The goals set out for November’s COP26 climate summit in Glasgow make clear how little time there is to waste if the aim of securing net zero carbon emissions by the middle of this century is to remain achievable. All participating countries have been asked to come prepared to set ambitious 2030 emissions reductions targets, including accelerations in the phase-out of coal, the switch to electric vehicles and the transition to renewables, as well as increased action against deforestation.
The goals of the summit also emphasise the vital role that private capital will need to play in the journey to net zero – and advisers and their clients are already increasingly factoring sustainability considerations into their investment decisions. Of course, the urgency of the carbon transition is one reason why this is no easy task.
The drivers of portfolio risk are increasingly well understood but the impact of sustainability factors on those risk factors is not. This is a nascent and rapidly evolving field, and industry-wide standards of measurement and disclosure have not yet been established.
Read more: Portfolio Adviser’s Professionals’ Guide to COP26 and Beyond
In many cases, environmental, social and governance (ESG) factors are more challenging to quantify than other drivers of performance. And even where they can be quantified, there has simply not yet been sufficient time to assess their impact. As a result, the risk of introducing unintended biases into portfolios – and of setting clients up with expectations that will not ultimately be met – is unusually high.
Be prepared
Nevertheless, with climate change high on the agenda for governments, regulators, companies and households, waiting for a fuller picture is not an option. Advisers need to be prepared to have these conversations with their clients now – indeed, this is a valuable opportunity for those who are equipped to do so to demonstrate their worth.
So how can advice firms ensure they have the fullest possible understanding of how funds are approaching sustainability, so they can then ensure they are recommending approaches that are aligned with their clients’ preferences?
The Financial Conduct Authority (FCA) is well aware of the challenges, including in its 2021/22 business plan a pledge to develop high-quality climate and sustainability disclosures, as well as a commitment to tackle greenwashing. Furthermore, in June this year, the Treasury and the regulator committed to working together to develop a sustainable investment label.
Then, in August, the FCA wrote to the chairs of authorised fund managers to warn about the proliferation of poor-quality applications for launches of funds with a sustainable or ESG focus, and set out three ‘guiding principles’ for those managing sustainable products to follow.
A more structured regime is clearly on its way. In the meantime, the Investment Association’s definitions for responsible and ESG funds, established in November 2019, are a useful starting point, providing broad classifications of the various approaches to sustainable investing that funds may follow.
Shades of green
Within each band, however, there are many shades of green. ESG ratings from providers such as MSCI provide a valuable snapshot of the sustainability characteristics of a fund’s holdings. Even so, to gain a fuller picture, and to understand how a fund’s approach may evolve over time, it is more important than ever for advice firms to do their due diligence.
This means evaluating the extent to which managers are looking beyond third-party ratings and the headline information provided by companies. Are they engaging with the management of listed companies to gain a fuller picture? How are they ensuring a consistency of approach across companies, as well as across industries and markets? If they are talking publicly about the need for clear transition plans and improved disclosures, is this backed up in their voting record and engagement?
Approaches among managers vary widely – from those reliant on single external ratings providers to those using multiple inputs, to those who have built whole teams and developed internal scoring systems to conduct in-house research. The way these findings are used varies too and so understanding the extent of the influence sustainability considerations have on the investment decision is vital when seeking to match a fund with a client’s preferences.
Informed decision-making
The way information is communicated is also important. One of the guiding principles in the FCA’s letter to managers is that both ‘pre-contractual and ongoing periodic disclosures’ on sustainable funds should be made readily available to consumers. As well as doing the work behind the scenes, managers need to be prepared to share that work to support informed decision-making.
Over time, the parameters of sustainable investing will become more formalised, and the relationship between the various ESG factors and investment performance will become clearer. In the meantime, asset managers are best placed to understand the sustainability characteristics of the companies that make up any underlying portfolio, and to help advisers understand how those characteristics align with client preferences – both before investment and on an ongoing basis.
In a complex and evolving landscape, transparency throughout the process – from manager to adviser to client – is required to support the alignment of investment approaches with client needs.
Ben Goss is CEO of Dynamic Planner. This article first appeared in Portfolio Adviser’s Professionals’ Guide to COP26 and Beyond
