reasonable steps” to ensure their disclosures of transition plans towards a low-carbon economy are consistent with the TCFD, to the extent relevant. The FCA has also exempted firms with less than £5 billion in assets under management (on a three-year rolling average), although such firms are encouraged to disclose voluntarily where possible or start building the capability to do so.
Practical challenges
So, the impetus is there, but what are the practical challenges faced by asset managers and others seeking to embrace the climate-related disclosure regime? First and foremost is the time lag between the proliferation of legislation and the development of tools and methodologies to ensure that data is available against which performance can be measured. If disclosures are to be fair and not misleading, they must be based on metrics which are consistent and reliable. For many firms (and their investee companies), collecting, verifying and assessing the impact of the relevant data is still an imperfect process. Like-for-like comparisons remain difficult and even the FCA acknowledges that we are in a transitional period.
Recognising this, the FCA’s rules do not currently require firms to disclose information (for example, in relation to quantitative scenario analysis) if data gaps or methodological challenges cannot be addressed through the use of proxies and assumptions, or if to do so would result in disclosures that are misleading. Firms must, however, explain where and why they have not been able to make disclosure, as well as the steps they are taking towards being able to do so.
For many firms, the pressure to establish ESG programmes quickly has meant that, although some ESG expertise may be in place, the wider firm does not yet have a deep understanding of the relevant ESG concepts. Educating staff across the organisation must therefore be a priority if firms are to successfully establish the holistic ESG strategy that will be required to achieve meaningful change.
There is no doubt that responding tactically to changing customer preferences can offer a significant opportunity to develop new product ranges to address this demand. However, the risk of accusations of ‘greenwashing’ and the reputational damage that can cause is real, and firms are rightly concerned to avoid this.
Beyond the potential to benefit from the growing demand for ESG-focused products, cultural and brand benefits may be gained for firms which genuinely commit to prioritising the wider ESG agenda. For example, firms which strive to improve performance in areas such as inclusion and diversity and pay transparency – and which seek to link remuneration to management of ESG risks – should also expect to benefit from a competitive advantage in recruitment and retention of employees.
Investment due diligence is another area where ESG is making itself felt, as firms adapt their policies and processes to assess the impact of ESG risk factors. Again, obtaining reliable data remains a challenge in this area, but firms should be engaging with their investment portfolio on ESG issues and setting clear expectations for the information they expect to receive, not just to satisfy regulatory obligations, but to drive long-term investment returns.
Increasing impact
ESG considerations are set to have an increasingly significant impact on the financial services sector and the wider economy in the UK and beyond. This will require asset managers not only to provide innovative investment solutions for clients seeking to migrate capital away from high carbon products and services, but to be able to demonstrate a clear understanding of the ESG profile of the assets in which they invest.
To stay ahead of the competition, a more purposeful culture should be developed in which ESG considerations are deeply embedded in the firm’s risk management frameworks and operating models. It is all too easy to see ESG compliance as yet another box to be ticked. However, the potential for proactive ESG compliance to drive value creation should not be underestimated.
Share via:
Recommended for you