Financial institutions face challenges to ESG investment credentials

12 Jun 2023

Financial institutions should brace for a surge in challenges to their green investment credentials, argues Beatrix Lohn.

Asset managers are under increasing pressure to demonstrate their commitment to environmental, social, and governance (ESG) goals and set out their green credentials. These promises are, however, triggering a greater degree of scrutiny – reinforced by a raft of negative coverage on the performance of ESG funds and fund outflows and the wider political context of the Competition and Markets Authority’s (CMA) announcement that it will examining the accuracy of certain “green” claims that mislead consumers and the recent consultation on the future of ESG ratings providers conducted by HM Treasury.

It is hardly surprising, therefore, that investors are beginning to ask whether green funds themselves are attractive.

At DRD Partnership, we advise on a range of climate-related issues where ESG reporting has led to scrutiny and legal action. Our expertise has assisted clients with a range of different issues including bringing an OECD complaint against a plc over its ESG reporting, acting for shareholders bringing a claim against a company for overstating its ESG credentials and assisting an ESG fund under pressure to explain why it held certain stocks.

Analysis in the Treasury’s consultation reveals that nearly 50% of the £10 trillion worth of assets under management in the UK have integrated ESG into their investment processes, explicitly claiming to be driven by ESG fundamentals, with that proportion sure to increase. However, as political uncertainty persists, investment managers are confronting the twin pressures of balancing risk and returns, while simultaneously navigating a raft of heightened regulatory scrutiny.

Mandatory ESG reporting is becoming increasingly widespread. In the UK, asset owners and managers must report in accordance with the FCA’s ESG rulebook and the Taskforce on Climate-related Financial Disclosures (TCFD). As outlined in the Government’s Green Roadmap, this is to ensure that the UK reaches its legislated net zero target by 2025. It goes without saying that in order to achieve the 78% reduction in emissions by 2035, finance will have to play a central role, with green finance unlocking the possibility of a low-carbon world. The 2023 Green Finance Strategy “Mobilising Green Investment” sets out the UK’s Government’s approach to supporting the asset management sector to prioritise investment in the green economy. By the start of 2024, the UK will, in essence, have clear financial deliverables and a green action plan in place, along with measures to ensure consistent and substantial investment in the green economy as well as a sufficient buffer installed to mitigate against any financial instability triggered by climate change.

Nevertheless, this journey will not be without its challenges. With the sharp increase in climate-related litigation, transparency is crucial in ‘green’ investments. Even the UK’s financial regulator, the Financial Conduct Authority (FCA), has found itself in muddy waters after being hit by a legal complaint from ClientEarth, an environmental organisation that uses the law to protect life on earth. ClientEarth filed a complaint on the regulator’s decision to approve the prospectus of a company with “significant interests in the Cambo and Rosebank oil and gas fields in the North Sea”. This complaint, albeit in its early stages, carries significance as it demonstrates that organisations like ClientEarth are determined to challenge and call out decisions that do not align with a green agenda.

As more stakeholders become increasingly aware of ESG as a tool in investment decision-making, asset managers that stop or pause their ESG focused investments will risk reputational damage for being seen to back off from earlier commitments.

Beatrix Lohn

While factors such as inflation and the energy crisis triggered by the war in Ukraine and Russia may act as a stimulus to return to oil, those at funds must remain steadfast and transparent in their approach to ESG investments. Whilst performance in the short term can be driven by macro shocks there are benefits to a longer-term focus. Firms such as Gore’s Generation Investment Management Fund, a climate-driven fund to back carbon cutting projects in currently “unloved” sectors, demonstrates that there continues to be appetite for forward-looking green funds. Firms such as this, with an investment strategy based on delivering net zero can and will, in time, hope to deliver attractive returns that investors will want access to. As more stakeholders become increasingly aware of ESG as a tool in investment decision-making, asset managers that stop or pause their ESG focused investments will risk reputational damage for being seen to back off from earlier commitments

There is no going back when it comes to ESG. Regulatory pressure will increasingly mean that performance will be monitored and tracked against independent, verifiable, climate-related criteria, and asset managers will need to invest time and build the capacity to meet these demands. What’s more, if this reporting does not add up, asset managers will increasingly be the subject of third-party scrutiny, stakeholder mutiny and litigation.