Regulatory Outlook | Investment Funds | February 2020

Current issues

Alternative Asset Managers under the spotlight

The Financial Conduct Authority (FCA) has written a "Dear CEO letter" outlining some of the risks of harm that alternative investment firms pose to their customers and the markets in which they operate. For example, the FCA has found that the appropriateness of investment products for investors is often not adequately considered, which presents a significant risk of harm where high-risk alternative investments are made available to less-sophisticated investors.

The FCA has therefore set out its regulatory expectations against six supervisory priorities. Alternative investment firms should consider whether they present the risks the FCA has identified and develop strategies for mitigating them. Firms should also be aware that they may be the subject of an FCA review and/or be asked to take part in one or more pieces of work related to these priorities in the future.

Revised and strengthened UK Stewardship Code now in force

On 1 January 2020, the Financial Reporting Council's (FRC) revision to the UK Stewardship Code came into effect. The new 2020 code substantially raises expectations for how money is invested on behalf of UK savers and pensioners. It establishes a clear benchmark for stewardship as the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.

The focus of the code has been extended to include asset owners, such as pension funds and insurance companies, and service providers as well as asset managers.

New AIMA Guides published

AIMA has published new guides on responsible investment: (1) ESG Considerations at Alternative Investment Management Firms; and (2) Responsible Investment Policies for Hedge Fund Firms. This comes at a time when BlackRock, with $7 trillion assets under management, has stated that it will take a "harsh view" of companies that fail to provide hard data on the risks they face from climate change.

Responsible investment is having a significant impact on the investment management industry. Investors are using environmental, social, and governance (ESG) factors to analyse the conduct of the firms to which they allocate, and those firms are in turn using ESG factors to analyse their investment portfolio.

In Focus | Responsible business

Which aspects of responsible business are driving the regulatory agenda?

The Financial Conduct Authority (FCA) considers that directing investment towards sustainable value creation generates higher returns and more positive societal outcomes, benefiting consumers both as investors and as stakeholders in wider society.

In furtherance of those objectives and as part of its work on stewardship, the FCA is considering how well its rules support and encourage asset owners and asset managers to take a long-term perspective, where this is appropriate. As part of this, the FCA is also considering how companies address climate and other ESG risks in their business, risk and investment decisions.

The FCA intends to hold an industry workshop in the first quarter of 2020 with representatives from across the institutional investment community to consider how asset owners set and communicate their stewardship objectives, and how well these are adopted by asset managers and service providers. The FCA will also continue to engage with the Financial Reporting Council (FRC) in relation to the FRC's UK Stewardship Code 2020 which came into effect on 1 January 2020.

Many public companies will come under pressure from their shareholders to disclose in line with industry-specific guidelines on ESG. For example, as discussed above, BlackRock has stated that it will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and plans underlying them.

Are responsible business considerations having an impact on the tools that regulators are using?

The FCA has acknowledged that market-led incentives are likely to be a more effective mechanism than further regulation to encourage investors to engage more actively in stewardship, complementing existing measures and the UK Stewardship Code 2020. The FCA therefore intends to engage with ongoing industry work in this area, led by the Investment Association.

In November 2019, the Investment Association published the first industry-agreed Responsible Investment Framework. The framework itself separates out distinct components for a firm-level and fund-level approach to responsible investing. It aims to categorise, define and harmonise common investment terms, as well as exploring the creation of a standardised UK retail product label to clarify to investors which funds have adopted the responsible investment approach.

Other industry-specific guidelines on ESG – such as those set by the Sustainability Accounting Standards Board and the Task Force on Climate-related Disclosures – are also gaining traction in the market. Both of these standards have recently been endorsed by BlackRock.

Which of the recent or upcoming developments are based on international consensus or agreements?

The concept of responsible investment came to prominence with the formation of the UN Principles for Responsible Investment (PRI) in 2008. The PRI is a set of six principles that provide a global standard for responsible investing as it relates to ESG factors. Subsequently, a number of international industry and regulatory initiatives have developed in this area. Most notably, the European Commission is pursuing a wide-ranging and ambitious Action Plan on Financing Sustainable Growth to put ESG considerations at the heart of the financial system. This includes:

• the Disclosure Regulation (Regulation (EU) 2019/2088) which came into force at the end of December 2019 and will apply 15 months later. This will integrate ESG considerations into the investment decision-making or advisory processes of alternative investment fund manager (AIFMs) and undertakings for the collective investment in transferable securities (UCITS) management companies;
• the Low Carbon Benchmark Regulation (Regulation (EU) 2019/2089 amending Regulation (EU) 2016/1011) which also came into force in December 2019. This will amend the Benchmarks Regulation; and
• the proposed Taxonomy Regulation (2018/0178(COD)) which is expected to come into force in 2020. This will aim to establish an EU-wide classification system or taxonomy of environmentally sustainable activities.

What are the main challenges for businesses in complying with these developments?

Environmental – particularly climate change – and social factors, in addition to governance, have become material issues for investors to consider when making investment decisions and undertaking stewardship. However, the widespread adoption of ESG reporting has been variable, and many firms have either failed to report on the financial impacts of ESG risks or have reported any ESG risks inconsistently.

Investment managers that fall within scope of the Disclosure Regulation will need to consider complex issues such as how sustainability risks are integrated into the investment decision making process, what sustainability risks exist (and their impact on returns), and even how remuneration reflects sustainability risks. While most of the provisions in the Disclosure Regulation don't start to apply until March 2021, product providers and advisers should use this time to prepare and think about these significant issues within the context of investment decisions and investor disclosures.

The increasing focus on ESG by the investment community will have a wider impact in encouraging businesses to include ESG in their strategies and value creation plans. There are increasing expectations from stakeholders around transparency and accountability – from employees who expect more from their companies and employers to investors, the public, regulators and the media. ESG is increasingly becoming a differentiator for companies in terms of how they attract and retain the best talent.

Dates for the diary