You can’t say anything these days. Try to publish an article on ‘ESG’ funds and you’ll have the green police asking why you didn’t talk about its lack of oil exclusions, or why you’ve been mixing your tilts with your thematics. What’s that? You dropped an impact fund in there too? Dear God, man!

I jest. It is important to get these distinctions right and, for advisers, it is now urgent.

Until recently, 21 March 2021 was the day all UK advisers would have to become taxonomists of sustainable investing.

This was the date when EU rules known as The Sustainable Finance Disclosure Regulation (SFDR) were to come into force. The myriad definitions of the sector were to be an unavoidable part of doing business, whether you think of yourself as an ESG specialist or not.

The rules will now not come into force as planned. Indeed, they are the latest casualty (if you see it that way) of the Brexit negotiation deadlock. It still matters though

SFDR would have introduced extra disclosure requirements for advisers.

Essentially, you would have had to provide evidence of the sustainability factors and risks associated with investments (a good explanation is provided by Allen & Overy here).

Key sustainability factors include the environment, society and employment practices, as well as human rights, anti-corruption and anti-bribery. A sustainability risk is ‘an environmental, social or governance event or condition that, if it occurs, would cause a negative material impact on the value of an investment’.

Do you understand how the funds you are using have applied or ‘integrated’ ESG criteria into their process? Indeed, have the asset managers themselves grasped the full implications of ESG? The answer in some cases is no.  

Change is coming

The Brexit transition period has played host to ‘onshoring,’ whereby EU regulations have been brought back into the UK.

That process has not included SFDR. And since SFDR was not already part of EU law when the transition period started, it has essentially fallen between two chairs.

The FCA said the SFDR would not apply next March on a call with advisers last week. The regulator also indicated that, were a UK version of the rules to be devised, it would consult on the final outcome in the usual fashion.

I asked long-time sustainable investment specialist IFA John Ditchfield, head of responsible investment at Helm Godfrey and chairman of Impact Lens, what this means for advisers.

‘Fund management groups will still be impacted by SFDR because many of them market into the EU, so there will be some adoption by asset managers used by UK advisers. The UK should reach some agreement with the EU regarding financial services. It is reasonable to expect it would come back,’ said Ditchfield.

‘There has already been widespread adoption of ESG questions into client questionnaires by advisers, so it’s going to come in anyway.’

Other ESG experts have indicated that, if the UK does not adopt SFDR, it will align itself with a parallel set of international sustainability standards –namely those set by the Taskforce of Sustainability Disclosure (TCFD), a product of the G20 group of nations.

Earlier this month chancellor, Rishi Sunak announced the UK would become ‘the first country in the world to make TCFD-aligned disclosures mandatory.’

What does this mean for advisers? The anticipation of SFDR rules (or something like them), the surge of ESG fund launches this year, cultural acceptance of climate change as an emergency issue, publicity around welfare and governance stories in the press (see Boohoo, Wirecard), and the sheer opportunity to engage clients on these issues, means the boulder has started rolling down the tunnel.

Indeed, change is already happening within advice firms. Internally the cogs are already whirring inside businesses to put investment propositions on an ESG footing. If the conversations I have been having with IFAs over the past few months are anything to go by, most are bracing themselves for a raft of questions about sustainable investment in 2021.

The ESG bullwhip

I believe advisers must align their business with one of three approaches: ethical, impact, or ESG.

Size, resources and time will be crucial factors. Only small firms will be able to offer clients real ethical investment choice in a safe and cost-effective fashion, but large firms can make impact work. In fact, the larger the better.

The final option – ‘ESG’ – is a bit of a misnomer. Right now a firm can differentiate itself by getting to grips with what ESG should actually look like for asset management, and prune laggards accordingly. In time, though, the entire industry will catch up.

A fourth option, ‘do nothing’ is viable in the short term if the UK does not achieve equivalence with new EU rules. But assuming ESG is not going away, advisers need to think about how they want to position themselves.

There are different routes into this problem.

One is to look for a universal, objective measure of ESG integration and apply that standard rigorously.

How? Luckily there is something called the Principles of Responsible Investment (PRI). These come from the United Nations, which, as well as sounding spectacularly grandiose, connects retail asset managers to the institutional investment world. Pension schemes are much further down the ESG road and can be seen as the grown-ups in this space right now.

Arguably an asset manager who is a PRI signatory should by definition run ESG funds, regardless of what they label them as.

It’s not just a sticker though. You have to practice what you preach. Indeed, the UN de-listed four investment firms in France, Indonesia and the US and one Dutch asset owner from its signatories list in September.

These firms supposedly failed to meet the minimum requirements for PRI membership in 2021. The minimum requirements are likely to tighten further still.

A full list of UK investment management signatories can be found online here. A quick tally reveals there are 352 UK investment manager signatories.

These include The Vanguard Group, WHEB Asset Management, and EdenTree Investment Management (and advice firm Equilibrium Financial Planning, see below). Fidelity and M&G are also on the list.

But not all signatories are equal; there are scores given. Out of 3,000 signatories worldwide, only 20 make the PRI’s ‘leaders group’.

A word on labels. Julia Dreblow’s excellent website FundEcomarket lists nine different ‘SRI Styles’ (socially responsible investment styles). These include ‘socially themed’, ‘negative ethical’ and ‘ESG plus’. They operate in conjunction with a plethora (truly, it is a fantastically wide array) of other options and search criteria.

As Ditchfield lamented at a New Model Adviser roundtable last year, ‘the industry has managed to turn this into the ultimate alphabet spaghetti of acronyms, abbreviations, and classifications’.

But if you set aside personal, subjective ethical requirements, then the PRIs should cut through the tangled nomenclature, in principle at least. In practice, there remains a significant greenwashing risk even among those who have signed up.

Last week we told you how Equilibrium Financial Planning, an advice firm that manages £1bn of client assets, was using its clout to hold asset managers to account.

Equilibrium Investment Management will now only use funds whose custodians are signatories of the PRI by the end of 2021. It will require the firms it invests in to have an average PRI score of ‘A’ within the ‘strategy and governance’ and ‘active ownership’ categories.

This is a bull whip. Like Indiana Jones disarming a retinue of temple guards, as long as you have hold of the handle, a relatively small effort produces a big effect. Low PRI score? Crack! You’re out.

This is a smart strategy for a big firm applying the PRIs to itself as well as others. The reason is that it does not have the luxury smaller IFAs do of a mainly exclusion-based approach.

Ethical Investment

This second solution is ethical investing, which is not the same as ESG.

Ethical investing will exclude all companies that engage in certain activities – oil extraction, animal testing, arms dealing, for example – purely by virtue of that activity. A good example is the Aegon Ethical Fund, whose managers spoke to us as part of our 2020 ESG takeover issue.

ESG investing, meanwhile, allows for degrees of damage. A polluting company will have to work hard to be included but will not be ruled out by definition. It is up to the manager and their ESG process to weight the scales.

Some seasoned ESG managers cannot believe what slips through the net in rival ESG funds. But as the market matures you could reasonably expect these differences to narrow.

I spoke to one advice firm that has been developing its ethical investment process over the past three or four years. It approached a handful of core clients to float the idea and then began conversations about where they would feel comfortable investing their money, and where not.

Rather than being fully bespoke, it has assembled a single portfolio, choosing exclusions by survey and conversation. It is a finely-tuned operation built on close communication and established client relationships. It also requires the operational capacity to take a week off each quarter to vet a suite of funds.

It is remarkable though, that even one of the most rigorously exclusionary funds can fall short when put under the microscope.

In one example I have seen, a fund that excluded animal testing (a bit of a hallmark of funds with the strictest ethical criteria) invested in Unilever.

Unilever does not use animal testing in its healthcare products, except, it turned out, where local law actually requries it. This is the case in China, which is a massive market for the multinational. However, given that the advice firm’s ethical portfolio accounted for over 10% of the funds’ assets, it was in a position to ask questions about what was going on.

Engagement with the manager secured a defence and an explanation.

The fund said it had been persuaded by Unilever’s claim it had been an influential voice among regulators and governments. It had called for a worldwide animal testing ban on cosmetics by 2023. Indeed, Unilever is recognised by animal rights organisation Peta as ‘working toward regulatory changes to reduce the number of animals used for testing’.

In fact, the Chinese government approved non-animal testing methods that passed into statute this year. From the adviser’s point of view, the important thing was to document and prove engagement, and relay its findings to its clients.

Why go to such lengths? After all, there is not a single recorded complaint upheld by the Financial Ombudsman Service (FOS) on the basis of failure to invest in line with stated ethical preferences. I certainly could not find one, and the FOS was not able to provide one either.

Earlier this year the FOS told me that, if it were to see a sharp rise in ethical-related complaints, it would work outwhether a new approach was needed with the FCA.

When I enquired again about this, the FOS added it was ‘important to note that we look at the individual circumstances of each complaint’.

Last year Ditchfield said that while this type of complaint has not yet happened, ‘it should happen’.

‘I’ve had clients who have invested multiple millions into portfolios, and major stockbroking and investment houses have completely ignored their ethical restrictions,’ he says. It may be that SFDR, TCFD, or similar rules. will catalyse huge change.

A note on asset allocation – in most cases I have seen, it is not currently possible for a firm to replicate a standard portfolio’s allocation in ESG form.

The ethical firm I spoke to only runs aggressive portfolios because it is just not possible to control volatility in the same way its balanced and cautious portfolios do.

When funds are pursuing specific investment themes like clean water and urbanisation, the process also makes comparison with an index less meaningful. They are just not going to behave the same way.

IFA Matthew Douglas recently explained that for the ethical version of its aggressive portfolio it combines its usual allocations of US, European and Far East equities into one global allocation. The upside, it said, was that the global allocation had a wide remit of investments.

The next crusade

This brings me on to advice firms’ third option: impact investing. From what I have seen, big advice firms should not be offering ethical investments. Keeping on top of exclusions is bound to become unwieldy, resource-intensive and therefore expensive very quickly.

Knowing this full well, EQ Investors launched its impact portfolios in 2012.

Doing this enabled the business to offer liquid investments in a diverse portfolio, without feeling they were missing out. Damien Lardoux, head of impact investing at EQ, told us more earlier this year.

‘We thought managers in the ethical space focused too much on negative screening – avoiding harmful sectors,’ he said.

‘We saw an opportunity to focus on companies that are doing good, and we knew clients wanted that. Discretionary fund managers would give them lists of 30 things they might want to avoid, but people are put off by anything phrased negatively.’

EQ’s ‘Impact Calculator’ sums up the firm’s promise to clients.

Over the last year, £1m would have recycled 26 tonnes of waste, treated 68 patients or provided 176m litres of clean water, it claims.

Impact does not do away completely with the idea of avoiding companies, but that decision is a judgement for the portfolio managers. EQ sifts through corporate reports (rather than take a manager’s word) to determine if companies’ actions match their policies. According to Lardoux, the business is ‘less keen’ on shareholder activism.

In February, for instance, he told us ‘management mentality’ in companies like BP and Exxon Mobil ‘is hard to change because they are incentivised to make short-term profits.’

There will be others who disagree. Oil companies are the biggest investors in renewable energy by far. The problem is that they still spend many multiples more on extracting oil from the ground, so it depends on your definition of impact.

Just this month BP signed a deal with Danish renewables multinational Ørsted to produce hydrogen from wind power.

If you hold sustainability funds you may recognise Ørsted, as it is held by many of them. The deal came a few months after BP CEO Bernard Looney announced he wanted to make BP a net zero carbon company by 2050.

So, while advisers might scoff at yet another new reporting requirement, the spread of ESG investing in the minds of clients as well as fund managers will make it increasingly difficult for disinterested firms to ignore.

Firms that think they can guarantee not a single one of their clients will be interested in some form of ESG may have time to sit back before the regulator forces their hand, but my money is on this happening sooner rather than later, Brexit or no.

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