To date, firms have been encouraged by investors, by regulators or by governments to adhere to recognized Principles for Responsible Investment.
The tide is now firmly turning. Firms can expect to see a steady move from industry good practice to rules, and from general regulatory guidelines to law. Now is the time for asset managers and institutional investors to engage in the European debate, to have a regular dialogue with their clients and beneficiaries on sustainability issues, and to evolve their investment strategies and product options for a world in which sustainable finance is the norm, not a “nice to have”.
We noted over a year ago that, as a result of the Paris treaty on climate action, policy makers were beginning to turn their attention to how they can encourage or require institutional investors and asset managers to adopt strategies that will support countries in meeting their new commitments. We predicted that new regulation would ensue. In May of this year we commented on an OECD report on ECG factors. The European Commission is now seeking views and opinions by 22 January 2018 on institutional investors' and assets managers' duties regarding sustainability.
The High-Level Expert Group (HLEG) on sustainable finance, appointed by the Commission, has identified two imperatives for Europe's financial system: to strengthen financial stability and asset pricing, by improving the assessment and management of long-term risks and intangible factors of value creation; and to improve the contribution of the financial sector to sustainable and inclusive growth by financing long-term needs and accelerating the shift to a sustainable economy.
It proposed eight recommendations, one of which was that the Commission should clarify that the fiduciary duties (i.e. of loyalty and prudence) of institutional investors and asset managers explicitly integrate material environmental, social and governance (ESG) factors and long-term sustainability. The Commission is therefore seeking to assess whether and how such a clarification could contribute to a more efficient allocation of capital, and to sustainable and inclusive growth.
The objective of the initiative is to ensure that material sustainability factors are consistently taken into account and disclosed by institutional investors and asset managers. It is believed that this will improve the investment process, increase transparency around the integration of sustainability in the investment process of asset managers and institutional investors, and lead to reduced search costs for end-investors.
The duties of care, loyalty and prudence are already embedded in the obligations under EU regulation that institutional investors and asset managers owe to their end-investors/scheme members (Solvency II, IORP II, UCITS, AIFMD, MIFID II etc.). These obligations include the duty to act: in the best interest of beneficiaries/investors; with due care, skill and diligence, including the identification and management of conflict of interests; with honesty; and to ensure adequate and proportionate performance of activities.
However, the Commission observes that it is unclear that these obligations require assessment of the materiality of sustainability risks (i.e risks relating to environmental, social and governance issues). It believes that market practices indicate that institutional investors and asset managers generally understand these duties as requiring a focus on maximising short-term financial returns and that they disregard long-term effects on performance due to sustainability factors and risks. This may be due to a number of reasons: time horizon or nature of the investment, governance arrangements, lack of explicit mention in the rules or because current rules are not fully aligned across sectors.
This can lead to misallocation of capital, it is said, and might give rise to concerns about financial stability since markets can be vulnerable to abrupt corrections, such as those associated with the delayed transition to low carbon economies.
Furthermore, there is a lack of transparency on how these sustainability factors are factored into the investment process. End-investors may not get the full information they need to inform their own investment decisions. This lack of consistent information could in turn hinder investors and others from considering ESG-related issues in their asset valuation and allocation processes.
Also, the interpretation of institutional investors' and asset managers' duties as regards sustainability factors leaves large flexibility for Member States. The commission suggests that some specification of these duties would be warranted to avoid fragmentation, inconsistency and unpredictability in the functioning of the internal market
The Commission is therefore asking a range of questions to inform its impact assessment and future legislative proposal. The questions are targeted at pension funds, insurers, investment funds and asset managers.