It is common for terms like “sustainable investing”, “socially responsible investing”, “environmental, social and governance (ESG) integration” and their acronyms to be used as nice to have’s interchangeably by asset managers. Historically, asset managers have focused predominately on the “S” and “G” in ESG, however, the elements in ESG factors are not necessarily mutually exclusive and as ESG continues to evolve, a more holistic approach is being followed by asset managers. As such, asset managers are being forced to appoint dedicated teams focusing on ESG and embed into their investment process an approach to allocate capital and investments to achieve a more positive impact of a lower carbon economy. This includes raising of new and dedicated funds to finance a transition to a less carbon intense economy.
The need to address ESG in allocation of capital is not new. Regulation 28 of the Pension Funds Act, 24 of 1956 (PF Act) requires all retirement funds to “give appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund's assets, including factors of an environmental, social and governance character”. Further, on 14 June 2019 the Financial Sector Conduct Authority (FSCA) published Guidance Note 1 of 2019 titled, “Sustainability of investments and assets in the context of a retirement fund’s investment policy statement”, which explicitly notes that investment policy statements should include ESG integration, as well as efforts to mitigate the risks of climate change.
The PF Act is not the only piece of legislation that requires ESG factors to be considered, the Carbon Tax Act, 15 of 2019 came into effect mid-2019, requires large emitters of greenhouse gas to report emissions and pay a tax based on their emissions. This is intended to drive financial institutions to consider the risks associated with climate change and promote a just transition from high to low-carbon investments.
Recently we have also seen climate-conscious shareholders compel the adoption of a public policy on lending to coal powered projects and related mining operations. Shareholder activism is becoming a powerful tool for raising the awareness about the importance of achieving a lower carbon economy, and more importantly, compelling business and financial institutions to act to mitigate and avoid climate risk. The call for better climate risk disclosure is a call heard loudly by other financial institutions and shareholders alike. It is only inevitable that other shareholders will consider proposing similar climate conscious resolutions.
National Treasury's draft technical paper: “Financing a Sustainable Economy
To this backdrop, National Treasury's draft technical paper: “Financing a Sustainable Economy” published in May 2020, is acknowledgement by our regulators of the impact of climate change on the financial sector. The paper aims to, among other objectives, define sustainable finance for the South African financial sector and to identify gaps in the existing regulatory framework and recommend actions required of regulators, financial institutions and industry associations. This article does not intend to cover all aspects of the paper but rather certain aspects as noted below, with the focus being on financial service providers.
An important recommendation the paper makes, which is applied to all financial service industries, including banks, retirement funds, insurance, asset management and other capital markets participants, is for the adoption for a common definition of sustainable finance in South Africa.
The paper acknowledges that while international frameworks which are adopted by financial service providers “integrate E&S considerations in lending decisions to avoid or mitigate financial losses, reputational risk, or harm to the environment and communities.” The types of environmental and social risks do not adequately address climate change risk. The paper also further acknowledges that “corporate governance has grown in importance in recent years and has been added to the integrated concept of E&S risk management”. Pursuant to the above the proposed definition of sustainable finance is used here as an overarching definition that incorporates these various concepts and reads as follows:
“Sustainable finance encompasses financial models, products, markets and ethical practices to deliver resilience and long-term value in each of the economic, environmental and social aspects and thereby contributing to the delivery of the sustainable development goals and climate resilience”.
How do financial service providers (FSP’s) achieve sustainable finance?
In this regard, the paper recommends that FSP’s:
· Evaluate their portfolio as well as transaction-level environmental and social risk exposure and opportunities using tried methodologies and best practice norms;
· Pursuant to the evaluation above, link these to products, activities and capital allocations; and
· Maximising opportunities to mitigate risk and thereby achieve benefits in each of the social, environmental and economic aspects which effectively contributed to the delivery of the sustainable development goals.
The paper reads: “Recognition is growing about the urgent need to make a ‘just transition’ to a lower carbon economy as well as achieve the Sustainable Development Goals (SDGs) to improve the lives of growing populations.”
In order to assist the FSP’s in further achieving sustainable finance, regulators are recommended to:
· develop or adopt technical guidance, standards and norms for use across all financial sectors in identifying, monitoring and reporting and mitigating their environmental and social (E&S) risks, including climate-related risks, at portfolio and transaction level;
· develop a benchmark climate risk scenario for use in stress tests by the sector; and
· develop a taxonomy for social and sustainable finance initiatives to build credibility, foster investment and enable effective monitoring and disclosure of performance.
Can sustainable investing or financing have an effect on industries it currently does not or has a low level of impact on?
Save for certain pieces of legislation and regulations, the codification of ESG consideration is not prevalent in South Africa. However, in the near future, and considering the FSCA’s commitment to refining the regulatory framework relating to issues of sustainability in consultation with the industry players which was seen in the regulations of the PF Act, specific requirements may be incorporated into the conduct standards in future once the Conduct of Financial Institutions Bill is enacted.
A recommendation by the paper is for industry to identify potential financial policy innovations in order to increase sustainable financing. For industry and regulators to increase collaboration, upskill and enhance capacity to align with international best practice and implement through education and training, the principles, methods and programmes which are widely applied by leading organisations in other financial industries.
A specific area of mention in the paper is private equity, the paper sets out the challenges in the private equity sector regarding the lack of standardised methodologies for determining ESG and externality risks. It can, however, be argued that private equity firms are the best adopters of ESG as their limited partners mandate this of them and given the limited size of partnerships, the bespoke nature of investments and time horizon, private equity firms are the best positioned to allocate capital and investments to have a more positive impact to achieving a lower carbon economy.
A clear future?
It is clear that financial institutions will increasingly be required to assess, monitor and disclose the sustainability of its investments. The paper notes that sustainability and making a just transition towards a lower carbon economy need to inform all financial decision-making, as the cost of post impact remedy far outweighs a precautionary approach. Although the measures to achieve sustainable investing is likely to represent an increased cost to businesses, it further presents opportunities for the development of new innovative products.
Ashburton Investments is committed to, among other factors, incorporate sustainability considerations, including ESG factors, into its investment process, from research and analysis to engagement and decision making and seeking appropriate disclosure on ESG issues by the entities in which we invest.
Ashburton Investments is represented on the Association for Savings and Investment South Africa (ASISA) Responsible Investment Committee. We are also signatories to the United Nations Principles of Responsible Investment (UNPRI) and facilitate the work of the UNPRI by contributing to research, convening’s and case studies. Furthermore, Ashburton Investments supports various industry initiatives such as the Impact Reporting Investment Standards (IRIS) and the Carbon Disclosure Project (CDP).
Our long-term success is not measured in investment performance alone, but also on the impact on society and the environment. Incorporating ESG factors into our investment and ownership decisions supports the pursuit of superior risk adjusted returns for our clients.