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The European Commission is considering whether to clarify that institutional investors’ duties include taking into account sustainability risks.

The European Union’s executive has decided to start work on an impact assessment to assess whether and how such a clarification could contribute to a more efficient allocation of capital, and to sustainable and inclusive growth.

The Commission launched a public consultation today to help it “gather and analyse the necessary evidence to determine possible action to improve the assessment and integration of sustainability factors in the relevant investment entities’ decision-making process”.

The move follows up on one of the eight recommendations made by the High Level Expert Group (HLEG) on Sustainable Finance, an advisory body to the Commission, in its interim report in July.

As paraphrased by the Commission, the HLEG recommended it “clarify that the fiduciary duties (duties of loyalty and prudence) of institutional investors and asset managers explicitly integrate material environmental, social and governance (ESG) factors and long term sustainability”.

The duties of care, loyalty and prudence were embedded in the EU financial legal framework, said the Commission, but it “appears unclear” that they required institutional investors to assess the materiality of sustainability risks.

“Market practices indicate that institutional investors and asset managers generally understand these duties as requiring a focus on maximising short-term financial returns and disregarding long-term effects on performance due to sustainability factors and risks,” it added.

“This can lead to misallocation of capital and might give rise to concerns about financial stability since markets can be vulnerable to abrupt corrections, such as those associated with the delayed transition to low-carbon economies.”

The Commission positioned the consultation in the context of its efforts to mobilise private capital towards the transition to a low-carbon economy. It said the consultation showed the EU’s strong commitment to mitigate risks posed by climate change and environmental challenges.

Investor members of the HLEG welcomed the Commission’s consultation.

Magnus Billing, CEO of Alecta, Sweden’s largest pension fund, said: “Clarification and enhancement of fiduciary/investor duties integrated in market participants’ investment processes has the potential of transforming in a meaningful manner the European financial markets to sustainable European financial markets.”

Claudia Kruse, APG

Claudia Kruse, APG

Claudia Kruse, managing director for global responsible investment and governance at €456bn asset manager APG, said: “We invest on behalf of Dutch pension funds who consider it part of their fiduciary duty to take sustainability and governance factors into account, and reflect this in their investment beliefs and strategy. This contributes to risk adjusted returns and aligns with beneficiaries’ preferences.”

Fiduciary duties have long been a battleground in the fight to get investors to take into account ESG factors.

Some investors believe doing so would be incompatible with their fiduciary duties, while a more vocal – and increasingly large – constituency of investors and interest groups has argued that fiduciary duties are not a barrier to considering ESG issues as part of the investment decision-making process.

In a 2005 report for the UN Environment Programme Finance Initiative, law firm Freshfields Bruckhaus Deringer said the 1984 Cowan v Scargill court case had coloured the position in the UK on the integration of ESG issues from the perspective of fiduciary duties, but had been misunderstood. The conclusion of the law firm’s report was that integrating ESG considerations into investment analyses was permissible but in certain circumstances mandatory.

In 2014 the UK’s Law Commission drafted guidance for trustees on whether they could consider factors beyond short-term investment returns. It was seen by many as arguing there were no legal barriers to considering ESG issues.

The Principles for Responsible Investment, meanwhile, is working with Generation Management on a programme to get consideration of ESG factors embedded in investors’ fiduciary duties. Generation Management chairman and former US vice president Al Gore will be speaking at IPE’s annual conference in Prague later this month.

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