9 minute read
Foreword
The scale of sustainability driven marketing in finance has become, to excuse the deliberate pun, unsustainable. The scale conflates, confuses, and sadly presents a real risk of the legitimate cause of climate change mitigation (and many others) being undermined by the questionable nature and depth of much of the material published. Even without the hype, the subject has a capacity to confuse. A myriad of initiatives, standards, principles, and international quangos all compete to be the 'one version of the truth' . There are numerous topics and many terms, some interchangeable, some not. Together with a rapid pace of development the scale of the hype risks turning many people away. Here we provide nothing more than a 'thirty second' , 'bottom line' summary.
Climate change and green finance
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Climate change and green or 'climate' finance is perhaps the simplest thread of sustainable finance to understand. There are two sides to the green finance coin. 1 Climate finance: the deployment of capital to the task of climate change mitigation and adaption* .
2 Climate risk: the need to incorporate consideration of climate change on the value of physical and financial assets and to act accordingly. Climate finance can be thought of as one part of the sustainable finance theme. Indeed, climate action is the UN's social development goal 13. Climate risk is basically the E of the ESG investment philosophy. Determining climate risk to be so great a threat to financial markets and financial stability, regulators have seen fit to roll out a new set of global regulations in the guise of the TCFD (Taskforce on Climate Related Financial Disclosures) requiring firms disclosure how they measure and assess climate risk. Regulations first directed at global banks and insurers are now more broadly applied across fund managers and pensions funds too.
ESG and Risk
‘Sustainable investing (or, as some call it, responsible investing) isn’t anything new, but it has undergone some evolution. What started a few decades ago as a somewhat basic ethical assessment of business activity has matured into a more thorough integration of environmental, social and governance (or, ESG) factors via quantitative and qualitative assessments. ’ World Economic Forum ESG integration, commenters explain, is the consideration of ESG factors as part of prudent risk management and a strategy to take investment actions aimed at responding to those risks** . The World Economic Forum goes on to explain that it views ESG as the consideration of ‘ESG factors’ as part of prudent risk management and strategy.
Sustainability and the 'SDGs'
The 'SDGs' are the United Nation’s 17 Sustainable Development Goals which set out targets across a range of environmental and societal objectives to be achieved by 2030. This strand of sustainable investing broadly encapsulates the thinking that humanity cannot continue along its current path, that we consume too much of the planet’s resource and that countries and societies are too unequal and unfair. Here the investment philosophy is that capital should be directed towards investments and projects that make a positive contribution to a better more 'sustainable' future. It is this theme, discussed later, which corresponds to a sustainable trust 'purpose' . Impact investing falls within this strand of sustainable finance where the 'purpose' of the investment is to create 'impact' as much as generate return, often attempting a measurable objective aligned with one of the SDGs. Whether or not there is a trade-off between the two is a matter for personal preference. The more return is sacrificed the more investments have the characteristics of philanthropy.
*It is a shame therefore, to have to register that between CoP21 in Paris and CoP26 in Glasgow, global net new investment in fossil fuel energy production outweighed sixfold investment in renewable energy generation globally.
** Whereas economically targeted investing, ie sustainability and the SDG's, by comparison, is investing with the aim to provide financial as well as collateral, non-financial, benefits. It is this small but crucial point and a red herring debate around 'loss of returns' due to ESG we believe is the underlying cause of most of the resistance to the incorporation of 'consideration of ESG' . Loss of returns due to 'purpose' is a different issue.
‘Climate change poses material risks to the financial sector and it is, therefore, within the mandate of supervisors to ensure that the financial system is resilient to climate risks. ’
The Network for Greening the Financial System And thus the case for regulatory action is made. TCFD, published in 2017, provides a set of recommendations regarding climaterelated financial disclosures; in the framework of four key pillars covering governance; metrics and targets; strategy; and risk management. Now mandatory for listed companies and many financial institutions in Europe, Japan, Canada, New Zealand, Australia, Singapore and Hong Kong, and with its introduction in the United States this year, TCFD has become, in just five years, the bedrock of international sustainability standards and climate disclosures. Regulators identify climate risk as presenting financial stability issues, a logical endorsement that climate risk has pecuniary impact, and require on prudential grounds financial firms take account of such risks within their business strategy. Thus, whether or not climate disclosure rules presently relate to the assets of a trust, the prudent fiduciary should ensure that they are properly informed. Our view is that calculation and knowledge of TCFD type metrics relating to trust assets is clearly consistent with fiduciary duty. The more than merely academic question is whether regulators have a mandate for transposing TCFD type rules and practices onto the sector. Many will argue that the prudential and conduct principles that provides legislative legitimacy in public markets is lacking in private markets. Irrespective of the strength of this case, climate risk is real and has the potential to significantly impact asset prices. Knowing that such risk has an impact on price clearly means it would be an abrogation of fiduciary duty not to assess portfolios against this risk. Logically It would be perverse to purchase an asset today where no attempt has been made to consider the impact of climate on its price tomorrow1 . The metrics at the core of TCFD, in particular 'Scope III, Category 15' financed emissions, provide the foundation for understanding the impact of climate risk on portfolios and assets. Common sense dictates that prudent stewardship of assets would entail calculation of climate (TCFD) metrics. Baringa Partners' report on the role of private finance supporting the transition to net zero commissioned by Guernsey Finance recommended that fiduciaries should 'measure and disclose portfolio emissions in line with industry standards (PCAF) or develop solutions to support measurement of portfolio emissions' . We believe that if owners of private capital have no other information about climate risk, knowledge of their emissions intensity and of their assets and portfolios is vital for prudent stewardship. Furthermore, as outlined by ISICI earlier this year2 the use of streamlined or a singular measures of climate risk serves is a cost-effective proxy measure of sustainability. A route to be encouraged and a position endorsed by the Economist this summer.
1 As set out in 'TCFD, Climate Risk and Private Capital, What relevance public disclosure rules to private markets' , the ISICI believes there is a case for limited climate change metrics being required to be produced, if not published, for private assets.
2 'How sustainable is the EU's approach to sustainable finance? A €2.5trn question' , ISICI March 2022. "A recent but remarkable development since assessment round five is that climate change has been explicitly recognised by financial supervisors as a source of financial risk that matters both for financial institutions and citizens’ savings. ”
International Panel on Climate Change (IPCC) Working Group III Assessment Round 6
“Empirical and academic evidence demonstrates that incorporating ESG issues is a source of investment value. ESG analysis assists investors to identify value-relevant issues. Neglecting ESG analysis may cause the mispricing of risk and poor asset allocation decisions and is therefore a failure of fiduciary duty. ”
United Nations
The basic premise of the World Economic Forum is that consideration of ESG factors is nothing more than sensible, sound risk management practice. Historically, this view has been contentious with some arguing that such an approach conflicted with the traditional concept of fidcciary duty of maximising return. This perceived conflict being particularly pronounced in common law jurisdictions and of particular relevance to the private wealth sector.
In an attempt to clarify the issues, the United Nations with the public backing of Al Gore and Generations Investment Management, established the global initiative,The 21st Century Fiduciary Duty, in 2016, to demonstrate that the traditional and modern concepts were not mutually exclusive.
Over the course of three years, the project worked with governments, investors and intergovernmental organisations to develop and publish a global statement on investors duties and obligations. The project concluded that modern fiduciary duties does indeed impose a requirement on managers.
We would put it slightly differently. Any prudent exercise of fiduciary duty, modern or traditional variant, should incorporate consideration of ESG risks with a potential material impact on price in any investment management process. The UN summarised its view of the requirements on fiduciaries as being to:
• Incorporate financially material ESG factors into investment decision-making, consistent with the timeframe of the obligation.
• Understand and incorporate into decision-making the sustainability preferences of beneficiaries/clients, regardless of whether these preferences are financially material.
• Be active owners, encouraging high standards of ESG performance in the companies or other entities in which there are investments.
• Support the stability and resilience of the financial system.
• Disclose the investment approach in a clear and understandable manner, including how preferences are incorporated into a scheme’s investment approach. '
The UN justified this position by providing three key reasons why the fiduciary duties of loyalty and prudence require the incorporation of ESG issues.
1 ESG incorporation is an investment norm. 2 ESG issues are financially material. 3 Policy and regulatory frameworks are changing to require ESG incorporation.
Considering a broad range of risks is to us the sign of a good investment manager. And doing so does not preclude a wealth maximising objective. Nor does it require investment in particularly 'impactful' assets. This is a separate choice variable of the beneficial owner. If there remain concerns as to the conflict of ESG and the capital preservation and maximisation duty of a fiduciary, these should be erased by the ERISA amendments of the Trump Administration. These made it clear that consideration of ESG factors, where they had a pecuniary impact, was consistent with the primary investment objective of the trustee duty, that is maximising pecuniary returns.
‘ESG factors and other similar considerations may be pecuniary factors and economic considerations... if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories. '
To us this is little different, merely a change in emphasis, from the perspective of the World Economic Forum and the United Nations.
ESG as it should be understood relates to consideration of ESG factors as part of prudent risk management.
Thus being assured that the risk management process relating to investment of the trust assets is broad, taking ESG type factors into account, and that proper governance processes exist to ensure this is so, is the extent of the required actions consistent with the general fiduciary duty.
