Institutional investors must prove effectiveness of engagement over divestment and restore public’s faith, says UKSIF CEO.
Reports submitted by asset owners and managers under the revised UK Stewardship Code are inconsistent, demonstrating plenty of “room for improvement”, according to a Financial Reporting Council (FRC) report.
“Reporting on the activities and outcomes relating to conflicts of interest, review and assurance, and monitoring agents was poorer,” the report noted. But it also acknowledged the “high quality of disclosures in the areas of governance, resourcing, and the integration of stewardship and ESG factors with investment”.
According to the FRC, a comprehensive report should: clearly state outcomes for each Code Principle; outline how effective engagement efforts have been in achieving desired outcomes; and provide evidence of engagement outcomes, including internal metrics, reviews, client feedback, and case studies. Many organisations did not consistently report the outcomes of their activities across all the Principles, the UK regulator said.
One area highlighted for improvement by the FRC was the how asset owners and managers deal with conflicts of interest. Under Principle 3, the Code asks signatories to explain how they have identified and managed any instances of actual or potential conflicts. They must then demonstrate how this was handled and the various outcomes, such as whether it is currently resolved or ongoing. Information on when conflicts of interest have occurred and how they have been resolved was, more often than not, too vague, the FRC said.
Asset owners and managers largely did demonstrate how they incorporated ESG-related issues into their stewardship efforts, the FRC noted. However, the integration of stewardship and ESG factors into investment decision-making varied across asset classes.
While some reports only explained common features of integration that could be applicable across many asset classes, such as communication between different asset class teams during the investment process, others more clearly demonstrated how they take a “wholly integrated approach, with analysts and portfolio managers integrating ESG and stewardship as a standardised process”.
To adequately address ESG and stewardship integration, the Stewardship Code notes that asset owners and managers can: set targets for stewardship on ESG issues faced during the ownership of an asset, such as energy usage; implement a clear action plan to address issues identified; and use appropriate frameworks or certifications to prove that issues have been addressed.
Asset owners should also explain what they have communicated to asset managers about the ESG issues they expect to be prioritised in investment, engagement or escalation, the FRC said.
The reports analysed by the FRC have been provided by the first list of signatories to the new Code. There were 125 successful applicants, representing £20 trillion in assets under management (AUM). The FRC has received over 100 further applications which are now being assessed. Successful applicants will be announced Q1 2022.
The regulator also identified examples of good practice from asset manager and asset owner signatories across the 12 principles, providing case study examples of firms that have disclosed correctly and with comprehensive detail.
Among these, Aviva Investors effectively disclosed how it has worked with others to address market-wide and systemic risks to improve the way the market operates, the FRC said. The asset manager demonstrated how it has collaborated with policymakers to address biodiversity risks, “putting forward their biodiversity policy mechanisms ‘to help bring natural capital externalities onto corporate balance sheets’”, the report noted.
To support asset owners in their reporting efforts, next year the FRC aims to provide an update on how it plans to introduce differentiation of reporting for asset managers and service providers going forward. The FRC will also publish the results of commissioned research exploring how the stewardship landscape has changed over the past few years and the influence the updated Stewardship Code has had.
Realising the power of stewardship
How asset owners and managers integrate ESG principles into their stewardship activities has become an increasingly urgent issue due to the slow progress of carbon-intensive firms to adjust their business models and increasing public pressure on shareholders to divest fossil fuel stocks.
Engaging with investee companies on ESG-related issues is a far more effective strategy than immediately divesting, said James Alexander, UKSIF CEO, speaking at an event this week on UK regulatory developments hosted by UKSIF, ShareAction and CDP.
However, financial institutions “need to do better” and ensure the general public and the UK government sees the positive impact stewardship can have.
“It was really disappointing to see 130 UK MPs signing a letter calling for all parliamentary pensions to divest from fossil fuels,” he said. “Clearly, we’re not getting the message out there that stewardship is impactful and can be aligned with ensuring 1.5°C of global warming.”
Engagements with companies can take multiple years and may require escalation before bearing any fruit, the FRC report highlighted. Improved disclosures on stewardship activities would provide increased visibility of the stewardship process, such as whether, and to what extent, progress with companies is being made on ESG-related issues.
Alexander said increased UK regulations beyond the Stewardship Code in order to ensure good stewardship will be a key part of ensuring the general public has faith in the outcomes of stewardship efforts. “There is still so much to dig into around stewardship – it’s an incredibly important component [to the low-carbon transition],” he added.
The FRC has been criticised by industry experts and the UK government on its ineffective regulation of audit quality, which has prompted plans to introduce the Audit, Reporting and Governance Authority (ARGA). In the interim, the FRC will endeavour to continue improving the quality of Stewardship Code-aligned reporting, the regulator said.