Fairtrade for finance

A Fairtrade-style kitemark for responsible investment is in the pipeline. Properly implemented, the initiative should improve industry standards on ESG, writes Steve Waygood.

4 minute read

forest leaves

Death, philosophy, the afterlife: for a television comedy, The Good Place explores some weighty themes. The Netflix series follows the adventures of four characters who try to become better people to earn ‘points’, or karmic rewards. It slowly dawns on them that the complexity of the modern world makes it fiendishly difficult to behave ethically.

Is your pension invested in companies that damage the environment?

This is a theme we can all identify with. High-tech gadgets, just-in-time supply chains and globalised markets have made life more convenient for most of us – but they have also made it more complicated. Do you know how the metals in your smartphone were mined? How are employees treated on the coffee plantations that grow your Arabica beans? Is your pension invested in companies that damage the environment?

Some industries have solved the problem of ‘information asymmetry’ by introducing commonly agreed standards, providing individuals with reassurance that minimum guidelines have been observed – for coffee-drinkers, the Fairtrade label means they can sip their morning latte with confidence it has been ethically sourced.

For too long, finance has lacked a set of publicly available standards of its own. If consumers want to make sure their savings are invested responsibly, it has been difficult for them to get a clear idea of the products on offer. But this is about to change: working with Aviva Investors and other industry participants, the British Standards (BSI) Institute is developing a kitemark that can be used by asset managers that meet voluntary standards on responsible investment. Think of it as Fairtrade for finance.

Ivory towers

The debate about responsible investment has typically been held within and between two ivory towers, with chairmen, chief executives and company secretaries on the corporate side talking to fund managers and their governance teams on the institutional side, with little recourse to those whose money it is. The end investor has had little or no insight into the governance decisions taken with their money.

It remains hard for individuals to know precisely how their capital is invested, and how those investments impact on the wider world.

Disclosure of asset managers’ performance against environmental, social and governance (ESG) criteria has improved markedly in recent years, but it remains hard for individuals to know precisely how their capital is invested, and how those investments impact on the wider world. Part of the problem is the inconsistent application of ESG-related terms. Take ‘negative screening’ – the phrase can refer to a wide range of filters used to exclude a variety of different assets from funds. A few negatively screened funds appear to have a very poor voting record and no real engagement at all.

To fill the gap, broad guidelines have been adopted as de facto standards for responsible investment, even if they were not designed specifically for the purpose. The UN Principles for Responsible Investment (PRI) are a good example. Launched in 2006, the PRI have brought much-needed recognition of the importance of ESG in finance, particularly as it applies to fiduciary duty. But for all their benefits, the PRI lack the accountability mechanisms that effective standards require.

To fill the void, standards have begun to spring up at an asset class level: the International Capital Markets Association has developed a set of guidelines for green bonds, for instance. Nevertheless, some issuers ignore them, choosing instead to ‘self-certify’ the environmental benefits of the projects they intend to finance, while third-party verification and auditing of green bonds can lack rigour.

Fairtrade for finance

The industry is now waking up to the problems that a lack of common standards on responsible investment bring

Thankfully, the industry is now waking up to the problems that a lack of common standards on responsible investment bring; the BSI plans to launch its kitemark within the next 12 months. Separately, the Investment Association is consulting on proposals for sustainable investment products., while the Financial Reporting Council and Financial Conduct Authority have recently published consultations on revisions to the UK Stewardship Code. The new code aims to increase demand for more effective stewardship and investment decision-making, aligned to the needs of institutional investors and their clients.

The BSI project is being developed by an advisory group and technical committee; Aviva Investors is involved alongside other industry players. The committee is working to create two sets of voluntary standards: a sustainable finance framework to establish a common language and high-level principles across the industry; and a sustainable investment management framework, which will set specific requirements for market participants, with robust oversight mechanisms built in.

To begin with, the latter standard will be ‘top-down’, applying to asset managers rather than individual funds. (A fund level standard is in the pipeline for later this year.)  To be accredited with the kitemark, managers will need to provide documentary evidence they engage with the companies they invest in and that ESG-relevant data is being properly considered by their investment teams. This will mitigate the risk of ‘greenwashing’, whereby market participants exaggerate their environmental credentials.

A simple kitemark on fund marketing materials that flags which managers are doing the right thing will represent a big step forward.

Properly implemented, the kitemark will provide consultants, institutional investors, advisers and individual investors with an easy way of identifying managers that meet minimum standards of integrity, from fee transparency to voting and engagement. The average end investor typically lacks the time and expertise to obtain or make sense of this kind of information, even where it is available. A simple kitemark on fund marketing materials that flags which managers are doing the right thing will represent a big step forward.

Transparency and harmonisation

Nevertheless, it is only a first step. As standards are introduced, industry participants should work towards greater international coordination and harmonisation.  While some might argue that a raft of national standards is better than none, too many competing labels will generate inconsistency and confusion. Rather than incentivising a race to the top, there is a danger competing standards could create the opposite scenario, leading some market participants to gravitate to whichever guidelines are least onerous to follow.

The International Organization for Standards (ISO) would be best placed to create a coherent framework for global standards.

Ultimately, the International Organization for Standards (ISO) would be best placed to create a coherent framework for global standards and provide the proper oversight. The ISO has already accepted a proposal from the BSI to develop a technical committee that is likely to build initial proposals in this direction. It will publish a report on its progress this September, and industry practitioners would be well advised to watch closely to make sure the proposals are sensible.

Over the longer term, the industry should also develop a more granular set of standards that apply at the asset class level, and consider the specific ESG implications of investments from infrastructure to real estate, listed equities to private debt. These should account for the idiosyncratic details of specific investments in each asset – how much cleaner is gas than coal? How does nuclear energy rate from an ESG perspective?

Like the characters in The Good Place, end investors have been in the dark for too long about the ethical ramifications of the decisions made in their name. But by creating a system of transparent and recognisable standards, the finance industry has the opportunity to help us all tally up a few more points in our favour. 

A version of this article appeared on Investment Week on May 21, 2019.

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