“I just pick stocks”. Until recently, this was the response you would normally hear from a portfolio manager asked to describe their job.
This no longer washes. Today, asset managers are expected to promote environmental protection and enhance social wellbeing. At least, this is a goal of the European Sustainable Finance Disclosure Regulation (SFDR). Similar UK Sustainable Disclosure Regulations (SDR) are expected to follow in coming months.
The problem is that a gap between theory and reality is already apparent. The top-down approach being adopted risks back-firing. There are three flaws with the current approach.
First: the rules are premised on a notion that regulators can neatly define what activities are sustainable
The Technical Annex to the Final Report on the EU Taxonomy runs to 593 pages. It covers technical screening criteria for 70 climate change mitigation and 68 climate change adaptation activities. This includes criteria for the requirement that any sustainable activity must “do no significant harm”[1] to other environmental objectives.
Broadly speaking, asset managers who are invested in companies involved in these sustainable activities can label their products sustainable. Thereby they can tap into the high public demand for green and ESG-tilted investments.
The trouble is that companies cannot easily be split between good and bad (or sustainable and unsustainable) in this manner. Is a solar panel producer sustainable if its supply chain depends on forced labour in Zhejiang and coal-fired power? Is it right to claim a cement company is unsustainable, even though cement is vital for building hospitals, schools, housing and transport infrastructure? What if it has committed to a 1.5°C-pathway? A world covered in solar farms without housing or roads would not be hospitable.
Added to this, companies are not static. Even if they are not ‘sustainable’ today, they may be investing to become more sustainable in the future.
None of this nuance is captured by the current ‘sustainability’ categorisation. As such, the EU Platform on Sustainable Finance recommended the Taxonomy be extended to ensure it covered a wider range of ‘transitional’ activities. These will be critical to delivering sustainability tomorrow[2].
While the European Commission has yet to formally respond to these recommendations, it is unrealistic to think any top-down framework, even extended to define what counts as ‘transitional’, will ever be able to manage real-world complexities, or the rapid changes inherent in the clean technological revolution that is underway.
Secondly: by prescribing what counts as sustainable, regulators undermine asset managers’ responsibility to think for themselves
The result is that asset managers too often treat sustainability as a compliance function. They tend to tick environmental and social boxes in their process, and never stop to think about either the importance or veracity of the environmental and social data they are using.
Worse still, taking a more intelligent – but differentiated – view that, for instance, captures a company’s strategy to become an enabler for sustainability amongst its customer base, could expose asset managers to regulatory risk. They would need to justify how they arrived at a different conclusion to everyone else. They would be exposed to accusations of greenwashing. Few would choose this path. This herding behaviour only exacerbates the problem of capital misallocation. The regulatory effort’s objective to drive more enlightened investment is lost.
Thirdly: we need to ensure asset managers act as responsible owners of companies and thereby ensure more sustainable behaviour
Rather than focusing on the companies that asset managers buy and sell securities in, what really matters is how companies deploy capital on the ground. Here asset managers’ leverage is through their engagements with companies, backed up by their voting. This is where regulators should be focusing their energy.
Asset managers’ failure to act as engaged and responsible owners is widespread. Whether we look at banks caught out in the financial crisis of 2007/’08, healthcare companies involved in the US opioid epidemic, or individual instances of fraud like Wirecard – shareholders seem unmoved. They continue to pay little attention to what they vote for and reappoint directors at annual general meetings, it seems without question.
The problem of asset managers’ being asleep at the wheel takes on a new level of urgency in the face of the climate crisis. According to Majority Action’s latest research of asset manager voting at the largest US-listed carbon emitters[3], the vast majority of the 73 investors supported over 90% of directors. Signatories to the Climate Action 100+ initiative represent almost $70 trillion in assets under management. If they choose to use their votes, the effect would be transformative.
While the notion of responsible ‘ownership’ is not new – the EU’s Shareholder Rights Directive and UK Stewardship Code, for instance, underscore these important responsibilities – the follow-through has been weak. Under the proposed UK SDR, the ‘sustainable improver’ label rightly recognises the importance of engagement and voting to drive sustainability. The problem is: this remains optional.
Encourage responsible ownership from asset managers
Governments want companies to become sustainable and view asset managers as a means to deliver this goal. Their instinct is right. The problem is that centrally-planned sustainability risks crowding out the enlightened investment that it seeks to support, as asset managers delegate environmental and social analysis to tick-box compliance processes. This approach risks neutering one of the most powerful levers to drive positive change. What the world needs now more than ever is for regulators to underscore asset managers’ role as responsible owners and to ensure this is delivered. This should not be optional.
[1] Technical Annex to the TEG Final Report on the EU Taxonomy
[2] https://finance.ec.europa.eu/system/files/2022-03/220329-sustainable-finance-platform-finance-report-environmental-transition-taxonomy_en.pdf
[3]https://www.majorityaction.us/climate-action100-report-2023