ESG values and risks must ‘be ingrained’ into core investment decisions

EU regulatory reforms and initiatives, coupled with increasing investor demand, are among the catalysts that are seeing the adoption of environmental, social and governance (ESG) standards and practices become a key priority for regulators, policymakers and asset managers. "ESG is no longer a niche investment strategy or an ancillary consideration," says Aongus McCarthy, senior associate with Pinsent Masons.

The integration of ESG into the investment selection process is used globally across an estimated $17.5 trillion (€15.9 trillion) in assets under management, having grown by 69 per cent in the two years up to 2018. Fund managers are using it to incorporate factors such as climate change, natural resources, energy usage, governance, diversity, social, human rights and ethics into their investment strategies.

As a leading global financial services centre Ireland is already well positioned to play an important role in the integration of ESG into the asset management industry. "Ireland has sought to put itself at the forefront of the integration of sustainable finance and ESG practices, as was evidenced by the publication of the Ireland for Finance strategy, the success of Climate Finance Week last November, and recent Central Bank announcements," says McCarthy.

Many domestic and global asset managers use partnership structures to house investments such as sustainable and renewable energy and infrastructure assets. "The introduction of proposed reforms to the Investment Limited Partnership legislation in Ireland will be of benefit for managers investing in these assets," he adds.

Investment solutions

The rise in demand by investors for investment solutions that integrate ESG factors while seeking positive financial outcomes has increased pressure on asset managers at the same time as presenting new product opportunities for them, according to McCarthy. “For example, we have seen a number of funds focused on investing in companies based on their levels of energy consumption or water usage, or which have successfully implemented policies in relation to diversity and inclusion.”

Recent EU regulatory initiatives which long-termism as opposed to short-term investment gains, and in particular, the EU’s action plan on sustainable finance (EU action plan), are key drivers of the increasing ESG trend, he notes.

The EU Action Plan includes proposals to create a taxonomy, or classification system, of environmentally sustainable economic activity for investment purposes. It will also create two new categories of voluntary benchmarks for low carbon investments, and investments aligned with the Paris target.

“The lack of or inaccuracies in ESG-related data underpinning a fund’s investments is a concern, however,” McCarthy points out. “It is hoped that the introduction of the unified EU taxonomy will bring about more confidence in the data.”

New requirements for tailored investment advice to clients on sustainability, the consideration of ESG factors at an individual client level, as well as the integration of sustainability into risk management, organisational requirements and operating conditions will also be introduced.

“For funds, one of the most significant developments is the Sustainability Disclosure Regulation, which will introduce new obligations on what financial market participants must disclose about how they integrate ESG factors into their activities,” McCarthy adds.

"As the demand for sustainable products increases, the potential for so-called greenwashing also increases. Greenwashing is the process of creating a false or misleading perception that a financial product has an environmental or sustainable focus. This is a key concern for regulators and industry participants alike. In January 2020, Derville Rowland, director general of financial conduct at the Central Bank of Ireland said that the bank is cognisant of the 'obvious risks to consumer and investor protection that arise from the greenwashing of financial products – a type of mis-selling that can take many forms'."

Transparent and accurate

McCarthy believes regulatory authorities and asset managers must ensure that disclosures in financial products and investor communications are transparent and accurate and that directors and staff within investment firms are sufficiently experienced and have a good understanding of the fund or firm’s ESG policy and investment strategy.

He says European legislative and policy initiatives such as the EU action plan, which seek to improve transparency and accuracy for investors around ESG disclosures, are to be generally welcomed. “In order to be truly successful and effective, ESG values and risks must be ingrained by asset managers into the core investment decisions of firms and the investment objectives and strategies of their investment products,” he adds. “As a major international hub for the funds and finance industry, Ireland should continue to seek to position itself to be at the forefront of developments in this area.”