Is investing sustainably a duty or an opportunity?
Please note: This article is designed to be thought leadership content, to offer big picture views and analysis of interesting issues and trends that matter to our clients and the world in which we live. It is not designed to be taken as expert advice, investment advice or a recommendation, and any reference to specific companies is therefore not an opinion as to their present or future value or broader ESG credentials. Reliance upon any of the information in this article is at the sole discretion of the reader. Some of the views and issues discussed in this article may derive from third-party research or data which is relied upon by Barclays Private Bank and may not have been validated. Such research and data are made available as additional information for the reader where appropriate.
Investment managers have an obligation to act in your best interests and prudently when managing your wealth. These fiduciary duties serve as a cornerstone to entrusting them with your capital. But are these duties really resulting in portfolios that are aligned with your aims?
When it comes to investing, historically the focus of fiduciary duties has been on financial returns; however, the dominant view of what this means has changed over time. With increasing awareness and importance of sustainability issues, the expectations and requirements around fiduciary duty are evolving again.
This article reviews how sustainability is changing the ways that fiduciary duty is being viewed and how this is driving changes to laws and regulations. As an investor, understanding this is critical when understanding what you might be able to expect, and request, to invest in a way that more aligns with your specific values and aims.
Understanding your investment manager’s fiduciary responsibilities
Within the financial world, investment firms that manage money on behalf of clients are bound by fiduciary duties through the law and contract.
Amongst these duties, loyalty and prudence are particularly relevant in an investment setting. Loyalty requires the fiduciary to act in the ‘best interests’ of their client. This includes being honest in their dealings with clients and not acting for the benefit of themselves or another third party over their principal.
Prudence sets the expectation to act with due care, skill and diligence. It also obliges the manager to invest as a ‘reasonable’ person would.
Historically, the proof of fulfilling fiduciary obligations has been interpreted primarily in financial terms. In this sense, the ‘best interests’ and acting ‘reasonably’ have guided managers to seek to generate financial returns for a client – but without necessarily having to consider how these returns are made, nor the impact that the investments have on the world.
Views of fiduciary duty have changed over time
Fiduciary duty, however, is not a fixed concept1. It fluctuates depending on the nature of the relationship between two parties. It varies by jurisdiction, in how it is defined and enshrined in regulations, and it changes to reflect current market practices and social norms.
However, in 1952, Harry Markowitz published his seminal “Portfolio Selection” paper5. This revolutionised the investment world, laying the foundation for modern portfolio theory; and how fiduciary duties were understood. Thereafter, the aim was not solely focused on returns, but in delivering risk-adjusted returns.
Additionally, this led to other considerations around fulfilling fiduciary duty, such as appropriate diversification of assets, aligning with an investor’s time horizon, and asset-liability or cashflow matching.
Nonetheless, even with these modifications, financial returns continued to be assumed to be the sole criteria to fulfil fiduciary duty. More recently, this simplistic assumption has been called into question.
Sustainability issues are driving the next shift
Issues such as carbon emissions, worker health and safety or cybersecurity are increasingly central to how companies, governments and societies operate. For the investment industry, this has moved the above topics beyond moral or ethical preferences, to how they can be financially material to investment performance.
Simply put, sustainability issues in the world can impact a company’s performance. In more specialised terms, this is seen as “single materiality”. By integrating non-financial considerations, grouped within environmental, social and governance (ESG) categories, investors look to identify material corporate risks from the wider world; and how well firms understand, and manage, these risks or innovate to improve business performance.
From a fiduciary perspective, incorporating this analysis into investment decisions helps to satisfy expectations of both best interest and prudence. Thus, as early as 2005, a study from the United Nations and law firm Freshfields Bruckhaus Deringer, when reviewing the expectations of investment managers around ESG, concluded that integrating ESG considerations “is clearly permissible and is arguably required”6.
The result has enabled the adoption of responsible investment, which includes ESG integration as a core principle, in the mainstream investment industry. The growth of the United Nations-supported PRI (Principles for Responsible Investing) organisation, a global network of financial institutions that commits to responsible investment, in recent years backs this change in attitude.
When launched in 2006, there were 67 founding signatories to the PRI. Today there are over 5,300 signatories and, as of the last reporting period, signatories manage $121 trillion of collective assets under management7. Moreover, numerous jurisdictions began to clarify and formalise these responsible investing practices as expectations of all investors8.
However, ESG integration is only part of the way to fiduciary duty incorporating sustainability issues. Its primary aim is to reduce systemic environmental and social risks for investors. However, such integration doesn’t necessarily address these issues in our world.
Reaching double materiality
After ESG integration, the next step has been to consider the converse, the potential impact that companies have on the world. Adding in this consideration produces the concept of ‘double materiality’.
Through what they do and produce, companies have negative or positive influences on the world. This creates several implications – whether in terms of financially material or for the interests of the investor, or even other stakeholders. Companies can generate costs or damage to the environment or society for which they aren’t accountable in a financial sense. These externalities can create benefit for the company, while other individuals, communities, companies, or nature pick up the tab.
Environmental pollution is a classic negative externality – for example, air pollution from transportation, water or soil pollution from industrial waste, or greenhouse gas emissions. Ecosystem services, as explained in the Mid-year Outlook article – Is your portfolio ready for biodiversity loss? – would be examples of positive externalities that accrue to companies.
While historically these externalities have not always been priced into the enterprise value, they can be translated into materials risks, for example through reputational damage, legal liabilities, or regulatory changes. “Prudent” investors, therefore, would incorporate them into the assessment of individual companies or for their potential effect on overall market returns, or the impact they can have on other companies in an investor’s portfolio.
Moving beyond financial materiality
The inclusion of sustainability widens the considerations for investment managers in terms of fiduciary duty, even if viewed purely through a financial lens. But it also raises a more fundamental question – what are in the overall best interests for investors?
Calls for ‘best interests’ and ‘reasonable’ to be considered more broadly than in solely financial terms have come into focus more recently as the field has evolved. Understandably, those who see worsening negative impacts in terms of climate change, biodiversity loss, or inequality, may want to know their investment managers are investing to help in addressing such issues and not just mitigating the impact of them on portfolios.
As currently supported, fiduciary duties do not require an investment manager to account for the sustainability impact of their investment activity beyond financial performance. Hence, a later report in 2021 by the same UN and Freshfields authors, referenced earlier, begins to set out “A Legal Framework for Impact” that makes the case for where, how, and when to ‘invest for positive sustainability impact’9.
It reinforces the view that fiduciaries can invest to ‘achieve a sustainability impact’ where it is instrumental to realise the investor’s financial goals for individual assets or to protect or enhance the financial performance of the overall portfolio.
Going further though, fiduciaries today do not have a requirement to invest for positive impact as the ultimate goal. However, they can, with some variation by jurisdiction, seek to achieve a relevant sustainability impact as a goal in its own right alongside financial performance8.
Establishing your own preferences
As an individual, family, or organisation though, your sustainability preferences don’t have to be assumed or interpreted. They can be explicitly stated either because regulation requires a firm to ask you or because you have decided to express them yourself.
Regulators continue to clarify and evolve expectations around sustainability. For example, in July, as part of the wider sustainable finance framework, Europe confirmed the inclusion of double materiality in the first set of corporate sustainability reporting standards10. This follows the European Securities and Market Authority setting the requirement for firms to amend their suitability assessment procedures to obtain clients’ sustainability preferences and ensure that investment advice/decisions match those preferences11.
However, where relevant regulatory processes do not exist in your own jurisdiction, but you still have views about sustainability, it is possible to express them. Writing an investment policy statement can be a useful way to set out these preferences. In addition, you may want to review with a regulated advisor to refine your views on both what is feasible, theoretically and practically, in how a portfolio is invested.
An earlier article, How to start your journey to a greener investment portfolio, highlighted, within a specific environmental context, the considerations that would lead to a policy statement. In the end, though, as The Rolling Stones sang: “You can’t always get what you want, but if you try sometime, you’ll find, you get what you need.”
Aligning investment aims with those of the planet
As a sober reminder, our lives, livelihoods and investments ultimately rely on the health of ecological and social systems. Increasingly, those underlying systems are under strain.
So any prudent and self-interested investor should be (more) focused on addressing these challenges, even if the only motivation is financial. This starts with consideration of the impacts ‘of’ sustainability factors on companies and portfolios, and thereafter, the impact of the business ‘on’ the people and planet as a whole.
However, to truly address the challenges our world faces requires considerably more capital focused to intentionally generating an impact, with recent estimates of a $4 trillion gap to meet the United Nations Sustainable Development Goals in developing countries alone12.
Today your investments already make an impact on the world. So, the question is what influence do you want them to have on tomorrow?