A TIPPING POINT IN SUSTAINABILITY AND STEWARDSHIP REPORTING

INTRODUCTION

The investment industry is facing rapidly growing pressure from its stakeholders to meet new transparency and disclosure requirements and expectations in relation to sustainability. In the last decade, we have seen a surge in new regulations, principles and codes that require or encourage companies to report on their sustainability-related risks, opportunities and activities. So far, Europe has been the main source of new regulation in this area but other jurisdictions are starting to experience an increasing volume of mandatory, voluntary and “comply or explain” reporting requirements[1] [2]. The US is likely to ramp up its efforts in the coming months as ESG, RI and climate-related reporting take centre stage with the Biden-Harris administration, and with the recent commitment from the SEC to play a leading role in the development of new ESG reporting standards[3].

With recent reporting deadlines relating to an extended Principles of Responsible Investment (PRI) framework and the first reports under the 2020 UK Stewardship Code, and the EU Sustainable Finance Disclosure Regulation (SFDR) that came into effect on 10 March 2021, asset managers and their institutional clients need to meet several challenges, including: collating and interpreting information from underlying investment managers or investee companies (or other entities), recording progress and outcomes of stewardship activities, ensuring data accuracy, and integrating relevant information into firm-level, strategy-level and client-specific reporting.

VARYING EXPECTATIONS ON STEWARDSHIP REPORTING

Investors are increasingly expected to report upon the progress and outcomes of their stewardship activities, including their active dialogue or engagement with the companies in which they invest, voting of shares and involvement with policy makers and standard setters. Many asset managers are finding it challenging to meet this expectation for a variety of reasons, depending on their investment style and the asset classes in which they invest.

Active equities managers with concentrated portfolios generally have the capacity in terms of resources and time to develop close relationships with their investee companies, and are better equipped to report on the progress and outcomes of their stewardship activities than passive or quantitative investment managers. Stewardship in corporate and sovereign fixed income strategies is now common and fixed income investors are increasingly expected to comply with the same reporting requirements as equities investors. In addition to making stewardship reporting a more manageable task, active investment managers can benefit in the quality and consistency of their investment research by introducing or improving processes that enable them to record, manage and report upon their dialogue with investee companies (or other entities), including progress and outcomes.

However, those investment managers who tend not to interact directly with investee companies as part of their investment processes and those who have a very low ratio of investors to investee companies (such as those running passive or quantitative strategies) are likely to have insufficient resources to undertake stewardship effectively, whilst facing a rapidly increasing interest in this activity amongst their clients and other stakeholders. Such managers may rely upon third party engagement and voting agencies, such as Hermes EOS, ISS and Glass Lewis, rather than engaging and voting themselves.

While asset owners may adjust their reporting expectations to each manager depending on the asset class and investment style, regulators will increasingly expect passive and quantitative managers to comply with the same requirements as active investment managers. We believe that it would be systemically good for passive and quantitative managers to be required to undertake stewardship even though (or perhaps because) it disrupts their business models, however, regulators should be careful to avoid introducing a one-size-fits all approach, as this may encourage a compliance mentality that drives counterproductive behaviour and reporting outcomes.

THE FLIPSIDE OF FREQUENT REPORTING

As reporting requirements and expectations increase, it is important that we consider the long-term nature of investment and stewardship, otherwise we risk provoking undesirable short-termism and tokenism as investment managers rush to demonstrate the impact and outcomes of their activities. For example, some might choose to prioritise those engagements they consider “easy wins” over those that concern more material risks or opportunities but transpire over longer periods. Others may fill their reports with superfluous statistics, tables and graphs, or falsely claim the impacts of the investee companies as resulting from their own allocation of capital or stewardship. We can and should expect investment managers to report on their stewardship activities with case studies and statistics that differentiate between engagement for information and engagement for change, disclose clear objectives, and capture progress through the achievement milestones or stages within an engagement during the reporting period. Furthermore, we should encourage transparency on which engagements are progressing and which are not, and the expected time frame for each engagement, thereby providing the motivation and permission genuinely to prioritise the most material and impactful engagement in their investment process, whatever the time horizon.

On a related note, it is increasingly common for investors to engage collaboratively on issues related to a company or sovereign issuer (for example, through the PRI Collaboration Platform) and to participate in groups such as Climate Action 100+ and The Investor Agenda. Such initiatives are increasingly disclosed in the investors’ sustainability and stewardship reporting, as well as regulatory filings. Whilst this increased interest and collaboration are welcome, such initiatives may provide easy means of falsely claiming impact. The investment managers’ clients should critically evaluate their reporting on collaborative engagements and investor initiatives and expect them to be open about their level of involvement in describing progress and outcomes.

IMPACT IS EVERYWHERE

As investment managers increasingly report on impact, it is important that they and their clients have a clear and shared understanding of what this involves and how it can be measured. The investment industry has moved on from a narrow understanding of impact investing as an investment style within venture capital. We are starting to recognise that all investments have impact, which can be positive or negative, indirect or direct, intended or unintended. When reporting on impact, investment managers should clearly differentiate between that caused by the company or other entity in which they invest and the impact resulting from an investor’s engagement with the company or allocation of new or additional capital to company or other enterprise. Impact caused by investee companies can be challenging to measure, and investment managers need critically to assess the quality and accuracy of the data they receive. Investment managers can more directly measure the impact of their own stewardship by implementing an engagement framework as described above, which enables them to set objectives and assess the extent to which these objectives are met as a result of their engagement.

A NEED FOR GUIDANCE AND STANDARDISATION?

A major problem arising from the many new reporting requirements is a lack of consistency in the ways that investment managers (and third-party data providers) collect, process and distribute information related to sustainability, stewardship and impact. With varying and incomplete guidance from regulators and industry bodies, investment managers are developing and adapting their own reporting, leaving asset owners in the difficult position of having to compare, collate and determine the authenticity, accuracy and quality of a large number of disparate disclosures. In response to this problem there are emerging attempts to ensure consistency in the ways in which key terms relating to sustainability and responsible investment are defined and applied. For example, the SEC has suggested a single global ESG reporting framework, whilst expressing its support for the work of the IFRS Foundation in improving sustainability reporting[4], while the EU recently introduced a plan for developing EU sustainability reporting standards[5], and in 2020, the World Economic Forum introduced a set of “Stakeholder Capitalism Metrics” (SCM) and disclosures to bring greater consistency and comparability in ESG reporting[6].

In a systemically important and developing area it is understandable that people are looking for and introducing new guidance and definitions that are consistent. However, seeking to address this mostly through regulation and compliance is likely to be unsuccessful because it fails to address our motivations and understanding.

A SHIFT IN MINDSET

We should be careful in assuming that mandating disclosure or standardising definitions will change anyone’s behaviour or perspectives. Many investors see new disclosure requirements on sustainability and stewardship as either a compliance exercise or an opportunity to label new products rather than recognising and embracing the real motives behind these regulations. The true task is for the investors to realise their interdependence with their stakeholders and to attend to what matters most for the long-term sustainable growth of our economies. Regulatory initiatives will only be successful to the extent that they support such positive change. They will fail or hinder progress, if they are and are seen as confusing, rigid and bureaucratic rules.

[1] United Nations PRI. Whitepaper: Taking Stock: Sustainable Finance Policy Engagement and Policy Influence

[2] KPMG. (2016). Carrots & Sticks: Global trends in sustainability reporting regulation and policy

[3] Stacy, H. Mitchell; Cynthia M. Mabry; Kenneth J. Markowitz. (2021). Biden’s “Money Cop” to Shine a Light on ESG Disclosure.Harvard Law School Forum on Corporate Governance

[4] J. Coates. (2021). Public Statement: ESG Disclosure — Keeping Pace with Developments Affecting Investors, Public Companies and the Capital Markets. SEC

[5] European Financial Reporting Advisory Group. (2021). Proposals for A Relevant and Dynamic EU Sustainability Reporting Standard-Setting

[6] World Economic Forum. (2020). White paper: Measuring Stakeholder Capitalism Towards Common Metrics and Consistent Reporting of Sustainable Value Creation