Sustainable finance regulation fails to capture nuances

Centrally planned sustainability risks crowding out the enlightened investment it seeks to support

Natasha Landell-Mills, head of stewardship, Sarasin & Partners


Natasha Landell-Mills, head of stewardship, Sarasin & Partners

“I just pick stocks”. Until recently, this was the typical response of a portfolio manager asked to describe their job. This no longer washes. Today, asset managers are expected to promote environmentalism and enhance social wellbeing. At least, this is a goal of the European Sustainable Finance Disclosure Regulation and the UK’s equivalent expected to follow soon.

The problem is a gap between theory and reality is already apparent. While European regulators should be applauded for being first movers, the top-down approach risks back-firing. There are three flaws with the current approach.

First, the rules are premised on the 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, covering technical screening criteria for 70 climate change mitigation and 68 climate change adaptation activities, including criteria for the requirement any sustainable activity must ‘do no significant harm’ to other environmental objectives.

Broadly speaking, asset managers that hold companies involved in these sustainable activities can label products sustainable, and thereby tap into the growing public demand for green investments.

The trouble is companies cannot easily be split into sustainable and unsustainable. Is a solar panel producer sustainable if it depends on forced labour and coal-fired power? Is a cement company unsustainable, even though cement is vital for building hospitals, schools, housing and transport? What if it has committed to a 1.5C pathway?

Added to this, even if a company is not ‘sustainable’ today, it may be investing to become more sustainable in the future.

None of this nuance is captured by the current ‘sustainability’ categorisation – a criticism that led the EU Platform on Sustainable Finance to recommend extending the taxonomy to cover a wider range of ‘transitional’ activities critical to delivering sustainability tomorrow.

It is unrealistic to think any top-down framework, even if extended to define what counts as ‘transitional’, could ever manage real-world complexities, or the rapid changes inherent in the clean technological revolution.

A second problem is by prescribing what counts as sustainable, regulators undermine asset managers’ responsibility to think for themselves.The result is asset managers often treat sustainability as a tick-box compliance function, rarely stopping to consider the importance or veracity of the environmental and social data they are using.

Worse still, taking a more intelligent – but differentiated – view that captures a company’s strategy to become an enabler for sustainability, could expose asset managers to regulatory risk and accusations of greenwash. The resulting herding behaviour exacerbates the problem of capital misallocation and the goal of the regulatory effort to drive more enlightened investment is lost. 

A third flaw is what the regulators are missing: the need to ensure asset managers act as responsible owners of companies and drive sustainable behaviour. Rather than focusing on which businesses asset managers buy and sell, what matters above all is how capital is deployed by companies. Here, asset managers’ leverage is through their engagements with companies, backed by their voting. This is where regulators should focus.  

Asset managers must act

Asset managers’ failure to act as engaged and responsible owners is widespread. Whether we look at banks caught out in the global financial crisis, healthcare companies involved in the US opioid epidemic, or instances of fraud like Wirecard, shareholders continue to reappoint directors at annual general meetings come what may.

Asset managers’ passivity takes on added urgency in the face of the climate crisis. Majority Action’s latest research of voting found the vast majority of the 73 investors supported over 90% of directors at the largest US-listed carbon emitters. If signatories to the Climate Action 100+ initiative (representing almost $70trn in assets under management) choose to use their votes, the effect would be transformative.

While the notion of responsible ‘ownership’ is not new, follow-through has been weak. Under the proposed UK Sustainability Disclosure Requirements, the ‘sustainable improver’ label recognises the importance of engagement and voting to drive sustainability. The problem is that this remains optional.

Governments rightly want companies to become sustainable and view asset managers as a means to deliver this goal. The problem is centrally planned sustainability risks crowding out the enlightened investment it seeks to support, as asset managers delegate environmental and social analysis to tick-box compliance processes. What the world needs now is regulators to underscore asset managers’ role as responsible owners and to ensure this is delivered. This must not be optional.

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