Environmental, Social and Governance (ESG) Investment

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Last year around this time, I embarked on a project to provide a research document relating to Managed Portfolio Services as due diligence for one of my client firms.  That project mushroomed into a document of 165 pages of MPS containing details from  over 60 providers. If you want a copy of that document, please contact me.

In the course of my research for that report, there seemed to be a lot of providers who were majoring on their ESG credentials. On looking into this, I found that this is in preparation for the implementation of MiFID II regulation relating to the adoption of ESG investment principles. The EU Regulation on sustainability-related disclosures in the financial services sector (the Disclosure Regulation) came into force at the end of December 2019 and will apply 15 months later. It is yet another indicator that environmental, social and governance matters are growing in importance as a compliance issue for financial institutions.

There are some providers who are closely following this investment strategy and revolving their whole investment strategy around ESG investment. At the other end of the scale, I suspect some providers are labelling funds as ESG, but being little more than a tick-box exercise or greenwashing a portfolio to fulfil their obligations.

That means joining the dots between suitability and sustainability, regardless of whether the client has expressed any preference towards ESG investing.

Environmental, social and governance (ESG) investing takes into account ethical factors alongside financial markers in the decision-making process and has become more commonplace in the global investment space in recent years.

But greenwashing — a phenomenon of growing concern in the financial sector, which sees firms market products and investments to appear more sustainable and ethical than they really are — has been a thorn in the side of the responsible investment movement for many years.

I can remember arguing with a fund manager some years ago about the inclusion of the Daily Mail & General Trust in their ethical portfolio. The Daily Mail in an ethical portfolio? Really? But the answer that I received was that the group owned many local papers and they do good work in various communities around the country. So perhaps there was more depth to this than meets the eye.

Mifid II’s sustainable finance measures mean firms must explain what happens if clients say yes to interest in ethical investing

IFAs who have resisted ESG investing will now have to start taking ESG into consideration. And if IFAs fail to take heed of the proposed sustainable regulations , which are coming into force now, they could have to answer to the FCA.

In 2019,  the European Commission, in conjunction with the European Securities and Markets Authority, proposed changes to Mifid II to bring financial advice firms into line with the EU’s climate action plan through the integration of sustainability and ESG considerations. Assuming that Britain’s financial regulation remains aligned with the EU’s in the aftermath of Brexit, these changes could have a big impact on UK IFAs.

Dated 27 November 2019, EU parliamentary regulations stated advisers should ‘take sustainability risks into account in the selection process of the financial product presented to investors before providing advice, regardless of the sustainability preferences of the investors’.

That means joining the dots between suitability and sustainability, regardless of whether the client has expressed any preference towards ESG investing.

Additional transparency clauses in the EU’s report explained what advisers must include in their due diligence. These included the extent to which sustainability risks are integrated into investment decisions and an assessment of the likely impacts of sustainability risk on client returns.

‘Where 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,’ it said.

When a client shows interest in ESG, an IFA must have the knowledge and policies to ensure their clients receive suitable advice. A firm’s advice process will need to show how ESG funds are identified and how the IFA assesses one against another to ensure they can put together the appropriate products and funds to meet each client’s needs.

Is this just a short-term fad to enable the regulators to virtue signal to the world about their own ethical standards? Giving the industry a carte blanche to sell mor a certain types of funds to the gullible or the eco-warriors. Or is it that they genuinely care about future of our planet?

The original form of this type of investing, often known as ethical investing, was just negative/exclusionary screening – the screening out of companies or even industries based on specific criteria, such as a significant portion of the firm’s profit coming from: alcohol, gambling, tobacco or weapons; or the company using animal testing or child labour.

Such funds, however, usually had lower returns and higher risk compared to equivalent funds which had not been screened.

This is to be expected from a theoretical point of view – when investors limit their universe they risk underperformance and greater risk because they are not selecting the most ‘efficient’ set of investments – and is probably the main reason why this type of investing never really took off.

ESG investing involves searching out and including companies based on desired ESG characteristics rather than just excluding firms with undesirable business activities.

The approach involves a systematic consideration of specified ESG issues throughout the entire investment process in order to increase returns and reduce risk.

Using the Investment Association responsible investment framework, there are three different levels to ESG investing.

Exclusions, similar to the ethical investing described above, involves the exclusion of investments in certain situations.

Sustainability focus is where investment is made in companies on the basis of their fulfilling certain sustainability criteria and/or delivering on specific sustainability outcomes. companies and sectors from the fund or portfolio based on pre-defined criteria.

Impact investing is when investment is made with the intention of generating a positive and measurable social or environmental impact.

With the USA having re-joined the Paris agreement on climate change, it would seem that the countries across the world are now serious about climate change and this can only be good for the future of ESG investing.

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TC Compliance Services Tony Catt is a freelance compliance consultant working with several firms of different sizes. "I have previously been an adviser, which gives me a good understanding of the advice process and dealing with customers and I enjoy a close relationship with my adviser clients"

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