With a plethora of terms and acronyms associated with sustainable investing, there is a responsibility on asset managers to clearly articulate not only whether and to what extent ESG considerations are taken into account in their investment decision-making processes, but also the sustainability impacts of their own businesses. Many managers want to make investments that are considered to be sustainable, but they face several challenges from both a regulatory and an investor relations perspective.
Focus on greenwashing and the challenge this presents for asset managers
One of the challenges currently facing asset managers is how to ensure that their sustainability efforts are not construed as ‘greenwashing’. With an ever-increasing focus by regulators on greenwashing and the risks that it presents to the financial markets, managers need to take care in formulating and updating their sustainability frameworks and implementing their ESG policies and procedures.
Where a determination has been made that ESG considerations will be taken into account as part of a manager’s investment decision making process, it is typical for an ESG policy to be adopted by the manager setting out the details of the approach(es) being taken by the manager in respect of ESG issues. Where such a policy is adopted, the manager must make sure that the policy is being adhered to. The views of regulators should be front of mind when undertaking this work.
While the term ‘greenwashing’ traditionally referred to a company providing misleading information about its environmental credentials and the impact of its business operations on the environment (i.e. purporting to be environmentally conscious for marketing purposes but not actually making any notable sustainability efforts), the concept has developed and broadened. In the context of the asset management industry, the International Organisation of Securities Commissions (IOSCO) has stated in its final report setting out recommendations on sustainability-related practices, policies, procedures and disclosures in asset management (IOSCO ESG Recommendations) that the term “refers to the practice of misrepresenting sustainability-related practices or the sustainability-related features of investment products”.
Interestingly, in its Sustainable Finance Roadmap 2022–2024 the European Securities and Markets Authority (ESMA) notes “that greenwashing focuses on the environmental aspect (E) in the ESG concept. When also the social and governance aspects (S and G) are added, this is referred to as ESG-washing. The Sustainable Finance Roadmap uses the term ‘greenwashing’ since this is the term employed in the 2021 EC Strategy, however, in due course issues related to social- and governance-washing could also be addressed under this heading.” and states that “the term greenwashing refers to market practices whereby the publicly disclosed sustainability profile of an issuer and the characteristics and / or objectives of a financial instrument or a financial product and the related processes do not properly reflect the underlying sustainability risks and impacts”. While these terms differ slightly, the general concept is the same and such activity can equate to misrepresentation, mis-selling or mislabelling.
In March 2021, the US Securities and Exchange Commission (SEC) created a Climate and Environmental, Social, and Governance Task Force (ESG Task Force) within the Division of Enforcement, for the purpose of identifying and investigating violations related to ESG.
It is likely therefore that 2022 will see an increased degree of SEC scrutiny of ESG investing. Already this year, the SEC announced: (i) proposed rule changes that would require relevant entities to include certain climate related disclosures in their registration statements and periodic reports; and (ii) its 2022 examination priorities.
It is no surprise that ESG investing is highlighted as a priority issue with a focus on ensuring that registered investment advisers and registered funds are accurately disclosing their ESG investing approaches and whether there are misrepresentations of the ESG factors considered or incorporated into portfolio selection. In addition, the SEC has released an explainer video on ESG investing where its Chairman, Gary Gensler, states that where funds are being marketed as sustainable or green “investors should be able to drill down and see the ingredients underlying these funds”. It is certainly true that without a regulatory framework, asset managers claiming their funds are targeting ESG goals do not have to disclose, to any set standard, information regarding the criteria being met to support this. Even where there is a regulatory framework in place, for example in Europe, where the Sustainable Finance Disclosures Regulation (SFDR) has been implemented, there remains a risk of greenwashing.
While the intention of the EU legislators was that SFDR would encourage transparency on the extent to which a financial product could be considered to offer investors exposure to sustainable investments, it has resulted in a classification system being unofficially adopted with an increasing number of investors only considering allocating capital to products that promote environmental or social characteristics (known as Article 8 products) or products that have sustainable investment or the reduction of carbon emissions as their objectives (known as Article 9 products).
As a result there is pressure on asset managers from fund allocators to categorise their funds as either Article 8 or Article 9 funds and this increases the risk that although there is an emphasis on promoting environmental or social characteristics or investing in sustainable investments in the documents provided to investors, such disclosures do not reflect the extent to which ESG considerations are taken into account in the investment decision making process.
The approaches taken by asset managers in terms of categorising funds has varied widely. The challenge for asset managers in this regard is that the types of products that can be considered to fall within scope, of Article 8 in particular, are extremely broad and, as such, managers may be at risk from greenwashing claims. When the initial disclosure requirements came into effect on March 10 2021, more conservative asset managers erred on the side of caution in terms of funds being identified as falling within the scope of Article 8 in particular, given the lack of certainty as to what constituted “promotion of environmental or social characteristics”.
Guidance issued by the European Commission in July 2021 in the form of responses to queries raised by the European Securities and Markets Authority (ESMA) on SFDR highlighted how broad the scope of Article 8 is and emphasised that financial products falling within its scope “have a sustainability-related ambition lower than the ambition of financial products subject to Article 9”. In addition, the guidance provides that “where a financial product complies with certain environmental, social or sustainability requirements or restrictions laid down by law, including international conventions, or voluntary codes, and these characteristics are ‘promoted’ in the investment policy the financial product is subject to Article 8”. This seems to have provided some comfort to asset managers as, in the last year, a number of funds have “re-categorised” as Article 8 funds and this number continues to grow.
While the analysis in respect of products falling within the scope of Article 9 is slightly clearer, given SFDR defines ‘sustainable investment’, this has not resulted in a greater number of financial products falling within its scope as there is a higher threshold for financial market participants to satisfy. It is likely that the number of financial products falling within the scope of Article 9 will remain a small percentage of the overall figure of financial products being identified as ‘sustainable’.
The risk of misrepresentation of the ESG characteristics of a financial product falling within the scope of the SFDR is only one of a number of ways that greenwashing presents a risk to asset managers. A variety of other examples of greenwashing at both an asset manager level and a product level are identified in the IOSCO ESG Recommendations including: (i) at the asset manager level, marketing communications that do not accurately reflect the extent of the asset manager’s consideration of sustainability related risks and opportunities in its processes; and failure of an asset manager to meet its public sustainability related commitments; and (ii) at the product level, lack of alignment between a product’s sustainability related name and its investment objective and/or strategy; misleading claims about the product’s sustainability related performance and results; and lack of disclosure.
The key takeaway for asset managers is that they should be transparent in terms of the progress of their sustainability journey or whether they are choosing to embark on such a journey at all.
Differing approaches to consideration of ESG issues and their challenges
In addition to providing a return on investment for investors, fund managers (as well as corporations in general) have been under increasing pressure to take a moral stand on issues facing the environment and society. And, while a noble goal, the path of virtue is not always clear, particularly where the issues involved have compelling, competing viewpoints. Asset managers take different approaches in terms of their consideration of ESG issues and it can potentially be challenging to determine which approach(es) will work best for an asset manager. This determination is typically based on the strategies being employed in respect of the funds under management, the resources available to the asset manager and whether the asset manager has a specific sustainability focus.
In a risk alert issued in April 2021, the SEC observed that firms approach ESG investing in various ways and advised that “staff will continue to examine firms to evaluate whether they are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that accord with their ESG-related disclosures.” Such approaches can include managers: (i) engaging directly with investee companies; and/or (ii) excluding certain types of investments from the portfolios of their funds under management.
Active engagement
Active engagement is one approach taken by asset managers, whereby discussions with the companies in which they invest can result in positive changes to corporate behaviours. Such engagement is increasingly focusing on environmental, social and/or governance issues affecting the companies. High profile shareholder activism, such as Engine No. 1’s ability to win seats for three of its candidates on the ExxonMobil board of directors in 2021, show that climate and environmental issues are moving up the priority list for shareholders where companies are seen as failing to engage or falling short of shareholder expectations on these issues. Asset managers are coming under increasing pressure from their investors to explain what actions they are willing to take if they have engaged with companies on ESG issues but are not seeing sufficient progress being made on the issues raised, for example, voting against resolutions put forward by the company or divesting from the company.
A proposal announced by the European Commission in February 2022 for a Directive on Corporate Sustainability Due Diligence should assist asset managers in terms of the conversations they are having with companies in which they invest. The aim of the proposal is to foster sustainable and responsible corporate behaviour, anchor human rights and environmental considerations in companies’ operations and corporate governance and introduce new rules that will ensure that businesses address adverse impacts of their actions, including in their value chains inside and outside Europe.
Exclusionary policies
Furthermore, some asset managers implement exclusionary policies with sectors such as weapons, gambling, tobacco typically making the list. Such managers look to divest from investments that fall foul of such policies and there may be a percentage limit in terms of exposure to the sector in question. The sectors that form part of an exclusionary policy will vary based on the views of the asset manager, the strategies it is seeking to employ and the investors it is aiming to attract. It is useful to consider two examples of sectors that can be found in exclusionary policies: (i) weapons; and (ii) nuclear power and the development of thinking on these sectors from a sustainability perspective.
Weapons have been historically considered to be very ‘un’ ESG but the tides may now be changing with some asset managers asking whether investment in the defence industry could be classified as sustainable investment. From April 1 2022, the asset management arm of Swedish bank Skandinaviska Enskilda Banken AB will allow six out of its 100 plus funds to invest in companies that generate more than 5% of their revenue from the defence business – a sharp turnaround from a policy it put in place only a year ago as part of its ESG principles which prohibited such investments.
In terms of nuclear power, in February 2022 the European Commission adopted a draft delegated act which proposes including certain gas and nuclear power activities within the scope of the EU’s taxonomy. The EU taxonomy was established as part of the Taxonomy Regulation published in June 2020 and is a classification system that can be used to assist in determining whether economic activities can be identified as environmentally sustainable or not.
The aim is to create clarity (which would benefit fund managers and investors alike) about which activities are sustainable, thereby allowing them to distinguish between investments that are “environmentally sustainable” and those that are not. This proposal to include certain gas and nuclear power activities is a controversial one and faces the risk of being blocked by EU member states and the European Parliament or being subject to legal challenge in the courts.
Challenges created by the breadth of voluntary sustainability reporting standards
Asset managers require data in respect of the underlying portfolio of investments held by the funds they manage and the degree to which such investments are considered to be sustainable in order to accurately disclose whether a fund is considered sustainable or not. The challenges faced by asset managers relating to the availability of reliable, accurate and good quality data are well documented. While the use of voluntary sustainability reporting frameworks and standards has grown in popularity among corporates in recent years, the large number of frameworks and standards that have emerged makes it difficult for: (i) users of the reporting to compare the data provided by companies; and (ii) for corporates, including asset managers, to determine which frameworks and/or standards to use. The main sustainability reporting frameworks and standards are:
The recommendations issued by the task force on climate related financial disclosures (TCFD), which provides guidance for disclosing the impact of climate related risk on a business, focusing on how climate impacts on a business. While the TCFD recommendations are voluntary, countries are considering making reporting in line with these recommendations mandatory for certain categories of companies. The UK has introduced such mandatory reporting into annual reports for financial years starting on or after April 6 2022. The task force on nature related financial disclosures is building on the work of the TCFD to provide a framework for organisations to report on nature related risks. A version of the framework was published in March 2022 for consultation with it being anticipated that recommendations will be published in the third quarter of 2023;
The Global Reporting Initiative (GRI) published a set of standards that can be used by companies to report on the topics that are material to their businesses. There are three series of standards: the GRI universal standards, which apply to all organisations; sector specific standards which list topics that are likely to be material to organisations within that sector; and topics standards which deal with specific topics such as waste or occupational health and safety which may be material to an organization. GRI reporting focuses on how the business impacts on society and focuses on all three strands of E, S and G. It is useful to note that work has been done to link the GRI standards with the UN’s Sustainable Development Goals (SDGs);
The industry specific standards published by the Sustainable Accounting Standards Board (SASB), which help companies select topics that may impact their financial performance. These SASB standards focus on how ESG issues impact the business; and
The UN Global Impact is an initiative where companies commit to incorporate the 10 principles of the UN Global Compact into their business practices. These principles focus on human rights, labour, the environment and anti-corruption. Companies are required to prepare an annual communication on progress and a report detailing the work the organisation has done to embed the principles into its strategy and operations. This initiative focuses on how a business impacts society.
The creation of a new standard-setting board, the International Sustainability Standards Board (ISSB), was announced by IFRS Foundation at COP26 in November 2021. The intention is to build on existing reporting initiatives in order for the ISSB to become the global standard-setter for sustainability disclosures for the financial markets. In March 2022, the ISSB launched a consultation on exposure drafts of the IFRS Sustainability Disclosure Standards. The proposals build upon the TCFD recommendations and incorporate industry-based disclosure requirements derived from the SASB standards.
Certain EU companies are also subject to the Non-Financial Reporting Directive (NFRD), which sets out rules on disclosure of non-financial and diversity information in annual reports. The NFRD identifies four sustainability issues (environment, social and employee issues, human rights, and bribery and corruption) and, with respect to those issues, it requires companies to disclose information about their business model, policies (including implemented due diligence processes), outcomes, risks and risk management and key performance indicators relevant to the business. Proposed amendments to the NFRD were adopted by the European Commission on April 21 2021, by way of a proposed new directive, the Corporate Sustainability Reporting Directive (CSRD), which will not only see more companies subject to the reporting requirements set out in the NFRD, but also introduces a requirement for the reporting of sustainability information to comply with mandatory EU sustainability reporting standards.
The European Financial Reporting Advisory Group (EFRAG) has been assigned responsibility for the development of these standards and has been working on their development with the intention being that the standards will be developed in tandem with the movement of the CSRD proposal through the European legislative process.
The aim of this proposal is to ensure that companies are reporting sustainability information in a consistent and comparable manner and that such information meets the needs of investors and those entities, including asset managers that require this information in order to satisfy requirements set out in the SFDR.
Mandatory sustainability reporting standards will result in reliability and comparable data being available to asset managers in respect of underlying investments, but this is likely to remain a challenging area for asset managers until the implementation of such standards. In the absence of mandatory reporting standards, managers should consider consulting with investors to understand what their expectations and preferences are in terms of the use of voluntary frameworks and standards providing a set of criteria for managers to follow, in order to satisfy investors in the interim.
Looking to the future
The Cayman Islands regulatory regime does not currently prescribe any ESG rules or guidance that investment funds are required to follow, although where funds' offering documents or other marketing materials include ESG-related representations or other disclosures, the regulator will expect the funds to comply with them. This is based on general disclosure rules rather than anything particular to ESG. Having said that, the private sector continues to alter the landscape by including voluntary ESG disclosures. It may be that this development will lead the regulator to require certain minimum ESG standards in the future and it has indicated that it may do so. In a Supervisory Issues and Information Circular dated April 13 2022 the regulator said that it would “continue to undertake reviews, including assessing the available information, such as best practices undertaken in other key financial jurisdictions, with the aim of developing a suitable regulatory and supervisory approach” for ESG.
Asset managers managing or marketing funds in the EU and in particular those with Article 8 and/or Article 9 funds are focused on: (i) the next implementation dates under SFDR and the Taxonomy Regulation, being December 2022/January 2023; (ii) the sustainability amendments under Alternative Investment Fund Managers Directive, the UCITS Directive and MiFID II which all become effective in summer 2022; and (iii) the proposals to amend NFRD and the effect that these are likely to have on reporting requirements for such managers.
Understanding the rapidly evolving legal and regulatory landscape in the jurisdictions in which they operate or wish to market is a key first step for asset managers as they continue to grapple with the challenges associated with ESG investing and sustainability more generally.
In the context of the challenges set out above, consideration should be given to: (i) any sustainability disclosures set out in fund documentation and the extent to which these disclosures align with the actions being taken by the manager in practice and/or the information being provided by those entities in which their funds under management are invested; (ii) the approaches that can be taken to ESG issues and which approaches would best assist the manager with meeting its ESG objectives; (iii) whether to report against any voluntary framework or standards until such time as mandatory reporting standards are introduced; and (iv) how the requisite data to comply with either voluntary or mandatory standards will be sourced. Ultimately the specific challenges facing managers will be dependent on whether and to what extent: (a) the sustainability impacts of the business; and (b) ESG considerations in the investment decision-making process, are being taken into account by the manager.
Ingrid Pierce
Partner
Cayman Islands
T: +1 345 814 4667
E: ingrid.pierce@walkersglobal.com
Ingrid Pierce is Walkers’ Global Managing Partner and heads the Cayman Investment Funds Group.
Ingrid is recognised as one of the world’s leading investment funds lawyers. She acts for major institutions, asset managers, insurers, reinsurers, trustees and other fiduciaries. Her clients include many of the Who’s Who of asset managers, banks and trust companies.
Ingrid advises on fiduciary duties and matters of governance relevant to directors, trustees, principals and private clients and has considerable experience with contentious matters having acted in connection with the acquisition, restructuring and winding down of various high profile funds. She has written and spoken on the evolving ESG landscape and its impact on asset managers.
Jason Allison
Partner
Cayman Islands
T: +1 345 914 6358
E: jason.allison@walkersglobal.com
Jason Allison is a partner in Walkers’ Global Investment Funds Group. He advises on Cayman Islands corporate and investment funds law, with particular expertise advising institutional investment managers, banks and blue chip corporate clients on all aspects of structuring and establishment of private equity funds and hedge funds as well as cross-border M&A and other corporate and financing transactions. Jason also advises clients on ESG matters and sits on Walkers Global ESG Working Group Committee.
Christine Ballantyne-Drewe
Senior counsel
Cayman Islands
T: +1 345 814 4550
E: christine.ballantyne-drewe@walkersglobal.com
Christine Ballantyne-Drewe is based in Walkers’ Cayman Islands office where she is a senior counsel in the Global Investment Funds Group. She advises primarily on the formation, operation and restructuring of investment funds and has extensive experience in both open and closed ended investment structures, as well as downstream corporate transactions. She also has significant expertise in relation to mergers and acquisitions, joint ventures and other corporate transactions.
Christine advises a broad range of institutional asset managers, private equity sponsors, family offices and start-up and emerging managers. Her practice includes advising entities structured as companies, partnerships and limited liability companies.
Jill Shaw
Senior knowledge lawyer
Ireland
T: +353 1 863 8546
E: jill.shaw@walkersglobal.com
Jill Shaw is a senior knowledge lawyer for Walkers’ Ireland office in the Asset Management and Investment Funds group. She manages the legal resources and know-how for the team and provides updates on legal and regulatory developments.
Jill is also a steering committee member of the Green Team Network which is a forum for connecting and empowering change towards a sustainable environment within the Irish Funds Industry. Jill sits on Walkers Global ESG Working Group Committee.
Jill is a lecturer on the Law Society of Ireland’s Diploma in Finance Law including on sustainable finance.