ESG investment is surging. ESG bond fund sales are now worth more than $50bn and have tripled in three years. In equities, investors are increasing their demands on companies. After six months, 2021 has already seen a record number of ESG shareholder resolutions passed.
As investment activity grows, so does regulatory scrutiny. The ESG credentials of all companies are under the microscope. With product offerings multiplying there is rising concern about greenwashing under the ‘E’, and similar scrutiny will soon follow under ‘S’. What began as investor, NGO or media concerns are now firmly on the desk of regulators.
In green finance the ‘E’ is becoming better understood by investors and policymakers. The Bank of England and their counterparts already consider climate risk as a financial stability issue and have devised a programme of stress-testing. Similarly, the Taskforce on Climate Related Financial Disclosure is being transposed into national law in the UK, EU and other jurisdictions.
There is growing interest, but not yet regulatory clarity, around the ‘S’ in ESG. In the UK, there are live debates around whether the Companies Act and directors’ duties should be amended to take account of a wider array of stakeholders and communities. As investors express stronger interest in the question of purpose, regulators are likely to follow.
Financial services firms need to understand where the risk could be in their portfolio. This risk should be mitigated through portfolio management and asset allocation whilst also working with regulators to shape ESG policy.
The policy process will not be straightforward. Social risk is less easily identifiable than climate risk, but intangible assets like brand and customer loyalty can be wiped out overnight and licences to operate lost. The risk is less science-based and harder to measure - on data and disclosure, what are the ‘S’ and ‘G’ equivalents of carbon emissions?
Measures can be found for ‘transition risk’ – where a change in government policy or regulation significantly reduces the value of assets. But given the breadth of issues in ‘S’ and ‘G’, their subjective and cultural nuances and the vagaries of measuring outcomes, this process is fraught with political uncertainty.
Recent regulatory initiatives in ESG deserve careful engagement. They include the FCA’s commitment to drafting an ESG rulebook; the EBA’s Report on Social Risk for credit institutions and investment firms; and the suggested ‘Social Taxonomy’ – an ambitious attempt to define what is and isn’t ‘socially good’ for investors and clients. Capturing this in law will be hugely complex.
The market is beginning to manage ‘social transition risk’, as evidenced by the Deliveroo IPO, where institutional investors pointed to gig-economy labour-force issues and governance questions around dual-class shares.
What approach will regulators take? The FCA is concerned with investor protection and accurate provision of market information. It won’t seek to make policy judgements on what should and should not be an ESG consideration, but will seek to ensure that market participants and investors have access to the information they require and care about.
Who will determine what information this is? For example, wages are likely to be an important ‘S’ consideration. Paying the UK National Living Wage is a legal requirement but what about the pay differential between low paid staff and the CEO? As investors start to pay attention to such measures, and under pressure from politicians, NGOs and the media, the FCA may start to write them into the rulebook.
Other issues in scope are likely to include gig economy status, in-work welfare, upskilling and training, corporate tax planning and governance standards including board composition.
As with the GreenTaxonomy, regulators will have to make determinations about transition – not just whether a company is ‘good’ or ‘bad’ but its prospects for improvement. A company may have poor ESG scores, but if a fund has an approach to stewardship that can improve social outcomes it would be counterproductive to exclude the stock. That would raise their cost of capital and reduce the prospect for change.
The outcome of these regulatory initiatives will determine how ESG products are labelled and marketed, what their underlying assets can be and how they are managed. For corporates, correct positioning on these products and indices will influence capital raising opportunities through specialist bond markets, and cost.
The mainstreaming of ESG moves investors away from tick box compliance and into complex areas of political economy. It will be be vital for firms and their investee companies to engage in this process for several reasons.
The first is managing ESG transition risk in portfolios. It will be important to understand the regulator’s point of arrival in advance to avoid assets becoming devalued or ‘stranded’. Governance processes can mitigate this risk. Secondly, as ESG becomes a matter of regulation, differentiation and leadership will be harder to achieve in an increasingly crowded space.
Finally, we should expect these shifts to occur in both public and private markets. Given that public markets present exit opportunities for private equity, standards and approaches will need to be aligned. To avoid ‘social arbitrage’ it will be important to ensure that interventions apply across different ownership models.
ESG has so far been a question for firms and markets – but the role of regulators is growing and will be very significant. Every business needs to anticipate where their regulator(s) may land and prepare for this. There are acute risks to be managed but also significant opportunities to show leadership, attract cheaper funding, and improve brand and profile with customers and community stakeholders.
Simon Horner is a Director at Flint. He wrote this piece with input from Flint Partner Mary Starks. To find out more about how Flint can help you navigate the risks and opportunities of these developments get in touch.