The good, the bad and unintended consequences of sustainable investing 

There have been many commendable efforts to promote sustainability in our industry through investment decisions, but we also see examples where the execution of approaches or strategies has led to unintended outcomes. Actions without full due diligence can often come at a price, so asset owners must have robust governance processes in place when it comes to sustainable investing.

Greater adoption of sustainable investment strategies has been driven in part by regulation but also by increasing investor sentiment in recent years, as awareness around sustainability issues has grown.

Regulatory initiatives requiring financial services providers to analyse and disclose environmental, social and governance (ESG) considerations in a public way, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) and Task Force on Climate-Related Financial Disclosures (TCFD) in the UK, have made it easier for asset owners to understand the impact of their investment decisions through a sustainable lens.

Clearer rules and regulations on sustainable investment have helped standardise the sustainable investment industry by avoiding ‘greenwashing’ and holding asset managers to account. However, greater regulation and standardisation require more resources, which means additional costs.

Although many asset managers will try to absorb increased costs where possible, there will come a point where they need to be passed on to investors through higher fees, particularly as the disclosure requirements grow.

Since its introduction in 2021, the SFDR in Europe has helped give investors greater insight into which funds follow sustainable investment practices.  However, there have also been some unintended consequences in fund classification.  There are many investment products with the Article 8 classification: these are funds that promote environmental or social characteristics. However, the classification for Article 8 is broad and it can sometimes be difficult for asset owners to truly understand how sustainability characteristics are embedded in a particular fund.

Meanwhile, the Article 9 classification – assigned to investment products that have sustainability as their core focus – can be so strict that should a fund fail to meet one of the required criteria for a period of time, the fund classification would get downgraded, potentially causing considerable reputational damage to the asset manager, even if the reason for the breach is outside of their control.  This has created a reluctance in the asset manager community to award many investment products with the highest sustainability classification.

Another challenge for funds is mandatory climate reporting. In the UK, climate change governance and mandatory TCFD reporting is required for occupational pension schemes with over £1bn of scheme assets.  Climate metric data on underlying investment funds has been improving and we have seen a flow of engagement – asset owners have been engaging with their asset managers.  The asset managers needed to respond to their investors and now have to do their own mandatory reporting.  The asset managers are engaging with underlying corporates who will need to do some form of sustainability reporting.  Whilst it feels that the order of the mandatory reporting is backwards, we have seen an increase in momentum in providing supporting data.  And better data is needed in order to make informed investment decisions.  

Although better data is empowering asset owners to make more active decisions to reduce their carbon footprint, it is important not to invest in a sustainability product or approach without doing full due diligence.  It is great to see an increase in the availability of passively managed equity products that have a sustainability-driven index to track but the choice of which index to use is an active decision that requires good governance to avoid any unintended consequences, in terms of sector, regional or style exposures, when looking at the total portfolio level. 

In the UK, pension trustees that fall under the climate change governance and reporting regulations need to set a climate-related target based on one of the reported climate metrics.  It is important to remember that targets can’t be hit overnight – decarbonisation is a systemic process and short-term restructuring through divestment to reduce a carbon footprint is unlikely to have the desired real-world impact.

Ultimately, all asset owners should not let regulatory reporting be the driver of decision-making. Reports should reflect the decisions that have been taken along with the supporting analysis.  Understanding where the risk exposures and opportunities lie is good investment governance and covers all areas of sustainability: for example climate change; nature; social factors; and diversity and inclusion.

Active stewardship plays an important role in the carbon transition and enabling change across a broad range of critical issues.  Stewardship demands clear objectives to understand priority themes for engagement and voting along with an understanding of the escalation process if engagement efforts are not working.  Working with asset managers with robust engagement processes can give asset owners a seat at the table over the direction of a holding company’s future corporate strategy and how it meets its sustainability commitments.

Most asset owners don’t have the time or resources to be able to have a say on every vote in their portfolio and will delegate decisions to their asset manager, but there is no guarantee that an active engagement activity will lead to a change in behaviour or be in line with a scheme’s preferences or beliefs.

In some cases, asset managers may offer voting choices for investors based on themes or beliefs, which can support primary aims, such as the climate transition, but some offered structures can often be quite binary. There may be instances where an asset manager may vote against a shareholder motion but still support an overall theme.  It highlights how stewardship is not black and white and how having a blanket approach to voting and engagement may not support your overall aims.

It is important, therefore, that asset owners understand the stewardship policies of their asset managers and what their key engagement themes and priorities are. How do they engage? And what is the escalation procedure when there is no positive response?

Sustainable investing is not a ‘set and forget’ activity.  This space is moving quickly and asset owners should review their sustainability beliefs frequently and ensure the total portfolio investment implementation is still doing what they want it to do.