ESG+ Newsletter – 29th July 2021

FCA moves to increase Board, Management diversity and disclosure

In a significant step to increase diverse representation at senior levels of listed businesses, the Financial Conduct Authority (FCA), responsible for the UK Listing Rules, has launched a consultation focused on improving transparency on the diversity of listed company Boards and their executive management teams. Under the plans, which would apply to the UK and overseas issuers admitted to the premium or standard segment of the FCA’s Official List, companies would be required to publicly disclose in their Annual Reports their progress towards achieving specific targets for gender and ethnic minority representation on their Boards and executive management, on a ‘comply or explain’ basis. The FCA’s proposed targets include that 40% of the board should be women (including those self-identifying as women), with at least one of the senior board positions (i.e. Chair, Senior Independent Director, CEO or CFO) being filled by a woman. The proposals also require that at least one member of the Board should be from a Non-White ethnic minority background. The FCA does not propose that Listing Rule diversity targets be mandatory – specifically stating they are not setting ‘quotas’, but “providing a positive benchmark for issuers to report against”.

Clare Cole, Director of Market Oversight at the FCA stated that they expected “enhanced transparency may strengthen incentives for companies towards greater diversity on their boards and encourage a more strategic approach to diversity in their pipeline of talent”…. with “benefits in terms of the quality of corporate governance and company performance in due course.”

The FCA is consulting for 12 weeks, with a closing date of 22 October 2021 and will seek to issue revised rules by the end of this year.

Private firms’ representative criticises UK governance reforms

While the FCA is focused on driving enhanced disclosure for listed companies, the UK government’s plans to extend governance regulation beyond listed companies have been criticised by Sir James Wates, creator of the eponymous ‘Wates Principles’ on corporate governance for large private firms. The proposed reforms, first published in a March white paper, redefine ‘public interest entities’ (PIEs) to cast a wider net that will also include privately-owned companies above certain turnover levels or employee numbers. The proposals have come about following the high-profile collapses of several organisations, including privately-owned BHS, as a result of perceived poor governance.

In an interview with the Financial Times Wates described the proposed reforms as a “sledgehammer” and stated that the additional reporting and auditing requirements would place a significant financial burden on affected companies and could act as a disincentive to growth and innovation for smaller firms. Rather than enforcing regulations, Wates proposes self-regulation whereby private firms would voluntarily follow the governance guidelines set out in the 2018 Wates Principles. However, there seems to be little support in UK government circles for this approach as they state that this additional oversight is necessary to protect stakeholders, in particular employees. With the consultation period for the white paper now passed, their implementation seems imminent.

Met Office data shows latest evidence of UK climate change

As concern mounts over rising average temperatures, new data from the UK Met Office starkly illustrates how greenhouse gas (GHG) emissions are significantly altering global weather patterns. Today, it announced that in the last 30 years, UK temperatures on land have warmed by 0.9 degrees centigrade. Sea levels, the result of polar ice melts, have risen by 2cm per decade for the last 60 years resulting in increased storm damage and flooding. Further, 2020 was a year of extremes for sunshine, rainfall and temperature with the wettest day on record occurring on 3rd October. The data will feed into discussions about efforts to mitigate further climate change through reducing GHG emissions, and adaptation to changes already underway, with Professor Liz Bentley, Chief Executive of the Royal Meteorological Society, noting that it “can help to update government, businesses, scientists and the public about changes in our climate and the impacts.”

Link between ESG performance and dividend growth

Leading ESG companies are more likely to offer long term dividend growth than ESG laggards, research from Fidelity International has revealed. On average companies rated ‘A’ for sustainability have the highest level of historical dividend growth at over 5%. It is believed good management of environmental and social risks and opportunities assist companies to avoid higher regulatory costs, litigation, brand degradation and stranded assets. Good management of governance also reduces risks associated with over-leveraged balance sheets.

However, the analysis also found that sectors play a role and, for those with structural sustainability issues, such as oil and gas, even if ESG risks are well managed, they may face “weaker dividend growth”. On the contrary, organisations in areas such as renewable energy are benefiting from “regulatory and investment tailwinds”, positively impacting dividends. The research complements earlier research by Fidelity on how ESG leaders outperformed laggards during the COVID-19 crash and recovery. Both pieces of research highlight the importance and growing business case for managing ESG risks and opportunities.

The ‘brown discount:’ engage now or lose later

Another piece of analysis from Fidelity raises an issue for the real estate sector – the issue of the ‘brown discount’. This is the idea that buildings which lack environmentally-friendly features will be more difficult to sell as they get older. The findings suggest that these so-called brown discounts will be sufficiently significant to incentivise investment to upgrade older buildings with retrofitted greener designs. Indeed, while the cost of upgrading buildings now will impact returns in the short term, Fidelity anticipates that the cost of delay will be far greater. The research is highly relevant: Today, around 97% of commercial buildings will not support the transition to net zero in their current form. In its analysis, Fidelity estimates that occupier demand, investor demand, and upgraded valuation processes will contribute to the brown discount, all a result of increasing multi-stakeholder interest in greener design. Perhaps most importantly, retrofitting will secure a building’s long-term value. This may also inspire other sustainable initiatives perhaps not directly related but that can have a notable impact, such as promoting sustainable community living or greener business practices. As governments upgrade building codes and stakeholders increase their demands, expect to see increased returns for those who engage constructively, and scrutiny for those who do not keep up.

Quis custodiet ipsos custodes? Who’s watching the ratings agencies?

Quis custodiet ipsos custodes, as Classics students will know, is the Latin phrase for ‘who watches the watchmen’? Today this centuries-old question has new salience with respect to the ESG rating agencies. While ESG raters have growing influence, some bodies have voiced concerns that they are largely unregulated, lack transparency, and may have conflicts of interest. The International Organization of Securities Commissions (IOSCO), which groups market regulators in the US, Europe, and Asia, pointed to these issues in a recent consultation paper. This states: “IOSCO undertook a fact-finding exercise that revealed, amongst other risks and challenges, a lack of transparency about the methodologies underpinning ratings or data products and an often uneven coverage of products offered across industries and geographical areas.” As a solution, IOSCO recommends that regulators formally regulate the sector, similarly to credit rating agencies after the last global financial crisis. This will surely be a difficult process, as IOSCO says that ESG focused funds currently rely on about 160 raters globally and users often don’t conduct formal verification of ratings. MSCI was one rating agency that said it was reviewing the report and is committed to “applying sound practices in our operations.”

ESG funds benefit from EU Climate Benchmarks, but are ESG investors “winging it”?

Last July, the EU Commission, as part of its sustainable finance agenda, adopted new rules that set out minimum technical requirements for EU Climate Benchmarks, as well as a number of ESG disclosure requirements. These measures were introduced to enhance the transparency of ESG benchmarks for investors and to mitigate greenwashing of ESG funds, coming at a critical time with the Index Industry Association (IIA) revealing that the number of funds measuring ESG grew by more than 40% last year. The introduction of these measures is already helping investors. A Bloomberg article reports that inflows have more than doubled since January building on the $1.2 billion now tied to gauges that meet European Commission requirements. The increase in the flow of capital towards these funds since the introduction of the benchmarks indicates that investors are searching for assurances in terms of transparency and reporting when assessing what ESG products to invest in, particularly as asset managers are consistently concerned about greenwashing. This has led Jas Duhra, the EMEA head of ESG indexes at S&P Global, to assert that, before the creation of the new benchmarks, you “could have smacked that label on a product and gone, ‘Paris Aligned,’ and there could be anything going on in that index”. This was echoed by Rick Redding, chief executive officer of IIA, who said that that the EU rules provide “much-needed clarity on which can be labelled Paris-aligned or climate-transition.”

However, despite the initial success of the EU Commission’s enhanced transparency for ESG benchmarks and the growing influx of capital into ESG investing, there does appear to be a disconnect between choosing a company and their ESG performance. A recent survey conducted by Investopedia and TreeHugger revealed that investors are still relying heavily on brand perception, rather than a company’s ESG policies or disclosures, in their decision-making. When it comes to researching companies and their ESG impact, the survey argues that investors are “winging it” . Perhaps as mitigation, it then points out that respondents were dissatisfied with “available tools for capturing accurate ESG metrics or knowing how aligned an investment is with their values.”

In Case You Missed It

• An increasing number of stakeholders in the world’s food system are backing a growing number of new sustainability metrics and rankings, according to the Financial Times. This trend is being driven by a view that benchmarks and index rankings can raise awareness of sustainability factors, while also helping to guide banks, investors, and those in the supply chain, to engage with food systems that will not damage the planet.
• Fidelity International, the global asset manager, says it will vote against company directors falling behind in their response to climate change and board diversity-related issues. The Financial Times reported that Fidelity will punish directors next year if they fail to tackle the issues of climate change and a lack of boardroom gender diversity. Fidelity says it is targeting about 1,000 companies that are large emitters of greenhouse gases at a sector level or contribute heavily to carbon emissions within the asset manager’s own investment portfolios.

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