Our September Investment Forum featured ESG experts Mikkel Bates from FE Fund Info, and Elizabeth Stuart and Anastasia Georgiou from Morningstar. In this post, we collected the advisers’ central questions about ESG regulations, discussing ESG with clients, and incorporating ESG into an advice practice for our experts to answer.
Question 1: What information will advisers be required to include on the websites about the ESG approach? How should advisers balance meeting regulations by publicizing their process and following what individual customers want?
FE Fundinfo: The short answer now is “they won’t be required to include anything”. The disclosure obligations of the EU’s Sustainable Finance Disclosure Regulation (the Disclosure Regulation or SFDR) will not apply to firms in the UK, as they don’t come in until after the end of the Brexit transition period, so will not be copied across into UK law
Instead, the FCA will undertake a consultation during the first half of 2021 into how best to implement the Treasury’s goal of aligning its ESG reporting with the Task Force on Climate-related Financial Disclosure (TCFD) recommendations.
That said, it wouldn’t hurt to apply the principles in the SFDR, as investor interest in ESG is rising rapidly, through a combination of climate concerns, media focus, fund groups emphasising their ESG credentials and because the UK government has stated that it intends to match the ambitions of the EU’s ESG disclosure rules.
The SFDR requires advisers to take an active stance on sustainability, rather than simply responding to requests from clients. It says “financial advisers should disclose how they take sustainability risks into account in the selection process of the financial product that is presented to the end investors before providing the advice, regardless of the sustainability preferences of the end investors.”
As well as asking clients whether they wish to incorporate ESG factors in their investments, if the FCA decides to adopt the. SFDR framework advisers would be required to post a statement on their website saying “whether and how they take into account adverse sustainability impacts within their investment or insurance advice”.
Under SEDR the information they provide “should clearly spell out how the information provided by financial market participants [eg fund groups] is processed and integrated in their investment or insurance advice. In particular, should the financial adviser rely on adverse sustainability impacts criteria for integration of financial products or financial market participants within the advisory portfolio, such criteria should be stated.”
The level 2 Regulatory Technical Standards (RTS) – which have been parked by the European Commission for the time being, but will come in later – instruct that the following information shall be posted on an adviser’s website in a separate section headed ‘Adverse sustainability impacts statement’:
“information as to whether, taking due account of their size, the nature and scale of their activities and the types of financial products they advise on, they consider in their investment advice or insurance advice the principal adverse impacts on sustainability factors.”
If the adviser does not consider sustainability adverse impacts in their advice, they must post the following information in a section of their website headed “No consideration of sustainability adverse impacts”:
“information as to why they do not to consider adverse impacts of investment decisions on sustainability factors in their investment advice or insurance advice, and, where relevant, including information as to whether and when they intend to consider such adverse impacts.”
In the latter case, “that section shall start with a prominent statement that the financial adviser does not consider the adverse impacts of investment decisions on sustainability factors in their investment advice or insurance advice. The clear reasons for why the financial adviser does not do so shall include, where relevant, information on whether and, if so, when it intends to consider such adverse impacts.”
Morningstar: Answered questions 1 & 2 together
Question 2: What do advisers need to know about the new regulations coming in March 2021 and January 2022?
FE Fundinfo: As well as the SFDR and Taxonomy Regulation, ESG factors are being incorporated into MiFID II, UCITS and AIFMD, to ensure that, where appropriate, ESG factors are included in those rules.
Although, again, the new MiFID rules won’t apply in the UK, financial advisers shall include descriptions of the following in their pre-contractual disclosures under MiFID II or the Insurance Distribution Directive, as 1 § applicable:
“(a) the manner in which sustainability risks are integrated into their investment or insurance advice; and
(b) the result of the assessment of the likely impacts of sustainability risks on the returns of the financial products they advise on.
Where financial advisers deem sustainability risks not to be relevant, the descriptions referred to in the first subparagraph shall include a clear and concise explanation of the reasons therefor.”
Under revisions to MiFID II, periodic reports prepared by investment firms from 2022 to explain to clients how the recommendation meets their investment objectives, risk profile and capacity for loss bearing should also include their ESG preferences.
Morningstar: The imminent requirements of the SFDR have been taken off the table, courtesy of Brexit. That said, the UK government committed in its 2019 Green Finance Strategy to at least match the ambitions of EU work. With that in mind, coupled with the continued growth of ESG investing, we think it’s still good practice for advisers to use the EU work as a guide. With the time pressure alleviated, the principles of the disclosures and the practices that they shed light on will still be useful to many investors.
The EU rules say that from 10th March EU advisers must explain how they integrate sustainability risks in their investment advice and whether they consider the principal adverse impacts on sustainability factors. The information should be published on their websites in a separate section titled, “Adverse sustainability impacts statement” with details on the process to select the financial products on which they advise
The statement should include how the information published by financial-market participants is used; whether the financial adviser ranks and selects financial products based on principal adverse impacts, and, if so, a description of the ranking and selection methodology used; and any criteria or thresholds used to select financial products and advise on them based on those impacts. Advisers must also explain how their remuneration policies are consistent with the integration of sustainability risks, as well as the likely impact of sustainability factors on returns of the financial products on which they advise.
In most cases this will be a pass-through of information taken from the disclosures of the financial-products being advised on and recommended.
A similar situation exists with regards to the pending MiFID requirements on advisers to understand clients ESG preferences as part of know your client and suitability processes.
Question 3: How can advisers make sense of the different rating systems evaluating ESG aspects? For example, what is a ‘good’ carbon footprint?
FE Fundinfo: While there will continue to be differences in approach, we expect that both ESG rating providers and the fund groups that use them will explain what is considered as part of the evaluation process.
Morningstar: Firstly, it’s crucial that the adviser understand the approach taken by the rating’s provider, so they understand the different views and approaches and make an informed decision on the provider(s) they use.
More uniform ESG ratings would not necessarily be a good outcome for investors, having diversity of views is a good thing, you wouldn’t expect stockbrokers to always issue the same buy/sell recommendations.
In terms of carbon footprint, the best way to describe what is good to a client is to firstly make sure that the client can relate to the emissions for example 100 tonnes of emissions = x number of round trip flights to NY, then provide them with a benchmark so they can measure how their fund or portfolio compares to that benchmark. If the client is focussed on climate change you could use a climate change benchmark as an example. For a company to have a ‘good carbon footprint’ it must be efficient relative to its peers and its output. Therefore it is useful to compare companies against one another normalized by an appropriate metric such as revenue, floor area or no. of employees. For example, it would not be appropriate to only normalise an oil company’s emissions by revenue as this will fluctuate with the price of oil. Should oil prices go up, the companies footprint will seem to reduce however there will be no improvement in actual emissions. Similarly, a consultancy firm will have a low scope 1 and 2 footprint (as they typically only occupy office space in modern cities) while hiding needless business travel emissions in the lesser reported, Scope 3 emissions.
Also, it is important to be wary of ‘carbon neutrality’. A carbon neutral company is not necessarily a low carbon company. Carbon neutrality simply means paying to offset your carbon footprint (by planting trees or investing in renewable energies) therefore one could have an unacceptable high carbon footprint but pay a lot of money and say its ‘neutral’.
Question 4: What are some good ways to explain ESG to clients who don’t know much about it or are more interested in returns than sustainability?
FE Fundinfo: It is important for advisers to explain what the regulations mean by ESG before asking them whether they wish to consider it in their investments, as a lack of direction could lead to a wide range of responses based on individuals’ personal values which may or may not be aligned with ESG considerations.
Morningstar: In explaining ESG, it will be important to communicate that this is not a simple topic and is multi-faceted. Advisers could talk about this in a 3 point framework that covers values, ESG risks and impacts.
Investors may be interested in sustainability but, of course, they also still strive to achieve competitive returns. Fortunately, a growing body of evidence suggests that using sustainable investments generally has not reduced risk-adjusted returns to date.
In a recent study, Morningstar researchers found that investors that focus on companies with positive ESG attributes generally do not sacrifice returns, although there may be a small ESG premium in the US. And according to a US Government Accountability Office meta-analysis, 88% of studies into the relationship between ESG factors and financial performance have found that using ESG information does not reduce financial returns.
In short, picking investments that score better on ESG metrics at the margin or as a tie-breaker could be a reasonable strategy for investors who want their investments to reflect their values.
However, there is no guarantee that this relationship will continue in the future. Advisers have a responsibility to communicate this potential risk, as they would any risk. For example, one risk might be that as more investors are looking for companies that perform well on ESG metrics, they might increasingly pay a premium to invest in them, which could reduce future returns.
A strict adherence to ESG criteria can also lead to large sector, market-cap, and geographical deviations from the market. At a minimum, investors weighting towards ESG preferences are making an active bet (whether they realise it or not) that the market has not fully priced in these factors, which may or may not pan out.
Question 5: Will ESG become considered in investing similarly to risk?
FE Fundinfo: Sustainability risks (defined in the SFDR as “an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment”) will need to be considered as part of the fund selection process. These will therefore become another category of risk to be considered.
EU policymakers clearly believe that consideration of sustainability and ESG should improve the likelihood of an investment surviving for the long term, thereby reducing the risk of loss over time (although not the volatility of its value).
Morningstar: ESG is considered a method through which to examine non-financial risks. This is why ESG risks are sometimes termed ‘pre-financial’ data. This means that poor governance in social and environmental activities may open a company up to fines, sanctions, expensive litigation and incur financial hardships. A company which properly manages its ESG is less likely to run into these financial or reputational risks down the line.
Question 6: What are some ways that advisers can evaluate companies that have a positive impact in some ways and a negative impact in others?
How should advisers look at impact vs. sustainability?
FE Fundinfo: The Taxonomy Regulation sets out the following six environmental objectives:
(a) climate change mitigation;
(b) climate change adaptation;
(c) the sustainable use and protection of water and marine resources;
(d) the transition to a circular economy;
(e) pollution prevention and control;
(f) the protection and restoration of biodiversity and ecosystems.
In addition to considering the positive impacts of companies on any of these objectives, funds should also aim to “do no significant harm” on any of the others.
Morningstar: The question raised on impact vs. sustainability is a very pertinent one, since the fact that a company has a positive impact on some ESG aspects, does not necessarily mean that it is doing overall well on ESG from a broader perspective.
It might indeed be the case that a company that offers products and services that have a positive impact on the environment and society, have other types of issues that have a negative impact on other stakeholders.
Example: Tesla only offers electrical vehicles and therefore has a positive impact when it comes to carbon emissions, but if we look at the broader picture the company is also exposed for instance to business ethics, product governance and human capital issues.
You can find the ESG Risk Rating company profile for Tesla here.
Or it could be that a company that operates in a sector which is well known for its negative impact, is in the process of diversifying its business model and offering more sustainable products.
Example: Engie is part of the electrical utilities sector, which is one of the most greenhouse gas emissions intensive sectors. While it is exposed to high impact fossil fuel, it has set targets to reduce its carbon emissions and is transitioning to an energy mix that is focusing more on renewable energy.
You can find the ESG Risk Rating company profile for Engie here.
Question 7: What are the main differences between UK, EU, and US regulations for ESG and sustainable investment?
FE Fundinfo: The EU regulations will apply to all funds marketed in or into the EU, wherever they are based. The UK has stated that it plans to match the ambition of the EU regulations following the end of the transition period, but has stated that it will not apply the reporting requirements of the SFDR (or the RTS that will be adopted later).
Instead, the FCA will consult on the proposed roadmap to align the UK’s ESG reporting requirements with those of the Task Force on Climate-related Financial Disclosure (TCFD), with obligations coming in for different company types between 2021 and 2025.
We are unable to comment with any insight into US regulations.
Morningstar: 2021 will start to see some divergence between the UK and EU. However, as detailed in our response to Q2, the UK government is committed to matching the EU ambitions. The FCA will are also aware of the operational challenges that would arise from firms having to conform to two sets of rules when they operate in the EU as well as the UK, and this is likely to limit the extent of divergence between the two regimes.
By way of comparison, the US is markedly different and we like to summarise it by saying ‘in Europe, advisers have to explain why ESG isn’t considered, while in the US they must explain why it is’. For the really keen we explored the issues in the attached paper. In essence, the US position is that investments should be selected to meet financial aims and restricting investment choice via ESG factors may dilute meeting those aims.
Question 8: What are some tips for facilitating a conversation with clients around sustainability and the issues that they’re individually interested in?
FE Fundinfo: Without the clarity afforded by the draft RTS, there are no hard-and-fast rules around what should be considered within such a conversation, but it would be advisable to start by leading with what fund groups mean by the terms used. This has been helped by the Investment Association’s Responsible Investment Framework, which is essentially a glossary of the key terms that have come into use in the fund industry over the last 30+ years without any previous guidelines. The framework is available at https://theia.org/sites/default/files/2019-11/20191118-iaresponsibleinvestmentframework.pdf . Failing to take the lead in this discussion could result in clients expressing a wide range of personal values, which may not be considered by any sustainable investment funds.
Morningstar: As outlined earlier, when talking to and explaining ESG to clients the 3 point frame work covering Values, ESG risks and Impacts will also work in facilitating a conversation around Sustainability.
- Is the client motivated to align their principals to their investments, this can often align to exclusions of certain product types from the portfolio such as Tobacco and/or Controversial
- Understand if your client is motivated more by the risks and financial impacts of ESG? Are they concerned that their portfolio might be exposed to companies that are not managing their environment, social and governance factors well which could have a negative impact on the value of those companies?
- Does the client want to make the world a better place? Are they motivated to have a positive impact in a specific area, such as clean water or the climate
Question 9: What extra technology do advisers need to incorporate ESG considerations? How can an ESG perspective be included efficiently without wasting time/money in a time of changing regulations?
FE Fundinfo: The regulations have stated that they take account of the principle of proportionality, so advisers should need no additional technology, provided they have access to fund ESG ratings and they are able to consider what factors they take into account when selecting funds.
Morningstar: As mentioned earlier, advisers will have to publish how they integrate sustainability risks in their investment advice and whether they consider the principal adverse impacts on sustainability factors and publish them on their website. So Advisers need to decide how they will manage this, it would seem sensible to have access to an independent source of ESG data and research to provide this, Morningstar is one of the providers that can support advisers with data and research.
Questions 10: Will everyone need to outsource to ESG specialists in the near future?
FE Fundinfo: The expectation is for ESG/sustainability to be embedded in the mindset and processes adopted by all financial market participants and advisers, so explaining how it is incorporated in the advice process should not require external specialist assistance. This is also true of the requirement to explain what factors are taken into account when considering whether investment products meet their ESG criteria.
Morningstar: That is a choice available to advisers, but given Sustainability is going to become another lens with which to assess investments over the long term, it makes more sense to spend some time in getting educated. Morningstar believe that ESG education is the first step to incorporating ESG within your practice.
Question 11: How can advisers better understand the UN sustainability goals and their relation to current regulations?
FE Fundinfo: The Paris Agreement on climate change and the UN 2030 Agenda for Sustainable Development (which has at its core the 17 UN Sustainable Development Goals) underlie the obligations of the Taxonomy Regulation and the SFDR. However, the six environmental objectives listed in Q.6 are the key drivers of the reporting requirements.
Further information on the SDGs is available at: https://www.un.org/sustainabledevelopment/sustainable-development-goals/.
Morningstar: The EU has considered the UN goals within many aspects of its rules and so, in some ways, they are already in-built in the regulations.
Question 12: Are sustainable funds a better long-term investment for consumers?
FE Fundinfo: It is not possible to answer this question objectively. However, policymakers and regulators have said that they believe sustainability considerations need to be considered as part of long-term investment. While sustainability considerations may help ensure the long-term continuity of an investment, it is no guarantee of the performance of its share price or of the volatility of returns.
Morningstar: Morningstar recently published a paper on the performance of ESG funds. Typically sustainable funds perform well and withstand market shocks such as the Covid-19 crisis better than traditional offerings. There is more work to be done on isolation the exact cause for this but it is likely that companies with strong ESG credentials typically have more conservative balance sheets and do well during periods of market uncertainly.
Please find the white paper on European Sustainable Fund Performance here.
Question 13: How can advisers effectively show their clients the positive impact that their investments are creating?
FE Fundinfo: It is important to be clear from the beginning of the relationship or the investment how the selected investment fits in with the client’s ESG criteria. Using the fund group’s periodic reports on the investment (which, over time, will include historical comparisons), it will be possible to report to the client how the investments are achieving their ESG objectives.
Morningstar: The thrust of the EU periodic disclosures will help with this, as they will require actual metrics to be published, which will be able to be tracked over time. other bodies, TISA for example, are doing work on visual display of ESG data and impacts.
Question 14: How can advisers work around the issue of their fiduciary duty coming into conflict with their efforts to invest sustainably?
FE Fundinfo: Fiduciary duty is defined as the “requirement of institutional investors and asset managers to act in the best interest of their end-investors/beneficiaries”. The intention of the regulations is to “(i) explicitly require institutional investors and asset managers to integrate sustainability considerations in the investment decision-making process [as part of their fiduciary duty] and (ii) increase transparency towards end-investors on how they integrate such sustainability factors in their investment decisions, in particular as concerns their exposure to sustainability risks.”
Morningstar: This gets to the heart of the EU/ US differences discussed above. It’s why the principles of the upcoming MiFID amendments to understand a clients ESG preferences are so important. With that information, advisers are then better equipped to make recommendations and highlight any potential trade-offs between financial returns and ESG goals. The growing library of work comparing the effects of ESG filters on investments will also have a part to play.