ESG and Regulation – factors in the investment decision-making process
Regulation to become a factor for ESG investors alongside existing financial factors in the investment decision-making process.
Socially responsible investment (“SRI”) is certainly not a nascent phenomenon. However, if one were to consider the recent hive of activity from regulators you might think differently. SRI origins date back centuries to when early SRI principles were articulated by John Wesley. The asset management industry should be applauded for the development of the concept and it is arguable whether regulators need to become involved at all given that SRI has evolved from the industry. Some believe regulatory resources might be better deployed focusing on markets or liquidity risk.
SRI is today widely understood as the integration of environmental, social and governance (“ESG”) factors into the investment process. The term ESG was first used in 2005 and it is estimated that ESG currently accounts for almost one quarter of all professionally managed assets globally. Climatic change and the reaction to this critical issue from asset managers might mean that we are soon referring to “CESG”.
Investors are increasingly more sophisticated in their understanding and approach to ESG and are demanding greater stewardship from asset managers to ensure that their money is invested in a socially-responsible way. This places an onus on asset managers to better articulate how they integrate ESG factors into their investment process and this engagement is bringing about real change at investment companies. Investors are also not always prepared to sacrifice performance for their moral or ethical beliefs so the task of the asset manager to deliver is challenging. ESG is most successful and effective when the SRI principles and beliefs of the asset manager are core components to their investment strategy and not merely included to “green” a portfolio. ESG can no longer be seen as a niche investment strategy as it is relevant to all investment.
Regulators have taken a more active interest to ensure that this integration of ESG does not occur to the detriment of investors and it is useful to consider how this activity might impact on Irish regulated investment funds.
The Central Bank of Ireland (“CBI”), while identifying some key focus areas in the regulatory landscape at the end of 2018, flagged that regulators, such as the CBI, believe they will have a key role to play in ensuring asset managers consider risks associated with ESG investment and disclose these ESG risks and any associated costs to investors.
See the CBI comment below:
...“ESG is something that in the past has been seen as an area of interest but perhaps not something that was at the centre of concerns for the financial services industry. It is fair to say that that period is coming to an end. The initiatives of the European Commission in this space during 2018, building on previous work of the FSB and the High-Level Expert Group on Sustainable Finance mark a significant moment. It is perhaps not the initiatives themselves, important though they are, that is the most significant thing to note. But rather how they have been received and how quickly they have gained traction and been the locus of a quickly developing consensus amongst policy makers and market participants that ESG factors have moved centre stage with the debate being not about whether but how to give them best effect from a regulatory perspective and to what timescale.”
It came as no surprise shortly after this CBI statement that the European Securities Markets Association (“ESMA”) published their consultation paper outlining proposed amendments to the UCITS directive and AIFMD directive in order to integrate sustainability risks and sustainability factors in the internal processes and procedures of UCITS management companies and AIFMs. The European Commission in its mandate to ESMA to prepare technical advices, had stated that its objective is to explicitly require the integration of sustainability in the investment decision process. The proposals put forward by ESMA intend to impose obligations on UCITS managers and AIFMs to:
a) incorporate sustainability risks (being the risk of fluctuation in the value of positions in the value of positions in a fund’s portfolio due to ESG factors) in their due diligence processes; and
b) assess and manage the sustainability risks stemming from their investments.
It proposes changes to the following areas of both the UCITS and AIFMD frameworks to address the above:
a) General organisational requirements;
c) Senior management responsibilities;
d) Conflicts of interest;
e) Due diligence requirements; and
f) Risk management.
A brief analysis of the responses received by the European Commission would suggest that respondents, while broadly supportive of the initiative, are mindful that the need for flexibility remains and a one size fits all approach should be avoided. Not all asset managers claim to invest with ESG in mind and not all investors require it.
The International Organization of Securities Commissions (“IOSCO”) recently published the IOSCO Statement setting out the importance for issuers of considering the inclusion of ESG matters when disclosing information material to investors’ decisions.
The IOSCO statement does not supersede existing laws, regulations, guidance or standards or the relevant regulatory or supervisory frameworks in any specific jurisdictions, or any IOSCO Principles.
The IOSCO areas of focus are set out below.
a) Developments in the disclosure of ESG Information;
b) Investor perspectives;
c) Issuer perspectives;
d) Voluntary disclosure frameworks; and
e) The role of securities regulation and existing obligations.
IOSCO is encouraging asset managers to consider the materiality of ESG matters and when such matters are considered to be material, they should be disclosed to investors. IOSCO are seeking clear disclosures in respect of methodologies and needs issues to ensure that plans of/or development in accordance with risk and also reflect opportunities in a balanced way.
IOSCO will monitor developments regarding the disclosure of ESG information, including private-sector initiatives that have promoted a voluntary framework. IOSCO will also continue to engage with different disclosure forums and task forces, issuers, and investor groups in order to be informed about the latest developments and their consequences, as well as to understand market participants’ perspectives and expectations regarding disclosure of ESG information.
ESG is certain to become a landmark on the regulatory map and I expect that this will benefit investors’ understanding of how ESG impacts their investments, but it is unlikely to have any impact either positive or negative on performance - that will remain the job of the asset manager.
Brian Dillon, Partner, Asset Management and Investment Funds at Dillon Eustace