In 2020, sustainable investing is a hotter than ever topic and it’s clear that finance professionals can no longer allow themselves to ignore environmental, social, and governance (ESG) issues in their investment analysis and decisions.
You may have come across it as ESG-compliant investing, responsible investing, or green finance – all these names describe the need for a more considerate approach to measuring the impact of investment decisions. Long under the carpet in the finance industry, this need is here today more than ever, pushing its way up the priority lists of forward-thinking investors.
From fig leaf to key issue
In 2005, the world’s largest institutional investors, supported by a group of industry and civil society experts, joined a process spearheaded by the then-UN Secretary-General Kofi Annan to develop the Principles for Responsible Investment (PRI).
Despite the early start, ESG-compliant investing remained a marketing-glossy fig leaf until 2015, when the Sustainable Development Goals (SDG), a set of international commitments to end poverty and build a better world by 2030, were adopted by the United Nations General Assembly. At the same time, the UN Climate Change Conference Paris 2015 was aiming to achieve a legally binding and universal agreement on climate action worldwide.
A remarkable example of this kick-off was the call-to-action speech of the then Bank of England Governor Mark Carney titled “Breaking the tragedy of the horizon – climate change and financial stability” in September 2015.
“The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity. While there is still time to act, the window of opportunity is finite and shrinking,” Carney warned.
Since then, the issues of sustainable investing have steadily been making their way onto the agenda of institutional investors, financial policy makers and supervisors. For the first time, finance specialists seriously began a trial and error loop on how to make sense when measuring desired and undesired impact. Only recently, regulatory initiatives turn into normative guidance, as seen in last year’s EU taxonomy for sustainable activities.
As Governor Carney concluded in his speech: “With better information as a foundation, we can build a virtuous circle of better understanding of tomorrow’s risks, better pricing for investors, better decisions by policymakers, and a smoother transition to a lower-carbon economy.”
SDG compliance can give you a competitive edge
After the global financial crisis in 2008-09, investment professionals that manage other people´s money loudly opposed re-regulation initiatives, complaining they have been too constricted in meeting their investment objectives and buried in administrative compliance work.
While this is partly true, we cannot leave aside the fact that legal frameworks like the Business Judgement Rule would allow asset owner representatives to take entrepreneurial decisions without facing litigation risks. They just have to act on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the asset owner. Due to convenience, complacency or ignorance by decision makers in charge, the leeway that comes with this regulatory safe-harbour is hardly being utilized.
Since 2016 regulators understood that more rules not necessarily lead to a more robust financial system. They now rather focus on inducing a culture of compliance through rules of better quality. For instance, the reviews of MiFID II or Solvency II in 2020 will breathe a different spirit, one that holds decision makers more accountable for doing the right things right.
Regulators are clear. In the years ahead, SDG compliance will not be another checklist exercise for boards, investment committees or portfolio managers. Professional investors cannot delegate their responsibility for understanding what they are doing to rating agencies, ESG databases or consultants.
Simply put, being SDG-compliant offers an opportunity for investment decision makers to strengthen their comparative advantage through innovative specialization.
Build advantage through narrative reporting
Life happens path-dependent. Causality is a feature of life.
Investment professionals are about to learn that. They now realize that they cannot fully understand the impact of their decisions by staying tucked in the same correlation-based mindset. What about those that don´t realize it yet? They can count on a nudge from regulators, for instance through setting standards for narrative reporting.
There is a growing consensus in the finance industry that narrative reporting plays a critical role in putting performance into proper context. It enables investors to stay compliant by switching from data creation, collection and reporting to evidence-based, causality-driven reasoning.
Here an example of how regulators will emphasize narrative reporting to run plausibility checks on whether professional investors know what they are doing: in January 2016, the PRI and UNEP FI (Finance Initiative) launched a four-year project to clarify investor obligations and duties (fiduciary duties) in relation to the integration of ESG issues in investment practice and decision making.
Their conclusions were published in the ‘Fiduciary Duty in the 21st century – Final Report’. The findings were perhaps best summarized by the US SEC Commissioner: “What you need to be is rigorous. What you must have is an explanation for the choices you make.”
The views and opinions expressed in this article are those of Markus Schuller and his team at Panthera Solutions and do not necessarily reflect the views and opinions of Monaco Life.
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