Building trust in sustainable investments

Speaker: Richard Monks, Director of Strategy
Event: SRI Services and Partners ‘Good Money Week’ panel discussion
Delivered: 21 October 2020
Note: This is the speech as drafted and may differ from the delivered version. Nikhil Rathi, CEO, provided further updates on our sustainable finance strategy in his speech[1], Rising to the Climate Challenge, at the Green Horizon Summit, 9 November 2020. 

Highlights

• Sustainability factors are increasingly influencing consumer decision-making. Consumers should be able to trust the products they are offered and rely on them to perform as they expect. 
• We are undertaking a number of initiatives that will help to address the concerns we’ve identified, including domestic and international work on issuers’ disclosures and ongoing work with Government on implementation of EU regulations.
• We have started to think about some principles that could help to guide the assessment of applications to authorise sustainable investment products.

The other day I came across a recent Scottish Widows report which quoted some survey statistics that made for interesting reading:

• 81 per cent of those surveyed thought that ‘we all have a responsibility to make the world a better place’
• almost half would accept slightly lower returns to make ethical choices
• more than 60% said sustainability was an important issue to them

Recent fund flows tell the same story. According to Morningstar[2], environmental, social and governance (ESG) products accounted for almost a third of European fund sales in the second quarter. We see the same trends across business, in Government, and in society. We’ve all heard the calls for more responsible business and a desire to ‘build back better’ from the pandemic. 

I want to talk to you about the work we are doing around sustainable finance. We want to help firms and consumers create an understandable, comparable and transparent market for sustainable finance products. 

This is about building a regulatory framework to achieve 2 things: we want to help firms deliver the reliably sustainable investment products that consumers and investors want, and we want to help consumers make better informed choices. This was one of the priorities we set out in our paper[3] in October 2019 on climate change and green finance. 

Sustainable investment strategies

As this audience knows well, a wide variety of sustainable investment products are available to consumers that employ a range of strategies. At one end of the scale, there are strategies that ‘screen out’ investments with poor ESG performance. This includes highly polluting companies or companies that don’t treat their workers or suppliers fairly for example. At the other end, there are strategies that directly target a tangible real-world ‘impact’, perhaps accepting the possibility of lower financial returns to do so.

The development of new products to meet evolving needs and preferences is a good example of innovation in the interest of consumers. This is something we firmly encourage. But it’s crucial that consumers understand the sustainable products they are offered and the differences between them. Particularly as demand continues to grow and new products come to market.
As regulators, we need to make sure consumers can trust these products. And that is about giving consumers the right information so they can make informed decisions.

To do this firms must ensure their communications are ‘clear, fair and not misleading’. What we don’t expect to see is firms exaggerating their products green credentials. That’s ‘greenwashing’ and misleads investors. I’d like to talk about some of the main issues identified in our work so far and some of the actions we’re taking. 

Informing decisions: data and information

The first theme I’d like to discuss is data and information. It is well understood that companies’ non-financial disclosures are often incomplete and difficult to compare across companies. 

There has been some important progress. The most notable is the widespread voluntary adoption of the recommendations of the Taskforce on Climate-related Financial Disclosures; or TCFD. But significant gaps remain and investors aren’t yet getting the decision-useful information that they need. And across the industry there is reliance on ESG ratings. Ratings providers also rely on public information so their outputs are similarly subject to data gaps. They also have very different methodologies leading to wide variation in ESG ratings for any given company. 

For example, Tesla, the electric car company, is rated as ‘high risk’ by one rating agency – Sustainalytics[4] – but receives an ‘A’ grade from another – MSCI[5]. Of course, divergence in methodologies isn’t inherently undesirable. After all well-functioning markets rely on trading between actors with different views. But there may be a concern if firms use ratings mechanistically. For example, without a detailed understanding of the methodologies the providers apply and careful consideration of whether they are fit for purpose. 

What’s in a product?

Second, product design and disclosure. One finding is that some products’ names do not seem to be well aligned with their objectives, investment strategies, asset composition or exposures. Our concern is that including some words in a product’s name or stated objective – ‘green’, ‘ESG’, ‘impact’, ‘climate’ – may create expectations among consumers that are not met. For instance, about the types of holdings they might see. 

It is not the FCA’s role to dictate where firms invest. But we need to make sure that firms describe their strategies clearly to consumers. Firms must not make misleading claims about the ESG credentials of their products. It’s worth noting that there can be good reasons for including investments in a sustainable investment product that might look ‘wrong’ at first glance. But this must be clearly explained to consumers.

Let me give an example. It may be reasonable for a transition product to invest in oil and gas stocks if these companies are taking credible action to transition to clean energy. And, once invested, firms can influence companies’ climate strategies through active investor stewardship. Investor initiatives such as ClimateAction 100+[6], for example, have successfully secured emissions commitments from many companies. 

To give an example, Rio Tinto, the global mining company, committed to exit from mining coal, publish a TCFD report, and to undertake an asset by asset review to set emissions reduction targets. And Nestle, the food and beverage conglomerate, has set a net zero emissions by 2050 target. 

Measuring impact

This links closely to a third theme: ongoing performance reporting. Reporting of ongoing financial performance is well-established and consistent. But measurement of performance against non-financial objectives is still evolving. 

Some sustainable investment products do not track their performance against sustainability characteristics in a way that would be clear to a consumer. And where products are targeting real-world sustainability impacts, some firms find it difficult to reliably attribute a quantifiable ‘impact’ to their actions. 
I’d like to highlight a few key actions we are taking in response to these findings. These are not exhaustive but hopefully provide a flavour of our direction of travel.

First, we’re taking steps to improve the flow of data and information into the investment process from investee companies. We recently consulted to require premium-listed issuers to make better disclosures about how climate change affects their businesses. These disclosures need to be aligned with the TCFD’s well-recognised recommendations. We are currently considering feedback to this consultation. Subject to what we hear back, we aim to publish a policy statement in the coming months. 

We are also looking at wider corporate reporting on sustainability. This includes co-chairing an IOSCO Sustainability Taskforce workstream. There are some promising industry initiatives in this area, which we hope will form the basis for a common international non-financial corporate reporting standard. 

Second, we want to improve firms’ disclosures to clients and consumers on how they are managing sustainability factors. This is in both dedicated ESG-focused products, and across their wider investment activities. We are beginning with climate and next year we will consult on TCFD-aligned disclosures by asset managers, life insurers and contract-based pension providers. We will draw insights from an industry guide published in June by the Climate Financial Risk Forum, which we co-chair with the Prudential Regulation Authority (PRA). The guide shares best practice on disclosure, risk management, scenario analysis and innovation. It is grounded in the TCFD’s recommendations.

Third, as the audience will be aware, the EU is pursuing several ambitious regulatory initiatives under the Sustainable Finance Action Plan. Some of these initiatives will come into force after the Brexit Implementation Period. We welcome the UK Government’s commitment in the Green Finance Strategy to ‘matching the ambition of objectives’ of the EU’s Plan. We are therefore working closely with the Government and other regulators on how to implement the EU’s proposals in the UK. Immediate areas of focus are the Sustainable Finance Disclosure Regulation and the EU’s Taxonomy for sustainable activities. 
The FCA recognises the benefits of internationally-aligned approaches. We therefore fully support the Government’s commitment to promoting globally consistent standards and to strengthen the UK’s status as a global hub for sustainable finance. 

Fourth, research. We are currently developing online consumer behaviour experiments to test consumers’ understanding and expectations of key ESG terms. We’ll also be testing how the presentation and content of product information might influence consumers’ decisions. We hope to run these experiments later this year and then look to publish results next year. The results will help inform whether additional guidance or rules are needed.
And finally, an important defence against potential greenwashing is to tackle misleading claims as applications for new products are submitted to us for authorisation. Over the past 18 months, we have seen a significant increase in applications for funds with an ESG focus. Our rules set out that financial promotions and communications with customers should be clear, fair and not misleading. This includes non-financial objectives that a product is seeking to achieve – such as reducing the fund’s carbon footprint. We review the strategy, investor documentation and model portfolios of applications to ensure that they meet this. And we will require changes to the way information is presented to consumers if we aren’t convinced.

Building some guiding principles

Building on this, we are considering whether it would be helpful to articulate a set of guiding principles to help firms with ESG product design and disclosure. This could help to tackle the concerns I’ve already outlined and ensure that consumers are protected from potential greenwashing. We have 5 areas for potential principles in mind.

• Consistency in messaging and approach. A product’s ESG focus should be clearly stated in its name. And then reflected consistently in its objectives, its investment strategy, and its holdings. This is all about ensuring that a product really does do what it says on the tin and matches consumers’ expectations. 
• A product’s ESG focus should be clearly and fairly reflected in its objectives. Where a product claims to target certain sustainability characteristics, or a real-world sustainability impact, its objectives should set these out in a clear and measurable way. 
• A product’s documented investment strategy should set out clearly how its sustainability objectives will be met. This should include describing clearly any constraints on the investible universe. This includes any screening criteria and anticipated portfolio holdings. This should also include the fund’s stewardship approach and actions the fund manager will take if investee companies are failing to make the desired progress.
• The firm should report on an ongoing basis its performance against its sustainability objectives. This is about giving consumers the information they need to understand whether the stated objectives have been achieved in a quantifiable and measurable way. 
• The firm should assure ESG data quality, understand their source and derivation, and articulate clearly and accessibly how it is used. This includes the use of ESG ratings in the investment process. 

Looking ahead, sustainable investing is surely here to stay. This is a fast-moving, evolving and innovative space. But innovation can’t come at the expense of undermining trust in the sustainable finance market. Trust is hard won but easily lost. 

We all have an interest in building and maintaining trust in this market. We will act where we find firms are not upholding the standards we expect. And we want you to tell us where you have concerns, so that we can act.

By working together in the interest of consumers, we can make sure this market continues to thrive.