Investment – available in any colour, as long as it’s green…
In 2019, climate change issues have never been far from the headlines, from Greta Thunberg’s odyssey across the Atlantic Ocean, to Extinction Rebellion’s protests in cities around the world. This background has seen ‘climate emergency’ become the Oxford Dictionaries word of the year and also grow into one of the few issues to rival Brexit in the UK’s General Election contest, meriting a special televised debate for political party leaders (and ice sculptures!).
It’s no surprise, therefore, that interest in ethical investment has surged in popularity. The Global Sustainable Investment Alliance has estimated that there was a 34% increase in the amount of global assets invested in responsible strategies, from $22.9 trillion in 2016 to $30.7 trillion in 2018. It’s clear, then, that customer demand is behind much of this increase in prominence, but regulators and governments around the world are now sharpening their focus on sustainable finance as well. This has added a strong regulatory ‘push’ factor to the ‘pull’ from clients.
In this article, we’ll take a brief look at the sustainable investment regulatory landscape and some of the areas that will be significant in 2020.
Mind your language!
One of the trickiest aspects of ethical investment is the complex terminology and litany of definitions used by different asset managers, often making reliable comparisons extremely difficult for investors. At various junctures, you might see the phrases: ethical; sustainable; responsible; sustainable and responsible investment (SRI); environmental, social and governance (ESG); green finance; impact investing… The list goes on.
To clarify this confusing muddle of terms, the Investment Association (IA) has undertaken a thought-provoking piece of work: their Responsible Investment Framework. This aims to provide industry-wide definitions for a number of investment terms and a common framework for the different approaches undertaken by asset managers. The lack of a common language has been identified as a significant barrier to progress in the promotion and growth of the ethical investment sector.
Attentive readers will note that I’ve referred to ethical, sustainable and many other terms so far… In the spirit of the IA’s framework, rather than adding to the confusion, I’ll refer to ‘responsible’ investment wherever possible throughout the rest of my article!
The IA is encouraging firms to adopt their framework when communicating to clients. Whilst there is no regulatory obligation here, it would be expected that over time, firms will gradually fall in line and harmonise their approach accordingly. For customers, this will be a welcome development as they research their investment choices. Perhaps most significantly, the IA is proposing a ‘UK Retail Product Label’, which will enable customers to easily identify products that adopt a responsible investment approach – a strategy that is widely supported by the investment industry. Initial work has been done in this area by the IA, with much more to come in 2020.
The only way is ethics
The move to clarify language around responsible investment will certainly be welcomed by customers. But more strategically, there are further moves afoot by governments and regulators to promote its use throughout the investment value chain.
Much of this regulatory thrust originates from the European Union, and is being delegated down through national regulators. The key philosophy underpinning all of these moves is the EU’s drive to meet the UN’s 17 Sustainable Development Goals by 2030. With an ambitious set of objectives and a limited timeframe, the EU has made it clear that a substantial amount of capital is required to be invested via responsible means, and it is aiming to legislate accordingly. This has resulted in a number of complementary initiatives.
- Amendments to MiFID II and the Insurance Distribution Directive (IDD): The European Commission has undertaken a consultation to assess the most efficient way to incorporate responsible investment considerations into the advice process that firms offer to clients. The chosen implementation route is an amendment of the MiFID II and IDD rules, which is no surprise given the huge scope of these pieces of legislation.
Currently, in accordance with Article 25 of MiFID II, firms providing investment advice and portfolio management services are required to procure information from clients about various topics – such as their knowledge and experience in the relevant investment field; their financial situation, including ability to bear losses; and their investment objectives, including risk tolerance – as part of an overall suitability assessment. Existing guidance in this area suggests that it is best practice to include considerations about responsible investment preferences as part of this process.
The Commission’s proposed changes, however, will mean that as part of the suitability assessment for a client, responsible investment considerations will have to be taken into account. This will need to be much more than a cursory question about a client’s generic ethical principles – portfolio managers and financial advisers will have to proactively obtain a variety of detailed pieces of information (as many clients will not provide this without prompting) and align their recommendations with any responsible investment preferences that result from this analysis, demonstrating how these preferences are met by the selected securities.
It is likely, therefore, that these developments will lead to a further uptick in demand from advisers and portfolio managers for a range of responsible investment solutions in order to meet the resultant customer demand.
- Sustainable Finance Taxonomy: This is the European Union’s attempt to establish the framework for a unified classification system (the EU’s term for this is a ‘taxonomy’), which will define what can be considered an environmentally sustainable activity. This will allow investors to see more obviously what proportion of an investment is routed into sustainable activities.
- ESG Disclosure Regulations: This will require firms to disclose how they integrate sustainability risks into their processes, systems and controls. Sustainability risk is defined as follows:
"...an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment arising from an adverse sustainability impact."
Firms marketing products as responsible, sustainable and so on will need to produce disclosures detailing how they are meeting their targets in respect of these labels. This might include, for example, the reduction in carbon footprint resulting from an investment. This enhanced disclosure should provide much more clarity, both for customers and for advisers recommending products to those customers.
- ESG Benchmark Regulation: This creates a new category of benchmarks, with two new sub-categories – the Climate Transition Benchmark (CTB) and Paris-Aligned Benchmark (PAB). Both benchmarks have a low-carbon/positive carbon impact theme.
In addition to these key European initiatives, the UK regulatory environment is also changing.
- The FRC’s Stewardship Code: The Financial Reporting Council created the UK Stewardship Code in 2010 as a reaction to the global financial crisis and an attempt to codify the principles of robust financial governance. Following a consultation in 2019, the FRC has published an update to the Code, which will take effect on the 1 January 2020. Responsible investment principles are embedded throughout. Stewardship is now defined as follows:
“…the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.”
Principle 7 in particular talks about responsible investing in significant depth: “Signatories systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil their responsibilities.”
- FCA Climate Change and Green Finance Consultation: In October, the FCA published a feedback statement on responses to a discussion paper from 2018. Based on this feedback, the regulator will be consulting on rule changes in areas such as climate-related disclosures, independent governance committee oversight of firm ESG policies and measures to combat so-called ‘greenwashing’.
- Shareholder Rights Directive II (SRD II): The FCA has also published a policy statement on proposals to promote shareholder engagement, as part of the UK’s implementation of the European Commission’s efforts to improve transparency in the ownership of companies. This links closely to the FRC’s work on the Stewardship Code, mandating that asset management firms should develop an engagement policy and embed responsible investment considerations within this.
This is a selection of the key pieces of regulation, but it’s certainly not an exhaustive list. Demand for responsible investment products is now being driven both by customers and by regulators, and it is likely that this trend will continue or even pick up pace in 2020. With this rapidly changing environment will come regulatory scrutiny and, as such, this is an area that should be watched very closely by asset managers, financial advisers and investors.