Fund Governance Insights

Rising to the challenge of
responsible and sustainable investment

5 minute read time

Sustainability and responsible investment (SRI) can no longer be regarded as a narrow issue that applies only to a subset of investment funds at the margin.

SRI is now a force in investing and is fundamental to the asset management industry and its clients. Rather than dampening enthusiasm for SRI, the global pandemic has instead acted as an accelerant. SRI funds have continued to attract high levels of investment over the pandemic period, attracting around £1bn of new investment per month over the past three to four months, according to Investment Association (IA) research figures.

That was a time when conventional funds were experiencing material outflows. Interest and demand is not only from retail investors but also from institutional investors, all of whom want to know how the industry is rising to the challenge of responsible investment. SRI is not confined to traditional authorised funds; it is also on the rise in alternative funds, such as private equity, where there has been an increase in the launch of environmental, social and corporate governance (ESG) funds.

The political imperative: the Paris Agreement and the transition to net zero

To tackle climate change and its negative impacts, 197 countries adopted the Paris Agreement at the United Nations Climate Change Conference in Paris on 12 December 2015. The deal aims to substantially reduce global greenhouse gas emissions and to limit the global temperature increase in this century to 2°C while pursuing means to limit the increase even further to 1.5°C. The Paris Agreement marks the beginning of a shift towards a low-carbon world but there is much to do as the world is currently heading towards more than 3°C.

In 2019 the UK raised its ambition on climate change by setting a legally binding target to cut its greenhouse emissions to ‘net-zero’ by 2050, becoming the first member of the G7 group of major economies to do so. The UK has also indicated it will at least match the ambition of the objectives of the EU Sustainable Finance Action Plan and the government will work with the financial services sector to strengthen the UK’s status as a global hub for sustainable finance.

The good news is that many of the UK’s biggest firms have got the message and are moving quickly to reduce their emissions. For example, at NatWest, we have set out an ambition to be a leading bank in helping to address the climate challenge by making our own operations net-carbon-zero in 2020 and climate positive by 2025.

The hope is that the demand for ESG ratings will make it harder for investee firms to engage in greenwashing, to the ultimate benefit of shareholders and the wider financial community

Regulatory interest in SRI hampered by a lack of common standards

There have been few other emerging trends that have attracted the same level of regulatory interest as SRI. This has led to a plethora of international standards with no common definition of what a sustainable finance product is. The multitude of frameworks makes it difficult for investors to compare one company’s disclosure to another and this creates issues around market integrity and the potential for greenwashing. The International Organization of Securities Commissions (IOSCO) has created a taskforce to bring the standard setters together to try to achieve some global cohesiveness in international standards frameworks and hopes to report back in about 18 months. It is an ambitious timeline, given the complexities involved as individual countries try to establish a leadership position in ESG disclosures.

Connecting the dots: the demand for ESG ratings

ESG ratings are becoming increasingly important in the world of investing. There is growing evidence that firms with high ESG scores will also produce stronger financial results. But unlike credit ratings, ESG scores are poorly correlated with each other. This is perhaps not surprising when many firms do not report on sustainability regularly or consistently, making it difficult for ESG rating firms to arrive at an accurate picture, given a lack of information. ESG rating methodologies are also proprietary to firms, meaning that rating firms can disagree about companies which are good or bad from an ESG perspective.

The hope is that the demand for ESG ratings and recent consolidation within the sector will bring greater consistency in ratings and make it harder for investee firms to engage in greenwashing, to the ultimate benefit of shareholders and the wider financial community.

How is the UK asset management industry rising to the challenge?

In November 2019, the Investment Association published its Responsible Investment Framework – an industry-wide common language for responsible investment with clear definitions and a framework for product categorisation. The IA is due to publish before the end of the year a best-practice guidance paper on fund level communication of responsible investment. Perhaps the most significant development will be the launch of a UK retail product label for authorised funds. The label will help the UK to compete with other European jurisdictions by showcasing UK expertise and will help simplify investors’ choice of SRI funds for the benefit of the investor and the industry. The Association of Real Estate Funds (AREF) is also considering the merits of an ESG label. A position paper on climate change and the role of the industry is also expected.

It is clear SRI is now a core strategic issue for the asset management industry. This gives grounds for optimism but this optimism should be tempered with reality. ESG remains an emerging frontier in finance and the scale of the challenge is profound.

By Chris Day

Assistant Director, Funds Regulation & Governance