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ESG is rightly increasingly an area of importance for investors. Some will want to ensure that their occupational pension is invested in appropriately responsible funds (and equally, not invested in areas which have negative ESG impacts). Others will want to consciously invest their savings into ESG positive investments, not only looking for a financial return but also an environmental or social gain. And there will be those merging both these approaches, taking a more active role in their pension investments by means of an ESG oriented Self Invested Personal Pension (SIPP).
In the second of our articles on ESG risks in the Financial Services sector, we take a broad look at the litigation and complaints risks that arise with these investments for pension and investment fund managers and SIPP operators and trustees along with how they can be mitigated.
If a pension or investment fund claims to be specifically aligned with ESG values, then it goes without saying that the fund manager must understand the claimed and actual ESG credentials of each investment that fund makes, and satisfy themselves that those credentials match the requirements and standards of the fund's own marketed ESG claims. Whilst a simple concept, the reality is that this is far from an easy undertaking, not least because defining and measuring those credentials can be complex in a world where there is increasing scrutiny over such claims.
Similarly, a SIPP administrator may be required under the relevant scheme rules to manage a specific list of permitted investments in a SIPP member's fund. That list may in some instances be in part defined by a set of ESG requirements. The SIPP administrator would then be obliged to satisfy itself that any investment the member wishes to make meets those ESG requirements, which is again a potentially challenging task.
All this means that fund managers and SIPP operators need a sophisticated understanding of not only what environmental and social sustainability is but also how it is measured. These are vast questions which require expert and in-depth knowledge. Is environmental sustainability simply reducing carbon emissions of a single business? Or is it seeking to contribute to a macro scale target such as the Paris Agreement temperature rise target? Where does social sustainability come in, beyond seeking local supply networks and encouraging social mobility? And how do you measure and hold firms and individuals accountable for any efforts they may make, or claim to make? Do you look towards corporate certifications such as B Corp status, or the Science Based Targets Initiative? Do you rely on a business' own reporting which may use a measurement metric not necessarily comparative to others or an independent audit process? And how far down the target's supply chain do you go when chasing clarity on emissions data?
The picture will hopefully become clearer in the UK with the forthcoming publication of the government's Green Taxonomy. The Green Taxonomy was first announced in October 2021 alongside plans for a Sustainability Disclosures Regime (which is discussed further below) as part of the government's Roadmap to Sustainable Investing. The Green Taxonomy once implemented will set out the criteria which specific economic activities must meet to be considered environmentally sustainable.
To date the UK's sustainability reporting has been largely focused on climate related risks based on the recommendations of the Taskforce for Climate Related Disclosures (TCFD). The TCFD was created in 2015 by the Financial Stability Board and developed recommendations for disclosures on how to manage the financial risks and opportunities that climate change poses to business. The TCFD recommendations have been accepted and applied worldwide.
HM Treasury, the Department for Business and the Department for Work and Pensions has developed the UK's Sustainability Disclosure Requirements (SDRs) as "the next step in putting the UK's finance sector in a better position to achieve the goals of the Paris Agreement". Once implemented the SDRs should help address the difficulty in finding information about the ESG credentials of investments, but there may still be interpretation differences when the taxonomy is first applied.
SDRs creates a framework for "decision-useful disclosures on sustainability" that works across all sectors of the economy. SDR builds on the recommendations of the TCFD and includes new sustainability disclosure requirements for companies, requirements on asset managers and owners to disclose how they take sustainability into account and a new sustainable investment labelling regime, all of which make it easier for consumers to compare and contrast different products and to understand whether their investments are being managed in accordance with their sustainability preferences. This framework and metrics will also be aligned with international standards.
In terms of disclosures for investment products, the Government's Greening Finance Roadmap envisages consumer-friendly disclosures at product level with more detailed disclosures required for sophisticated investors. Sustainability disclosures will be required for all produces whether they are marketed as sustainable or not to enable comparison.
It is important to note though, that many of the underlying issues will remain once SDRs and the Green Taxonomy are in place. Whilst firms' activities will have to meet the standards set by SDRs and align themselves to the Green Taxonomy, it is the underlying evidence they will rely on to show this that is likely to remain open to confusion or, worse, manipulation and challenge. SDRs and taxonomy alignment rely on solid and genuine measurable data – that is where the real risks around proving (or disproving) an investments' environmental performance will still lie.
Even if the fund manager or SIPP operator can get comfortable that they understand and are satisfied by the ESG credentials of a particular investment, they still need to effectively and accurately communicate that to the end investor. Confusing or inadvertently inaccurate investor communications can often lead to cross-portfolio risks, or quickly spiral into litigation.
The complexity of ESG issues and their measurability, together with the current lack of a standardised taxonomy means ESG investment is ripe for challenges over investor communications. A well-known example is the common misconception that the phrases "carbon neutral" and "net zero" can be used interchangeably, yet in reality they mean crucially different things (carbon neutral does not require any reduction in greenhouse gas emissions, merely a position of neutrality, whereas net zero requires a primary reduction of those emissions with offsetting a last resort). A simple error in marketing a specific investment using the wrong phrase can fundamentally change the promised and expected ESG performance of an investment to investors.
Managing investments is a regulated activity and UK investment and pensions fund managers are authorised and regulated by the FCA. The FCA Handbook imposes various obligations on fund managers to disclose information to investors before they invest which includes a description of the objectives of the fund and the type of assets which may be invested in. There is also a requirement to make periodic disclosures in relation to the current risk profile of the fund and the risk management systems employed to manage those risks, as well as an obligation to provide an annual report. These risks have traditionally been interpreted in relation to economic performance, although there is no express wording limiting the requirements to financial risks. There is therefore potential for ESG considerations to be included in the objectives of a fund and the risk management strategy.
Following on from publication of the governments Roadmap to Sustainable Investing, the FCA published a policy statement setting out rules and guidance in relation to a new climate related disclosures regime in December 2021. Those rules and guidance are based on the recommendations of the TCFD. The rules which form an ESG sourcebook within the FCA Handbook came into force on 1 January 2022 for UK firms with more than £50billion in assets under management and require disclosure reports to be made by 30 June 2023 (and on an annual basis thereafter), on how the firm takes climate-related matters into account when managing investments on behalf of clients and consumers, and disclosures on a product level. These disclosures are to be published on a prominent place on the firm's website and there is a core set of climate related metrics for the product specific disclosures.
Whilst the new requirements will offer more transparency and consistency upon climate related disclosures, it should be noted that for now, these rules will not apply to foreign asset managers that market their funds to investors in the UK and there is some flexibility around how group company disclosures are managed.
For SIPP operators and trustees, their duties will derive from trust law as well as the scheme rules and other establishing documentation. The trustee will have investment duties to deal with the SIPP investments in an appropriate way. This could include monitoring the ESG performance of an investment against claimed objectives. They will also have a duty to act at all times in the best interests of the beneficiaries of the SIPP. Whilst historically this has been interpreted as the best financial interests of the beneficiaries, arguably where ESG issues are in focus, that scope of duty widens out beyond the financial. Operators will also have a duty to act in accordance with the establishing SIPP documentation. Where that documentation has specific (that is, clearly defined and measurable) ESG targets or objectives as part of the SIPP investment objectives, then operators will have to have specific regard for those issues and ensure that their administration of the SIPP meets those requirements.
It is clear that ESG investments bring several fundamental challenges for fund managers and SIPP operators. None of these are insurmountable, but they require high levels of understanding of sustainability issues, a sophisticated knowledge of various measurables and an awareness of the risks of the undefined taxonomy that remains in use across ESG areas. Fund managers and SIPP operators will need to quickly upskill themselves to a high level of understanding of sustainability and ESG issues in order to ensure they do not breach their respective duties when managing ESG oriented investments, and manage investor expectations regards investments' expected and actual ESG performance. That will be the primary way to prevent or at least minimise complaints and claims arising in future.
If these challenges are successfully met, then the potential to work with investors not just for financial gain, but for positive environmental and social change is huge. That is surely a risk worth taking.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at June 2022. Specific advice should be sought for specific cases. For more information see our terms & conditions.
14 June 2022
Partner, Financial Services Disputes & Investigations London
Legal Director London
Insights 13 FEBRUARY 2023