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IPE special report May 2018

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ESG as a legal obligation?

The UN's Fiduciary II aims to take ESG integration to the next stage, while a shift in US policy is pushing demographic concerns up the agenda. Nina Röhrbein reports

ESG issues must be embedded in the legal contracts between institutional investors and their asset managers to hold asset managers to account, and ESG issues should be included in the periodic reporting by asset managers. This is a key finding of the ‘Fiduciary responsibility - Legal and Practical Aspects of Integrating Environmental, Social and Governance Issues into Institutional Investment' report by the Asset Management Working Group (AMWG) of the United Nations Environment Programme Finance Initiative (UNEP FI), a partnership between the UN's environmental arm and over 180 financial institutions worldwide.

The study, known as Fiduciary II, is a follow-up to the AMWG's 2005 Freshfields Report, which provided a legal interpretation of ESG issues in the context of fiduciary law.

"The Freshfields Report became a critical document in the formation of the UN Principles for Responsible Investment (PRI)," says Steve Waygood, head of sustainability research and engagement at Aviva Investors and chair of the UK's Sustainable Investment and Finance association (UKSIF), who was responsible for the initiation and design of the Fiduciary II project. "It helped establish the argument that ESG issues are investor-relevant and investors legally can and arguably should integrate those issues into their investment process. However, what was overlooked at the time were the different roles trustees and fund managers have and the different ways in which ESG issues are relevant to their roles and responsibilities. It fell short of showing trustees how to hold their external managers to account on their ESG performance."

The new report aims to help asset owners and managers, as well as consultants and policy-makers, find their way through the ESG jungle.

"It gives them guidance on how they should integrate and govern ESG issues," says Waygood. "For trustees, the main conclusion of the report is to embed a legal provision in their RFPs, RFIs and investment management agreements, which also requires their external managers to sign up to the UN PRI and use the performance measurement tool within the PRI as the governance structure for an ongoing investment assessment. This will enable trustees to make informed decisions at their board meetings."

The report also warns that professional investment advisers and service providers face "a very real risk that they will be sued for negligence" if they do not incorporate ESG issues into their investment services.

Fiduciary II is split into three major elements consisting of a legal review of fiduciary duty and the implementation of ESG in investment mandates, a survey of investment consultants and an update on literature and practical developments of ESG integration in the investment process.

Controversy has surrounded the claim that investment consultants have to pro-actively raise ESG issues in their advice to institutional investors. Although Waygood believes that some consultants struggle to update their view on ESG, which is still based on the 1990s notion of negative screening despite the seismic shift in ESG strategies since, he stresses that this is not the only conclusion of the report.

More important, he says, are the eight recommendations by Quayle Watchman Consulting for pension funds to implement ESG integration in investment mandates. These give advice on how a pension fund should compose its mandate structure, what kind of reporting they should look for from their fund managers and how they can structure incentives in this area.

Fiduciary II also provides sets of questions investors can use to challenge providers with regards to ESG integration, engagement, positive and avoidance or negative screening. "This should speed up the challenge trustees face and make ESG integration more efficient and a lot more effective," explains Waygood. "It will increase the sophistication of the demand environment for responsible investment, while rewarding good and sanctioning poor practice among asset managers."

The AMWG recommends that the PRI ‘should specify that, in order to maintain their membership, all asset manager and asset owner signatories will be required to embed ESG issues in their legal contracts - such as investment management agreements, and Statements of Investment Principles or Investment Policy Statements.'

"While the PRI has made huge progress since 2004 it now needs to build on those first steps by obtaining that informed, high-quality demand from institutional investors and make it much more systematic within signatories," says Waygood. "It means that PRI signatories will make very informed decisions about who their providers are. The market would then signal in turn that this is important for providers - whether it is asset managers, data providers or consultants - to be delivering on."

Fiduciary II also tries to make use of the PRI's analysis tool. "Respondents to the questionnaire receive a detailed performance chart showing how they perform relative to their peers in each of the principles," says Waygood. "But if it is not put to further use it wastes a huge amount of work on evaluating performance. Trustees need to be able to compare and contrast performance of their providers, so their fund managers should be required to share this analysis with them. The PRI should require their signatories to embed it in their investment management agreements."

Waygood does not view the legal side of ESG as a problem. "If the legal provision (see box) was an absolute standard on what exactly should be done, how and by whom, then it would be an issue," he explains. "However, the proposal is a requirement to be transparent to trustees and to present them with a performance analysis, using the mechanism that already exists within the PRI. In other words, it requires PRI asset managers to share their score and questionnaire with their clients. It does not define what should be done."

 

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