CMS - Focusing on Funds - Responsibility and Sustainability Matters
This Focusing on Funds update looks at a developing hot topic of sustainable, responsible and impact investment (SRI) and why this matters for funds. Environmental, social and governance (ESG) and SRI issues have become an increasingly important part of the investment process and the relationship between fund managers and investors. They are now moving from being voluntary and a matter of best practice to being expected and backed by legislation, fund documents and industry guidance.
ESG – a legal and regulatory matter
Besides existing principles and rules, the EU has published legislative proposals which will make ESG:
- a regulated area for AIFMs, UCITS Managers, MiFID firms, pension schemes and insurers, affecting their investment decisions and internal processes;
- an increased requirement for reporting and compliance; and
- an important “equivalence” area to watch post Brexit (i.e. the UK may need to have an equivalent regime in place in order to access EU investors post Brexit).
Legislative initiatives are not by the EU alone. National legislation and industry guidance are moving in the same direction. In any event, ESG is:
- relevant to how investors choose to invest;
- an opportunity to attract investment and finance for funds; and
- evolving asset classes/fund types.
What is sustainable, responsible and impact investment (SRI)?
SRI are holistic strategies whereby sustainability and ESG issues (including climate change, pollution, working conditions, gender balance, employee diversity, corruption and tax avoidance) are considered in connection with investment, divestment and financing decisions, and internal processes.
ESG and SRI issues are supported by global initiatives, such as the PRI principles, national rules and guidance, ranging from pension fund regulation (requiring that pension schemes consider ESG factors) to stewardship codes and corporate disclosure guidelines. There are also industry best practice codes.
At a global level, an increasing number of asset managers and investors (and their service providers) are signatories to the Principles for Responsible Investment (PRI), which are supported by the United Nations. As such, they commit for instance to:
- factor in ESG issues when making investment decisions;
- seek disclosures on ESG issues from the entities in which they invest; and
- report on ESG activities and their progress towards improved ESG.
Recently, the PRI launched an ‘Impact Investing Market Map’ which is designed to help asset managers and institutional investors to identify “mainstream impact investing companies”. This tool contains for instance common definitions and market concepts. These are intended to provide clarity and uniformity in the current investment landscape which the PRI states is “broad and fragmented”.
EU Sustainability Package and ESG Integration Rules
At an EU level, the European Commission published legislative proposals in May 2018 on sustainability, including proposals requiring asset managers and institutional investors to report on how they incorporate ESG factors into their investment decisions. Other proposals are:
- establishing a unified EU classification system of sustainable economic activities; and
- creating a new category of benchmarks which will help investors compare the carbon footprint of their investments.
These proposals have been broadly welcomed by the industry, but with some comments and concerns. For example:
- EU and national pension fund associations (including UK, German and Dutch associations) argue that the proposals were too prescriptive and fail to consider the diversity of existing approaches;
- Insurance Europe welcomes particularly the proposed classification system, but argues that it should consider sustainability in a holistic sense and include all ESG factors;
- the European Fund and Asset Management Association (EFAMA) said the proposals seem to equate sustainable investments with impact and thematic investing and that the effect of this could be that a number of valid existing strategies may be deemed not to be “sustainable”;
- a German pension body argues that the proposals fail to take into account current ESG requirements in EU laws on workplace pensions (the IORP II Directive).
There are also early stage EU “ESG integration proposals” which would require AIFMs, UCITS managers and MiFID firms to consider sustainability and ESG risks in connection with their investment decisions and processes (organisational requirements, operating conditions, risk management and target market assessment). Proposed EU regulatory amendments will also require investment firms and insurance distributors to consider ESG when advising individual clients.
ESMA and IOPA have been asked to advise the Commission on these “ESG integration rules” by 30 April 2019. This will form the basis of new (or amended) secondary legislation under the AIFM Directive, UCITS Directive and MiFID II (as well as the Solvency II Directive and the Insurance Distribution Directive).
National legislative proposals
In addition to EU developments, there are also national ESG and SRI proposals.
For example, in the UK recently proposed legislation will:
- amend what a pension scheme’s statement of investment principles (SIP) must include in relation to the trustee’s considerations on the selection and stewardship of investments;
- require the SIP to include the trustee’s policy in relation to “financially material considerations” including, but not being limited to, ESG (climate change is specifically referred to); and
- pension scheme trustees will be required to publish statements on how they consider members’ views when making investment decisions. This part of the proposal is particularly controversial and has been opposed by the Pensions and Lifetime Savings Association.
Industry guidance and fund materials
There are ongoing efforts in the fund industry for guidelines and to standardise ESG wording and definitions.
- the European Association for Investors in Non-Listed Real Estate Vehicles (INREV) will review its sustainability guidelines and online assessment tools, as well as develop global ESG definitions;
- the British Private Equity & Venture Capital Association (BVCA) has a sustainability toolkit;
- the European Public Real Estate Association (EPRA)'s Sustainability Best Practices Guidelines aim to provide a consistent way of measuring sustainability performance and cover ESG impact categories;
- the Invest Europe Professional Standards Handbook 2018 contains ESG factors; and
- Assogestioni (the Italian association of asset management companies) strongly supports policies that promote understanding and awareness of sustainability issues on all investment levels.
Accordingly, several asset managers companies have already adopted a methodology for selecting financial instruments applying ESG and SRI criteria to all actively managed investments.
In relation to fund materials, PRI has issued best practice guidance on how responsible investment and ESG provisions may be covered in fund documents. Currently, ESG provisions are typically included in side letters with investors, but the approach differs from investor to investor. However (especially with further pressure from large cornerstone investors), generally applicable ESG matters may become included in the constitutional documents of a fund, (such as limited partnership agreements) and, as such, be applicable to all investors. Asset managers are also including information on their approach to ESG in their materials including their websites.
In terms of geographical variations, Preqin has found that ESG is mainly documented by European funds, rather than US funds. To streamline the negotiation process and reduce the number of side letter provisions, it would be helpful to see more standardised ESG wording and definitions and industry efforts in this respect are welcome.
Evolving asset classes and EuSEFs
ESG factors are also evolving asset classes in their own rights, including green, renewable, ethical, social impact and general ESG products, such as ESG exchange traded funds (ETFs). This is relevant to fund product developers, but may require an objective standard/labelling (a topic also being considered by the EU).
In addition to ESG-themed asset classes, there is currently a voluntary marketing regime for European social entrepreneurship funds (EuSEFs). In order to use the EuSEF label, various asset level, registration and other regulatory requirements apply (for example the fund has to be EU domiciled and managed). The EuSEFs can then be marketed on a cross-border basis throughout the EU. As part of the Capital Markets Union, the EuSEF regime has been amended to increase its popularity, for example by making it available to large AIFMs.
ESG is now becoming mainstream and regulated. This hot topic will develop further in the coming months and we will consider specific fund subjects further.