Raising the bar

11 Nov

11 November 2022

The Financial Conduct Authority plans significantly tougher requirements for funds to be labelled as sustainable. That’s a good thing, although it’s not straightforward.

The Financial Conduct Authority (“FCA”) has proposed new rules on greenwashing, setting out the requirements for retail funds to receive one of three "sustainability" labels:

Sustainable focus – investment in assets that are environmentally or socially sustainable
Sustainable improvers – investment in assets that can improve their environmental or social sustainability over time including through stewardship
Sustainable impact – solutions to social or environmental problems to achieve real-world impact.

Here are my first impressions.

Things to like

There is much to like about the report on an initial read.

The FCA have set a high bar for receiving any of the labels. Funds must set specific objectives to which the fund has to deliver based on a clear theory of change. There are comprehensive disclosure requirements. The bar could prove too high for many funds. But this isn't a bad thing if it focusses the sustainability labels on the small proportion of funds that actually do something materially different from just investing for financial return.

The labels are relatively simple, capture key dimensions of how real-world impacts could potentially come about, and have been designed in conjunction with proper consumer research. Therefore, they have avoided technocratic jargon and use of words that mean something to those of us immersed in the worlds of ESG and stewardship, but which are meaningless to consumers.

The various documentation requirements look sensible, covering pre-contractual and ongoing reports at the product and entity level, as appropriate. In particular, the emphasis on having short and simple consumer-facing summaries as well as more detailed institutional or stakeholder-facing documentation is welcome. As anyone who has tried to invest "sustainably" will know, trying to figure out exactly what the various funds do is extremely difficult, and descriptions are often filled with jargon.

There will be a general anti-greenwashing rule, requiring all regulated firms to ensure that the naming and marketing of financial products and services in the UK is clear, fair, and not misleading and consistent with the sustainability profile of the product or service i.e. proportionate and not exaggerated. This cannot be said of all naming and marketing today.

There is a commendable focus on “doing what you say” by reference to governance, capabilities, resources, and processes as well as disclosure requirements. The focus is on transparency, rather than on a predetermined view of what “sustainable” means.

Finally, it is extremely welcome that the FCA did not impose any prohibitions in relation to stock-lending or use of derivatives, which could have had unintended consequences that are tangential to the objectives of the new regulation.

There are, however, some aspects that may need a bit of work.

Channels for real-world impact

The report identifies three channels for how investing achieves real-world impact:

1. engagement activities with portfolio companies through active ownership;

2. fund flows leading to share price and cost of capital impacts; and

3. making capital available to underserved markets or addressing market failures.

These are indeed three plausible channels for impact, as I’ve written elsewhere and as is also covered here. However, there are two areas of concern.

First, the vast majority of retail equity market investments are in well-established companies in well-developed markets. Whether, in such circumstances, any of these channels has particularly significant real-world impact is far from clear. The case for the second channel is highly contested; the first is more widely agreed, but the extent of impacts is often not large; and the third is most relevant to early-stage or blended finance investments that are off the risk profile of most retail investments.

So there is a risk that the existence of the labels creates an impression that such investments have a major impact on real-world outcomes when in fact, even when a high bar is applied as the FCA is proposing, it's quite questionable whether these strategies will have much impact within the universe of typical retail investor investments. So there is a risk of labelling providing false comfort. This is a particular concern given the evidence that even experienced investors are not that discriminating about the underlying impact of sustainable funds in which they invest. This creates the risk of firms being able to overcharge consumers once a sustainable label is obtained.

Second, there seems to be some inconsistency between the identified channels for real world impact and the guidance given on investment strategies that qualify for labelling. For example, the report states that exclusion / negative screening and basic ESG tilts “would not plausibly contribute to positive sustainability outcomes.” Yet if the second channel the report identifies - fund flows affecting share prices and cost of capital – is a valid channel, it isn’t clear why it would not apply in these cases but would apply in the reverse case of a fund just investing in “sustainable” companies.

There are lots of debates to be had here. Overall, although a contested matter, there doesn’t seem to be great evidence that divestment has a sufficiently material impact on cost of equity to influence real-world investment choices (see for example Berk and Van Binsbergen’s analysis). But there is at least theoretical reason to think that ESG tilts could have some influence on behaviour, as much through incentives as through a cost of equity channel (see for example this paper by Edmans, Levit and S chneemeier).

The point is that it’s not clear why the standard would disallow a strategy that seeks to raise cost of equity for a small number of companies by excluding them when it allows a “sustainable focus” strategy that seeks to lower cost of equity for a small number of companies by investing in them. The reality is that the impacts on either side are probably small, but they should presumably be symmetrical.

Impact on risk and returns

Does sustainable investing, whatever we mean by that, have an impact on what happens in the real world? And if so, does it affect portfolio risk and returns?

The FCA’s document spends a lot of wordage exploring what funds might have to do to demonstrate real-world impact, but much less on the impact on portfolio risk and returns. The issue is not entirely ignored, but simply covered in a requirement, under the sustainability objective, to disclose “details of the extent to which the sustainability objective has, or may have, impacted on the financial return of that particular sustainability product”. In the guidance, it is clear that impact on financial return may also include risk characteristics. But this passing reference, and lack of supporting guidance, contrasts with extensive requirements relating to disclosure of the relevant sustainability objective.

Yet this seems to be an important consideration for retail investors in fund choices. One of the mistakes of the industry has been to allow the myth to grow that sustainable investing inevitably leads to outperformance. In fact, the evidence is much more mixed on this (here’s a good recent paper on the theory of this with relevant references contained therein and a meta review paper that concludes that on average ESG investment strategies are not found to outperform – this is a huge topic area and I don’t pretend these two papers provide a comprehensive overview):

To the extent that “sustainable” funds have outperformed the market in recent years, it is unclear the extent to which this is a result of sustainability factors or sector sorting (for example overweight tech and underweight oil or differential exposure to certain risk factors). Indeed the market reversals during 2022 seem to have also reversed some of the recent tendency of sustainable funds to outperform.
Even if sustainable funds have outperformed, it could well be that this is simply a one-off rerating of “sustainable” companies as those characteristics become recognised and priced in, rather than any guide to the future.
Indeed, if the share price / cost of capital channel works, it does so by increasing share prices so as to reduce cost of equity. But the flipside of lower cost of equity is inevitably lower expected returns. So to the extent the strategy is successful it will likely reduce future returns.

It may well be that most ESG strategies are so diluted that they neither have much real-word impact nor much impact on returns, hence leading to an inconclusive literature. And there do seem to be pockets of sustainable investing strategy that do outperform with remarkable persistence, for example Alex Edmans’ findings on the link between employee engagement and stock returns which is as persistent today as when they were first identified over a decade ago. This suggests that sustainability factors are not always efficiently priced by the market.

However, if we accept that the market is even broadly efficient, it seems unlikely that there is a major free lunch of sustainable investments that both enhance societal outcomes and improve returns. If there is an “underserved market” there is probably a reason why. Indeed, the reason why there are gaps in funding for, say, climate adaptation and mitigation in the developing world, is that such investment opportunities are outside the normal risk and return characteristics that investors accept. This is way devices like blended finance are needed to encourage such investments.

Consequently, we should expect investments that have a material additional affect on real-world outcomes also to have a material adverse affect on risk-return characteristics. Otherwise they would be taking place already. This is not to say that there aren’t attractive opportunities available to investors, with good risk-return characteristics, in segments of the market that might be considered sustainable today, for example in low-carbon industries such as healthcare. But the point is that investing in such existing investments in secondary equity markets is highly unlikely to be creating additional social benefits.

As a rule of thumb, the more an investment strategy is creating real-world activity that isn’t already happening in response to today’s economic incentives, the more likely it is that the investment strategy has negative risk or return implications for investors.

This is not at all to say that such investments shouldn’t be offered. We know from research that some investors are prepared to incur a cost to invest in a way they consider is sustainable (see here for example). But this must be done transparently, with the trade-offs clearly laid out. The FCA could helpfully develop the disclosure requirements and guidance in this regard.

What is sustainable?

Products that fall under the Sustainable Focus heading need to invest in assets that meet a “credible standard” of social or environmental sustainability or align with a specified social or environmental theme. Sustainability Improvers will need to demonstrate improvements in sustainability, which presumably requires a standard to measure it by.

At this point the FCA is not mandating what is meant by a “credible standard”, simply saying it should be “robust, independently assessed, evidence-based, and transparent”. The FCA notes that development of a UK Green Taxonomy could provide such a standard. As debates over the EU’s taxonomy have shown, what is designated as sustainable is controversial, inherently political, and subject to change over time. It is therefore probably a good thing that the FCA has focussed instead on transparency in relation to the standard and KPIs adopted.

In certain areas, with straightforward objectives, this is not a problem. A Catholic Values fund can invest or engage in order to discourage US firms from providing mechanisms for women to receive abortions through corporate healthcare programmes. They would argue that promoting abortion is not sustainable because of its corrosive effect on the morals of society. A progressive women’s rights fund can do and argue the opposite. Both can qualify as being “sustainable” providing they are transparent and both can provide KPIs on their impact.

But what about climate change? Does an engagement strategy based on a theory of change that we will innovate our way out of disaster qualify as much as one that pushes firms to have net zero targets and transition plans? The former might focus on green R&D but have little regard to current business activities or carbon emissions trajectories. The latter would take a very different approach.

One great benefit of the proposed regulation is that it would require transparency on these questions, supported by a theory of change and clear measurements and disclosure. But it may replace one set of problems for the consumer (not knowing what a fund is doing) by another (judging the efficacy of theories of change based on limited information).

This is probably a better place than we are at now. And trying to impose a sustainability standard probably presupposes the regulator has more knowledge about the future than would be prudent. But people hoping for the standard to reinforce a certain policy view of what sustainable means may end up being disappointed. On the other hand, if the view of sustainability develops over time in a way that is viewed as politicised, then we risk welcoming US culture wars to our shores.

A brave effort

I’ve just skated over the issues in this ambitious proposal. There will be lots more to chew on in the coming weeks. I’m sure there are ways in which the proposal can be improved, and benefits and problems that I haven’t covered here.

But what’s clear is that the FCA has attempted to put in place a tough proposal that genuinely enhances informed consumer choice in an area that has become riven with confusion and obfuscation. There is a chance that the proposal would help to clear out the dead wood from the forest of “sustainable” products. That would be a triumph.

However, there’s a risk that good products will be swept away with the bad, given the apparently quite onerous requirements of the rule. The difficulties of demonstrating sustainability impacts may put off providers from issuing products that may actually do some good. And of course the proposal does nothing to answer for consumers the question “what is sustainable?”.

But perhaps that’s no bad thing, given that none of us really knows. As I heard someone recently say: “it’s much easier to identify what isn’t sustainable than what is”.