ESG-related investment has attracted both political support and antipathy.  In the UK, the political, regulatory, social and investor impetus is towards a more sustainable economy, appropriate financed in compliance with environmental, social and governance sustainability and responsibility (ESG S&R) standards, say partners Jeremy Irving and Paul Ray, and associates Tom Murrell and Kirsty Finlayson, at international law firm Browne Jacobson.

There are three broad, inter-related principles to carrying on investment services in a way that is consistent with ESG S&R:
1.    Know your - and the investment target's or portfolio business' - obligations under applicable ESG laws and regulations;
2.    Meet those obligations through effective data/management information-gathering and analysis processes;
3.    Don't greenwash or facilitate others' greenwashing.

The above require a holistic understanding of ESG S&R, especially (but not exclusively) by reference to science-based data, as available. 

Know your obligations

The UK's legal ESG obligations are less developed than other jurisdictions, especially the EU, but will start to have force soon, and will come to include for SMEs.

There are statutes which, depending on a firm's business model and financial dimensions, address a range of ESG risks, such as reporting on climate-related financial risks, gender pay gaps, and adherence to corporate governance codes.  

For larger financial services regulated firms, there are specific obligations in the Financial Conduct Authority's (FCA) ESG Sourcebook, in respect of climate-related financial disclosures. There are also specific FCA rules for listed companies regarding the diversity of board members.

Coming down the track

Additional obligations may follow in the next 18-months, including via Government action as to:
•    the UK Green Taxonomy;
•    the introduction of requirements for the UK's largest companies to disclose their net zero Transition Plans; 
•    the suitability of the IFRS Sustainability Disclosure Standards, for adoption in the UK.
Firms should also prepare for the FCA's new investment labels regime and the following sustainability concepts: 
•    "focus", for products investing in assets that are environmentally or socially sustainable; 
•    "improvers", for products investing in assets to improve environmental or social sustainability over time; 
•    "impact", for products investing in solutions to environmental or social problems "to achieve positive, measurable real-world impact".

Meet obligations 

The better the data, the more ‘orderly' the ‘house'.  Firms can seek to develop their own science-based KPIs as to data relevance, comprehensiveness, accuracy and credibility - caution is needed around sources of data, verification and validation, and the application of judgment, especially from third party providers.  Transparency and consistency in mapping KPIs to specified transition paths is essential.

As a funding source, banks have developed a range of products; "sustainability-linked loans" and "use of proceeds" facilities eg loans or trade finance to fund ESG projects, including social projects.  Private equity (PE) houses have also increased their appetite for sustainable funds, boosting the prospects of ESG-committed businesses and sectors.

On the operational side, Tier 1s/OEMs are driving ESG standards along their supply chain: Tesco has a supplier finance platform aligned to its ESG targets; Unilever has a policy that all their suppliers must pay the living wage; and car manufactures with significant scope 3 objectives are requiring KPI adherence from component providers. 

Don't greenwash

There is greater public, regulatory and industry sensitivity to greenwashing risks.
The FCA is introducing an anti-greenwashing rule: sustainability claims must be clear, fair, and not misleading, and proportionate to the sustainability profile of the product or service.
Additionally, the latest Loan Market Association principles relating to sustainable finance require performance beyond regulatory requirements, and external certification. 
Implications of firms not having their 'ESG houses' in order

Failure to comply with FCA rules risks regulatory investigation and enforcement; failure to comply with legislative requirements risks civil action.  Litigation, such as minority shareholder claims , is increasingly a tool for ESG activism.

Compensation can also be sought under section 90 or 90A of the Financial Services and Markets Act 2000 by anyone who has suffered loss as a result of "any true or misleading statement or dishonest omission" in relation to specific company documents.

An orderly ESG portfolio 

Investors want to invest in sustainable business and that is driving investment houses to find businesses on an ESG S&R pathway.

Data indicates that sustainable businesses will, over time, deliver a higher EBITDA - and so higher multiplies on exit.

Demonstrating ESG S&R in a portfolio will be primarily driven by the transparent deployment of credible KPIs.

So PE houses would have their own KPIs in their investment-decision-making, and would also help put in place, monitor and disclose KPIs specific to portfolio businesses.  These financing and operational KPIs could combine so that, for instance:

•    portfolio firms are incentivised with, say, advantageous terms for refinancing to demonstrate their own KPI adherence, thus reducing investor outlay on external certification in this area;               
•    widening the margin differential between a traditional finance product and an ESG one (this is usually about 2-5 bps at present) to encourage take up of sustainable finance.

By partners Jeremy Irving and Paul Ray, and Associates Tom Murrell and Kirsty Finlayson, partners at Browne Jacobson.