Climate change and sustainability disputes: Asset Management perspectives
Global | Publication | July 2021
Asset managers have become increasingly proactive in their pursuit of sustainable finance strategies. This has been driven by a genuine desire to move towards more ethical and responsible investment but also in response to the demands of investors. Investor concern about the impact of climate change on the value of investments has continued throughout 2020, notwithstanding the COVID-19 pandemic.
In the climate change and ESG space there are five fairly well defined areas of risk. These are:
- Physical: damage to land, buildings, stock or infrastructure owing to physical effects of climate-related factors. This can also include the results of physical risks, for example crop failure and supply chain disruption.
- Policy: financial impairment arising from local, national or international policy responses to climate change. The often cited example is carbon pricing or levies.
- Liability: financial liabilities, including insurance claims and legal damages, arising under the law of contract, tort or negligence because of other climate-related risks.
- Adjustments: financial losses arising from disorderly or volatile adjustments to the value of listed and unlisted securities, assets and liabilities in response to other climate-related risks.
- Reputational: risks affecting businesses engaging in, or connected with, activities that some stakeholders consider to be inconsistent with addressing climate change.
Asset managers will be approaching these risks from two different angles. First, in relation to how they impact the asset manager’s own business. Second, how the risks impact the performance of the asset manager’s underlying investment portfolio. Designing resilience to climate change and ESG risks has become an inherent part of the investment risk management process - protecting capital from hidden liabilities.
The number of climate change and ESG-related regulatory requirements being placed on entities such as asset managers is growing although it’s important to note that ESG is much more than just laws and regulation with investors being more demanding about the sustainability credentials of products and funds in which they invest.
In terms of regulation there are a number of interlinking initiatives. These cover international efforts that include those from the United Nations (UN 2030 Sustainable Development agenda), the Financial Stability Board (FSB) (the Task Force on Climate-related Financial Disclosures) and the European Commission (Commission) (Sustainable Finance Action Plan). There are also a number of national initiatives. For example the United Kingdom has its Green Finance Strategy.
Focus on disclosure
The work of the FSB and the Commission has tended to focus on minimum standards of disclosure to ensure that an entities ESG offering is as green as it seems. For example the FSB’s Task Force on Climate-related Financial Disclosures has developed a series of climate-related financial disclosures that are voluntary. The Commission’s Sustainable Finance Action Plan includes a Regulation on sustainability-related disclosures in the financial services sector (SFDR). This Regulation, which becomes applicable in Member States on 10 March 2021, sets out sustainability disclosure obligations for manufacturers of financial products and financial advisers. It aims to improve transparency in the sustainability of firms and the products they offer, aiming to tackle so-called “green washing” where sustainability credentials are overstated in order to gain a competitive advantage.
The legislation is broad in its scope. In respect of manufacturers of financial products it includes an alternative investment fund manager (AIFM), an investment firm that provides portfolio management and a manufacturer of a pension product. Financial advisers include, among others, an AIFM and a UCITS management company that provide investment advice. Financial product is also widely defined and includes an alternative investment fund and a pension product.
The Commission’s Sustainable Finance Action Plan also includes a Regulation on the establishment of a framework to facilitate sustainable investment (Taxonomy Regulation). This Regulation establishes the criteria for determining whether an economic activity qualifies as environmentally sustainable for the purposes of establishing the degree to which an investment is environmentally sustainable. The Regulation applies to “financial market participants” which are defined by reference to the SFDR. The Regulation will become applicable on 1 January 2022 in respect of climate change mitigation and adaptation, and 1 January 2023 in respect of the other environmental objectives.
Following Brexit the UK is no longer a Member State and is not bound by the EU legislation arising out of the Commission’s Sustainable Finance Action Plan. However, there have already been early signs of the UK’s post-Brexit ESG regime, with the UK Government announcing that the UK would become the first country in the world to make reporting under the FSB’s Task Force on Climate-related Financial Disclosures mandatory, whereby reporting on climate change will be required by almost all UK-regulated asset managers (including AIFMs). The FCA published a consultation in June 2021 setting out proposals on TCFD-aligned disclosures for asset managers (among others), which will apply on a mandatory basis to firms that have £5 billion or more in assets under management. Whilst the UK will not implement the SFDR directly, the Government and FCA are currently working on developing similar standards for UK financial services firms, having published a Roadmap in October 2021 which envisages the introduction of Sustainability Disclosure Requirements (SDR). The SDR will cover corporate disclosure, asset manager and asset owner disclosure, and investment product disclosure (including a sustainable investment labelling system).
The framework of the Taxonomy Regulation was retained in UK domestic law as it became applicable before the end of the Brexit transition period, but not the broader requirements such as the disclosure obligations and technical screening criteria. The Chancellor of the Exchequer’s announced in November 2020 the Government’s intention to implement a green taxonomy, aiming to improve understanding of the impact of firms’ activities and investments on the environment and support the UK’s transition to a sustainable economy. The Government has since set out its approach to the taxonomy in its Roadmap, which will be guided by three core principles: to be robust and evidence-based, accessible, and built for the UK to support a global transition. The taxonomy will recognise companies that invest in green activities, based on the taxonomy-aligned proportion of their capital expenditure, as well as transitional activities, by setting thresholds for best-in-sector emissions levels for activities that cannot currently be conducted in a way which is aligned with net zero ambitions.
Australia’s approach to ESG regulation, as it applies to asset managers and superannuation trustees, is primarily focused on the enhancement of product disclosures and the acknowledgement of ESG risks and opportunities. It is foreseeable that the growing acknowledgement that ESG factors impose a material financial risk in relation to financial products will encourage asset managers and superannuation trustees to more frequently include reference to ‘climate change risk’ within the ‘significant risks’ of the product disclosure statement.
Hong Kong has seen a number of ESG related developments including that the Securities and Futures Commission is currently consulting on a proposal to amend the Fund Manager Code of Conduct to require fund managers to take climate-related risks into consideration in their investment and risk management processes.
New US administration
President Biden’s inauguration will usher in a Democratic majority of Commissioners on the United States’ Securities and Exchange Commission (SEC). This will greatly enhance the likelihood that the SEC will mandate ESG disclosures in one form or another. Climate change in general is a key priority for the new administration.
In many jurisdictions voluntary initiatives are supplementing the position. For example in Germany the FNG – a professional association for sustainable investments – launched a label for sustainable investment funds in German speaking countries that is based on a minimum standard.
Investment managers’ duties
Investment managers owe duties to their clients where they exercise discretionary power over client portfolios. In the UK the duties by which investment managers are bound fall into four main categories: a (tortious) duty to exercise due skill, care and diligence, fiduciary duties of trust and loyalty, contractual duties as set out under the Investment Management Agreement (IMA), and duties arising from the regulatory framework. Our briefing note ESG and the duties of investment managers examined discusses the duties of investment managers, considers how ESG issues interact with those duties, and explores how legislative and regulatory changes may impact the applicable legal liability regime.
Including ESG-specific terms in IMAs and side letters are ways in which an asset manager can be held accountable to the ESG policies, practices and reporting that was agreed during the appointment process.
As mentioned in our briefing note ESG for asset managers: 10 things you need to know managers should consider their contractual arrangements with delegated managers, advisers and distributors to ensure compliance with ESG-related obligations. For example, amendments to agreements may be required to ensure out of scope counterparties either contractually apply with relevant requirements or, as a minimum, assist with information, data and documentation provision as necessary to enable managers to comply with their obligations. Managers should also ensure that any public disclosures made are consistent with those of their delegated managers, advisers and distributors, where possible.
In many jurisdictions, investors have the right to sue public companies that publish misleading information to the market, such as in a company's financial reports and RNS-announced press releases. In the UK, these rights appear in section 90A/schedule 10A of the Financial Services and Markets Act 2000.
Whilst there are already a number of climate change and ESG related legislative initiatives it is clear that this is just the beginning. There are already moves to link sustainability with the rules on regulatory capital and the remuneration of staff. Investor activism is also likely to increase. Given the clear direction of travel asset managers will want to stay ahead of the curve. Regulatory initiatives in the climate change and ESG space are being monitored on our Regulation Tomorrow blog. Commentary can also be found on our Sustainable Finance microsite situated on our Financial Services Regulation hub found on the NRF Institute. Our global financial services team has also published a Compliance Officer Bulletin on ‘ESG regulation – international developments’. The Bulletin provides an update on the work undertaken by financial services regulators on climate change and ESG. It covers the work of international regulators such as the FSB and the Commission and also the work of domestic regulators in the United Kingdom, the United States, Canada, Germany, Italy, the Netherlands, Hong Kong and Australia.