For those who care about environmental, social and governance considerations, watching the glacial progress towards standardised ESG disclosures has been frustrating.
There are more working groups, task forces, frameworks and roadmaps than you could shake a stick at (I have never tried shaking a stick at a working group, and it would probably get me fired, but you get the idea).
Dare I suggest that we might even spare some sympathy for the Financial Conduct Authority, which has the job of turning all the reams of recommendations and principles by such authorities as the Task Force on Climate-Related Financial Disclosures, International Sustainability Standards Board, International Organisation of Securities Commissions, and a score of others into a disclosure regime that is both straightforward and nuanced, stringent but flexible, endorsed by experts yet clear to consumers?
It is a tough job, but a hugely important one. What is at stake is the credibility of ESG itself. Is it a movement, or a marketing ploy?
Our own research suggests that advisers are not cynical about the notion of ESG itself (four-fifths think investments should make a positive difference as well as a financial return), but they are sceptical about ESG claims, and if the FCA’s ‘Dear Chair’ letter last year is anything to go by, they are right to be.
A proper disclosure regime offers the chance for asset managers to show that ESG is more than marketing. It is also crucial for advisers, who the FCA will require to take clients’ ESG preferences into account when selecting investments. Just as regulation governing the food we eat reassures us that it is safe, fresh and contains what it says on the packet, a good sustainability disclosure regime could instil confidence and aid choice while stopping greenwashers in their tracks.
Challenges
In some areas, the FCA has made a good start. The idea of a three-tier disclosure with a clear product label, a consumer-facing disclosure and a more detailed disclosure for institutions is a good one.
However, there are five big challenges for the FCA to navigate, where the early signs are not so promising.
To begin with, the S of ESG was largely ignored in the FCA’s recent discussion paper. Our research shows it is nearly as important to investors as the E, especially issues such as human rights and working conditions. Yet it has merged into the general concept of “wider sustainability topics beyond climate change”.
To the person in the street, 'sustainable' means green. The FCA needs to acknowledge this by making sure its disclosure regime clearly differentiates between environmental sustainability and positive social objectives (a product could, of course, focus on both).
Another area where the sweet smell of fudge can be detected is in the proposed ‘responsible’ and ‘transitioning’ product categories. The UK Sustainable Investment and Finance Association has already raised concerns that a responsible label – widely understood to be synonymous with ESG integration – could over-promise to investors.
They have a point. If I refrain from drink-driving, pick my kids up from school on time and generally keep my nose clean, I might call myself a responsible adult. But I do not expect a medal or a badge. Doing those things is ultimately in my own interest. So it should be clear that a responsible fund does not have any specific ESG objectives.
The transitioning category could be even more problematic, because according to the FCA’s suggestion, transitioning funds would fall inside the ‘sustainable’ investment universe.
You would expect a transitioning fund to be in a state of movement, from unsustainable to sustainable. However, as currently defined, the transitioning category could provide a home for funds that perpetually remained in a transitioning state. This is like me promising daily that I will be on time for the school pick-up tomorrow, but never quite making it. Far from combating greenwashing, the transitioning badge positively encourages it.
This fudging inherent in the proposed product categories links to another issue with the FCA’s whole approach.
Engagement
The “exclusions versus engagement” debate is perhaps the biggest one in ESG. And like most big debates, there is sense on both sides. If someone does not want fossil fuels, weapons or tobacco in their portfolio, there is no arguing with that personal choice. And yet, we have to at least recognise the argument that if all investors concerned about climate change divest polluting companies, then they will be left with shareholders who do not care, which could lead to worse consequences.
Engagement, or stewardship, is vital to ESG. But engaging with companies to set them on a more sustainable path is harder to do and harder to measure than simply including the ‘good’ companies and excluding the ‘bad’ ones.
This is where the FCA’s disclosure approach really falls down. Take two funds: fund A avoids holding polluting companies and instead holds sustainable ones, while fund B holds polluters and uses its influence as a shareholder, together with others, to push them towards reducing their emissions. As the FCA’s proposals currently stand, fund A would be granted the halo of the “aligned” category, while fund B would sit in the purgatory of the transitioning category with the greenwashers.
Yet fund A’s impact on emission reduction has been virtually zero, apart from marginal impacts on companies’ relative cost of capital. In most reasonable people’s eyes, fund B would be the one that had made a difference.
A similar issue occurs when it comes to holdings in unquoted companies or assets. We have investment companies that invest in wind and solar farms, battery storage, social housing and social enterprises. In a system that relies on asset managers using disclosures from listed companies to put together their own disclosures, these assets are shut out.
We already see this happen with ESG rating providers, who simply do not have the data to rate companies such as Greencoat UK Wind or Schroder BSC Social Impact. So if we are not careful, we will be in a bizarre situation where some of the greenest, highest-impact assets you could possibly invest in are sidelined by a new disclosure regime because 'the computer says no'.
A final challenge is one of supervision. On climate-related disclosures, which are already in force for some large asset managers, the FCA anticipates acting “reactively where needed” and taking action “if firms failed to make disclosures or if these were misleading/constituted serious misconduct”. It remains an open question whether the FCA will do what it takes to ensure that its new disclosure regime is followed in spirit as well as letter, especially if some elements of that disclosure are descriptive rather than pure numbers.
These are big challenges. But it is hard to think of many more crucial areas for the FCA to get right over the next 12 months. The prize is a disclosure regime that delivers on the regulator’s priorities of promoting transparency and trust. The risk is that the regime provides a comfortable home for greenwashers while leaving some of the most impactful ESG investments out in the cold.
Nick Britton is head of intermediary communications at the Association of Investment Companies
