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Commercial Question

Why all investors need to look beneath the bonnet

updated on 12 April 2022

Question

What are the investment issues relating to ESG?

Answer

Whether you are a large corporate entity or pension trustee, increasing regulatory requirements mean environmental, social and governance (ESG) is rapidly becoming a major factor in relation to investment decisions.

Since the bringing of 2021 we have seen the Task-Force on Climate-Related Financial Disclosures become mandatory for premium listed UK companies and the UK’s largest pension schemes with the obligation expected to apply to all pension schemes by 2024. New Sustainability Disclosure Requirements applying to all companies, financial institutions and pension schemes to make disclosures around ESG metrics and an expected obligation from 2022 for UK pension schemes to disclosure their investment portfolios alignment with the Paris Agreement further reinforce the positon.

In an environment where ESG investments have become the fastest-growing investment sector, with 10% of all worldwide fund assets in ESG, and both the regulatory regime and public sentiment clearly moving in favour of even greater investment in this area, it has become more important than ever that pension trustees and other investors know exactly what they are investing in. This requires proper due diligence on the underlying investment itself.

Some examples

If you were offered investment opportunities in the following, would they meet your ESG aspirations?

1.A fund outperforming the benchmark average with a specific focus on businesses moving towards carbon neutrality the fastest.

2.A carbon offset fund focused on sustainable alternatives to carbon-intensive business.

3.The eco sustainability green investment fund.

4.The social value impact fund.

In fact, all could be perfectly good investments for some investors, but for many others they could find they have invested in entities that are diametrically opposed to their beliefs and may have serious reputational effects if the investments were exposed and generate risks of financial losses.

The most significant problem with ESG investing is lack of any national or international standards and forms of comparison, which has allowed thousands of investment funds that weren’t in any way ESG orientated to simply rebadge themselves. Over the past few years, while simply maintaining the same underlying portfolio. Example three might easily have done this. So the first level of due diligence is to look at investment fund history and composition, and ignore the title and marketing brochure.

The way funds are constructed can also be enlightening. In the first example, anyone expecting significant investment in renewables or new technology like green hydrogen may be shocked to find that many funds of this type are heavily weighted to oil, gas and mining companies because as huge carbon emitters these are the businesses that are de-carbonising the fastest.

Digging deeper

Carbon neutrality, offsets and sustainable alternatives in example two represent a new set of due diligence issues for investors to consider. First, with sustainable alternatives the starting point is whether they exist, or whether you are investing in businesses hoping to develop these alternatives: emissions-free jet fuel, carbon capture and storage and biomass either don’t exist or cannot yet be produced at scale. 

Carbon neutral investments may often be underpinned by carbon offset trading. At its best this is using natural systems to lock up generated carbon from the air and supplementing wider de-carbonising strategies. In reality, due diligence often reveals the companies using these schemes are not reducing carbon usage and are using carbon credits to claim neutrality. In some cases, no new natural systems are developed and the credit is used to defend an existing resource.

Two physical issues to be considered with these investments are land use, where some commentators believe existing offset commitments exceed all of the available farmland across the world, and longevity, with worldwide weather events become more extreme. If, for example, wildfires have already destroyed vast swathes of forests and land earmarked for these offsets, then where does that leave the investment?

Social investing

Finally, the often neglected social element of investing has even fewer comparative and consistent metrics to allow transparency of material risks than the limited number for environmental investing. Just as greenwashing is a due diligence issue to be aware of, social washing is a rising issue in this sector. Most UK social value assessments focus on procurement and supply chain issues but defining social value is more complex than just social attribution metrics trying to capture value in monetary terms.

Due diligence can help to focus on other aspects of these investments, looking at estimated life changes through employment, or housing opportunities generated by the investment for individuals or a community.  Equally, it could assessing the impact on diversity, fair pay, working conditions, sick pay or any one of a number of areas that are important to the groups impacted.    

Getting it right

Ensuring investors understand exactly what they are investing in is important for a number of reasons, but mainly because we are still at a point with all ESG investing where the investor should beware. Just as there was a period before financial reporting metrics were standardised nationally and internationally, ESG is in a period where for investors and investment providers risks abound.

The Financial Conduct Authority has already written an open letter to the fund management industry with its concerns around greenwashing and there are already organisations operating who ‘out’ both investors and funds whose actual investment does not match the hype causing both financial and reputational risk for the investor. The move towards standardisation means the risk of regulatory breaches for both investors and providers is also increasing. As is the risk of an increase in litigation either from activist organisations (as in the 2021 Royal Dutch Shell case) or from individuals angry their investments are not what they thought they were.

Against this background, the role for legal due diligence is as important as ever in allowing investors to make informed investment decisions and understand and assess likely risks.

Nigel Barton is a partner at Bevan Brittan LLP.