In February, the FCA published a letter to asset management CEOs summarising the key priorities in its upcoming regulatory review of this systemically important sector. Out of the FCA’s four topics of focus, two are ESG related, including an assessment of the use of non-financial ESG data in reporting and the mis-selling of ESG products, as well as how firms are ensuring delivery of optimal consumer outcomes.
After some years of flying beneath the radar, it seems, the responsibilities of investors to ensure their products and services protect consumers and meet ESG expectations are coming under much greater regulatory scrutiny. It is therefore vital that asset managers take steps now to understand what is required of them and adopt coherent and well-organised strategies for addressing the complex and often cross-cutting ESG regulations that are coming into force in 2023.
Despite what some see as a ‘regulatory burden’, asset managers should be reassured by what regulations are requiring them to do. When approached in the right way, there is significant potential to turn regulatory risk into a key business opportunity that enhances value within and across portfolios.
Based on our long history and experience of working with asset managers, we see four key elements to any successful approach:
- Shifting the mindset beyond compliance
All comprehensive sustainability strategies should involve a regulatory scan to recognise current requirements as well as how these will evolve over time. Moving ahead of regulatory dynamics will enable asset managers to act in a considered, optimal manner rather than as a last-minute knee-jerk response.
Furthermore, most ESG regulations in the finance sector are related to disclosures, designed to provide greater transparency and information for external stakeholders. Yet there is also opportunity to use the insights internally, to enhance data-led decision-making in-house and in the investment process.
For example, the TCFD’s requirement for scenario-planning provides a framework to undertake an objective and considered approach to identifying the risks and opportunities to climate change at both an entity-level and at a product- or portfolio-level. This will provide valuable insights about how the economy may transition, consequently aiding the identification of nascent industries set for growth as well as emerging risks which can be used by investment teams to aid investment analysis and decision-making. Turning regulatory risk into a business opportunity as a result.
Given the FCA’s first mandatory TCFD reporting deadline for large asset managers is June 2023 (with a later phase-in for smaller asset managers in 2024), now is the time for investment firms to be considering their response. This will allow them to get ahead of the curve and start benefitting from the insights that such regulation will provide.
- Data collection
Getting data collection right is one of the seven drivers of success that we identified in our recently released Investor ESG Toolkit.
To respond to regulation, data collection infrastructure needs to be expanded beyond financial data to include non-financial ESG considerations such as greenhouse gas emissions and employee diversity.
Not only does collection of accurate and timely non-financial data enable investment firms to make data-informed decisions as explained above, but it also helps to respond to increasingly complex information requests made by shareholders and LPs.
As an example, asset allocators are increasingly requiring investors to report on scope 1 and 2 greenhouse gas emissions, yet currently fewer than 25% of private equity GPs are able to provide this information. Furthermore, as retail investors and purchasers of other financial products increasingly look for investments which contribute to the sustainability agenda, they will want to see granular data to understand the impacts of their investments.
Clear governance structures, responsibilities, and controls are crucial for implementing ESG policies and management systems that adequately respond to regulatory requirements. Meanwhile, having these in place enables the efficient allocation of resources and ensures that actions are prioritised and pursued effectively.
As an example, the FCA’s Consumer Duty regulation – the first phase of which comes into force on 31 July 2023 – places a requirement on firms “to act to deliver good outcomes for retail customers” as well as make judgements on subjective concepts such as “foreseeable harm” and “fair value”. The subjective and outcomes-focussed nature of the rules creates a requirement for clear frameworks and controls to collect appropriate data and monitor customer outcomes. In turn, a clear allocation of responsibilities is required to make considered data-centric decisions off the back of this.
Yet a common failing that we see amongst investment firms is to apportion their response to a specific department, resulting in siloed efforts which lack coherence. For example, instead of giving the compliance team full responsibility, there is the opportunity to work together with front-office staff to ensure that ESG and sustainability is coherently imbedded into the firm’s core operations and investment practices, and not simply as a response to regulatory requirements.
Effective communication is a key part of any firm’s ESG strategy and branding; it is natural for firms to want to communicate their ambitions and the achievements that they have accomplished.
But from the regulator’s perspective, such communications must be accurate and not misleading, particularly when it comes to the sale of investment products to professional and retail investors.
Getting this right is particularly important given the forecast rapid growth of the ESG and sustainable investment industry. Yet as these products contribute an increasing proportion to overall asset management group strategies (21.5% of total global AUM by 2026, according to the same report), the economic consequences of getting this wrong will increase.
Indeed, there have been several examples of high-profile firms which have miscommunicated or mislabelled products (we won’t name names), leading to accusations of greenwashing. Such accusations reduce customers’ faith in the credibility of ESG claims, leading to falling AUM and therefore fees.
Consequently, it is important that asset managers develop a clear communication strategy and approach to convey their ESG work accurately and widely, both at the entity-level as well as the product- or portfolio-level. This involves bringing together the key actions that we have described above to feed into a clear and compelling narrative.
By redoubling efforts around their ESG investment strategies (rather than turning away), asset managers can take the opportunities that an authentic and robust approach to this growing market can give, even in times when consumers and regulators are becoming more sceptical and less willing to trust overstated sustainability claims. This will enable those firms that have genuinely good ESG intentions to gain the recognition they deserve.
Sancroft has 25 years of experience working with businesses and investors to improve their ESG and sustainability performance, allowing us to bring unique breadth of experience and insight around the actions that deliver change.
One of our core services is working with asset managers to support them in developing frameworks to efficiently implement ESG management systems across the firm.
Now is the time to act – ESG and sustainability within finance is a fast-moving space with a lot to consider, and more in the pipeline.
We would be happy to talk through how incoming regulations are set to impact your firm and to develop an action plan for how you should effectively prepare for these in a way that brings value to your organisation as well as your customers. Please contact Alex Miller.