Why EU legislation could herald a boom in ESG investing

3 minute read

A poll from the Pew Research Centre earlier this year found climate change was now seen as the top global threat in most European countries, trumping even the danger of ISIS-related terrorism. It will no longer be possible to conduct the suitability assessment without ESG being part of the conversation.

That would suggest environmental, social and governance (ESG) criteria, which have been gaining traction within mainstream institutional investing in Europe, have the potential to start shaping the retail investment landscape to a much bigger extent too. If this is to happen, regulatory changes which are about to be introduced by the European Commission could have a crucial role to play.

Surveys suggest most retail investors want to ensure their values are reflected in the way their money is invested. Unfortunately, at present this happens all too rarely. That is primarily because so few financial advisers ask clients whether they have any ESG preferences, let alone whether they would like them to be reflected in the advice they receive or what their portfolio is invested in. Paradoxically, it appears advisers don’t ask about their clients’ ESG preferences because they are not mentioned by them, but the clients don’t mention any ESG preferences because the adviser hasn’t asked about them. The European Commission is looking to address this ludicrous situation by introducing legislation that would mean understanding a client’s ESG preferences would be weaved throughout the fabric of the suitability assessment carried out by advisors.

When enacted, the legislation will ensure they have to ask their clients about any ESG preferences and integrate them into the investment advice they provide. For example, advisors would need to reference any ESG preferences when explaining how they have reached their investment conclusions and when describing the nature and risk of their proposed course of action. Moreover, firms’ policies and procedures will need to be updated so they can demonstrate they understand their clients’ ESG preferences.

In other words, it will no longer be possible to conduct the suitability assessment without ESG being part of the conversation. Clients may not have such preferences of course, or they may put other elements of their objectives higher on their list of priorities. But at least they will be asked. We warmly welcome these proposals and believe the EU Commission deserves enormous credit. Having said that, we believe it needs to make sure it gets the detail of the legislation right if it is to ensure clients are given the broadest range of options, in line with their preferences.

At present, the draft legislation defines ESG preferences as “a client’s or potential client’s choice as to whether and which environmentally sustainable investments, social investments or good governance investments should be integrated into his or her investment strategy”. Sustainable investments are in turn narrowly defined as an investment in an economic activity that contributes to an environmental objective.

The legislation as currently drafted assumes all clients with ESG preferences are exclusively interested in increasing the exposure of their portfolio to economic activities that contribute to an environmental or social objective, subject to good governance and doing no harm to those objectives.

We believe while the definition of sustainable investments may accord with some people’s ESG preferences, there is a much wider spectrum of preferences that the suitability test needs to take account of. For example, we would like to see it encompass a whole range of sustainable investment approaches including negative screening, stewardship, and impact investments. Moreover, we believe investors want to see what impact their investment strategy is having in the real world.

Research suggests most clients with ESG preferences want to use their influence to favour positive outcomes in the real economy – such as changes in the investment decisions made by the investee companies – and expect evidence regarding the effectiveness of the investment techniques used. In our opinion, the definition of ESG preferences should be client-led, with the assistance of advisers or tools to outline the possible options and explain what they mean for clients, not pre-determined by a narrower version of what sustainable investment might mean.

There is no shortage of evidence that ESG factors, particularly relating to climate change, are important to members of society, particularly millennials. Furthermore, many of these people wish to see their values reflected in the companies they spend their money with and that they entrust their money to. Too few members of society understand how the financial system works and realise that through their pension and investments they are the ultimate shareholders of companies that affect every aspect of our day-to-day lives. This is their money.

Although financial advisers play a key role in helping them meet their investment objectives, for too long retail clients have not even known it was possible to invest in a way that reflected their values, let alone been given an opportunity to do so. Making sure clients are asked the question about their ESG preferences and can have a conversation about how they want their money to be used, should go a long way towards improving matters.

This article originally appeared on Responsible Investor.