Matching rhetoric to reality in values-based investment

Harm is what the Financial Markets Authority tries to prevent, but what about harm to investors who discover they have been investing counter to their values?

Tuesday, August 15th 2023, 9:06AM

by Andrea Malcolm

FMA director of enforcement Paul Gregory posed the question at the RIAA (Responsible Investment Association Australasia) 2023 conference held in Auckland last week: while there is harm from poor returns, risk management and value for money over an investment horizon, what is the ethical equivalent of failing to live up to your investment goal? And how do you regulate that?

He said views on harm have become more complex for regulators and the industry due to rapid changes in public expectation both formally, through laws and standards, and informally.

Once investors have had an “ethical jumpscare” and scratched below the surface of their portfolio, how can those informal expectations be given the same weight as formal ones?

Greogry said there is significant confusion around what should and should not be invested in and what is a regulatory issue. “Greenwashing is a fair dealing issue,” he said.

Apart from default KiwiSaver schemes which have legal restrictions on what they can invest in, the FMA is focused on the match between rhetoric and reality, said Gregory, and doesn’t make value judgments. It is interested in investors’ interests.

“It is not in members' interest to find they have been ethically defrauded for decades: that they have harmed people, animals and the environment when they had reason to believe otherwise. Good explanation and substantiation of an investment approach is a large part of preventing that. But there is not a fixed catchment of unacceptable ethical harm.”

Gregory said ethics are personal and can shift and expand but what doesn’t change is that any decision by an investment manager to exclude or divest investments reduces investors’ diversification. “This is not in their interest, especially if they are unaware of it.”

Letting investors know what they are in for ahead of time, again, is the answer but what about exclusions based on events being played out?

Indirectly referring to New Zealand fund managers excluding securities domiciled in Russia or DGL divestment because of public commentary by the CEO, he said investment managers should and do have discretion about what factors to consider when they invest. “We encourage investment managers to think broadly and be very thoughtful about what constitutes potential harm or risk to your investors. But the challenge of exclusions for geopolitics or for distaste, is how difficult it is for the manager to anticipate when relevant events will occur, what form they take, and how their investors will respond.”

The answer is to anticipate the need to make such judgments. This could include examples which may include explaining the criteria to be used, especially for materiality for example.

“Doing so gives investors some warning. It also avoids the investment manager being pushed into an exclusion decision. A rapid response can be a populist win, but can also set divestment precedent, which is a risk.”

A burgeoning thicket of standards

Gregory also spoke on the increasingly complex landscape of national and international standards, voluntary and compulsory.

Climate change obligations, both mandatory and voluntary through initiatives such as Net Zero, mean investment firms might have a “public reconciliation challenge” between regulatory scope 1, 2 and 3 obligations and voluntary scope 1 and 2 commitments. Adding to that some firms have green bonds or sustainability linked loans.

He said the FMA’s UK counterpart, the FCA (Financial Conduct Authority) recently picked up on banks counting sustainable linked loans towards their sustainable financial targets and found that in most cases the SLL transactions were not fit for that purpose.

The FCA solution was disclosure of climate transition plans considered alongside the settings of a particular SLL. “This would provide solid context for how an issuer was financing a greenhouse gas emissions reduction strategy, or would expose the SLL, the climate transition plan or both as no more than ethical theatre.”

Gregory said in New Zealand climate related disclosures making public climate transition plans are required for reporting entities so there is a firm specific reference point to understand the meaningfulness of a sustainability link loan or a green bond issued.

“All of this can help or hinder good alignment of the story investment firms tell through advertising, marketing and disclosure.” He said that may have to take in commitments from being a signatory to external standards such as RIAA accreditation or the stewardship code. And collectively, the whole package is the information investors see which helps them to make good decisions or be exposed to harm potentially over long periods.

“It's what we as the regulator look for as part of your fair dealing and your members’ interests picture. We look at what we call the overall impression. Is there substance? Does it chime? Is it complete? Does it conflict? Because of course, under Fair Dealing, we look at [what is] confusing, as well as misleading.”

Tags: FMA