ESG is a “hot topic” among UK investors and asset managers. Larger investors used to say (publicly and privately) that ESG-focused investments were costly but, in the UK, most ESG funds report parity or outperformance over one-, three-, five-, and 10-year periods. Lack of data on ESG-focused funds’ performance made many investors nervous, but multiple reports indicate that ESG funds may have outperformed their non-ESG peers, leading to a recent increase in UK ESG funds. “Responsible investment” has grown over 40% from 2014–2020, and this figure seems set to rise.
The Pensions Regulations described in question 1.1 for pension schemes, which are major investors in UK markets, have led to an increase in ESG-friendly investments, as pension funds pressure fund managers to invest in more ESG-conscious investments.
In the UK, ESG-only firms and “sustainable” funds within larger financial institutions have grown, while asset managers are being trained on ESG-conscious investing and upcoming regulations.
2.2 How do other stakeholders influence ESG?
Younger, “millennial” (and even “Gen Z”) investors, consumers, and stakeholders are more ESG-conscious than their “baby boomer” and other forebears, and have increased demand for responsible investment. Younger investors and other stakeholders place more importance on climate change, global warming, social justice, and other non-financial imperatives than their predecessors. Given the inevitable wealth transfer to these generations (and the desire to move with the times), organisations have been driven to demonstrate their ESG credentials competitively.
Younger, more ESG-conscious generations make up an increasing proportion of the workforce in large UK corporates, encouraging (or forcing) organisations to strengthen their internal ESG measures, such as increased employee engagement, better employee benefits (such as maternity and paternity leave), and more extensive recycling. “Older” generations in (and at the top of) UK businesses appear to have embraced ESG initiatives and be willing to adapt their organisations and business practises accordingly. Debt finance providers have also emphasised ESG investments, especially those seeking to reduce or reverse climate change.
2.3 Who are the main ESG regulators, and what are they pushing?
In the UK, the principal ESG regulators are the FCA, the European Commission (for EU financial services such as MiFID II, the AIFMD, and the UCITS Directive), the UK government, the FRC (to be replaced by ARGA as described in question 1.1 above), securities exchange regulators (such as the LSE), Companies House, and the Pensions Regulator.
Environment Agency, Scottish Environment Protection Agency, and Natural Resources Wales are UK’s environmental regulators. The Environmental Regulators can issue fines for violating environmental laws and regulations such as water treatment and discharge, waste disposal, packaging regulations, oil discharge, and environmental permit management.
The FCA released a Consultation Paper in March 2020 to enhance climate-related disclosures by listed issuers (on a “comply or explain” basis). All commercial companies with a UK premium listing (i.e. Main Market companies subject to the UK’s highest regulation and corporate governance standards) are required to include a statement in their annual financial report stating (1) whether they have made disclosures consistent with the TCFD recommendations, (2) instances where they have not followed the TCFD recommendations (and why), and (3) instances where they have included disclosures in a document. The FCA emphasises the TCFD’s recommended disclosures on risk management and governance, saying companies should only withhold them “exceptionally.” The first compliant reports will be published in 2022 for accounting periods beginning on or after 1 January 2021. The FCA proposes to change its Listing Rules to require companies to disclose annually, on a “comply or explain” basis, whether they meet board diversity targets and to publish diversity data on their boards and executive management. The FCA’s consultation ended in October 2021.
2.4 What ESG enforcement actions have happened?
Much of the UK’s ESG regulation is new, and many regimes are “comply or explain” rather than “comply or face sanctions.” Few significant enforcements have occurred. More section 172 statements (described in question 1.2) and new regulations may increase regulator action (and ability to impose sanctions) in relation to non-compliance.
The Environmental Regulators are the UK’s most active ESG regulators, issuing over £350m in fines since 2010. Southern Water was fined £92m in July 2021 for five years of illegal sewage discharges on the coasts of Kent, Hampshire, and Sussex. The Environmental Regulators can issue fines for climate change violations, which often involve the greenhouse gas emissions trading scheme.
Under the CMCHA 2007, organisations can be guilty of corporate manslaughter if they commit a gross breach of duty of care. While the suitability of the legislation has been questioned because convictions have been rare (fewer than 30 since 2007), the criminal sanctions for breach (and the associated reputational damage) mean that organisations are invariably focused on ensuring adequate measures are in place to ensure compliance with associated health and safety legislation and to avoid any possible breach of the CMCHA 2.
Under the MSA 2015, the UK Home Office has threatened organisations that haven’t published their modern slavery statement on time. Again, reputational damage is a bigger risk than legal consequences. We’ve encountered companies that didn’t publish their statement on time and were given a grace period, or that explained to the Home Office why the rules don’t apply to them (for example, if the turnover threshold is not met).
Multiple UK ads have been banned by the Advertising Standards Authority (ASA), often for misleading environmental claims. While not a direct ESG enforcement action, this is often described in the media as a “greenwashing” attempt by the company (misleading information being disseminated to present a (inaccurately) environmentally responsible public image). Again, ASA bans lead to negative press and investor issues. Ancol Pet Products, BMW, Fischer Future Heat, Ryanair, and Shell had ads banned in recent years.
In 2020, the UKSIF issued a report on pension ESG issues after the introduction of increased disclosure requirements under the Pensions Regulations (described in question 1.1 above). The report found “appallingly poor compliance with the ESG regulations.” “Policies were thin, noncommittal, and suggest pension trustees are not adequately interrogating their investment manager’s approaches to financially material ESG factors” The UKSIF also noted that many pension schemes haven’t published SIPs.
Given the lack of major enforcement actions to date, some critics argue that ESG-related litigation, including against governments and public bodies (such as regulators) for failing to act, as well as against companies to claim damages, may prove to be a more effective way of holding businesses accountable and forcing them to change their practises.
2.5 What are the main ESG-related litigation risks?
ESG litigation is rare in the UK, but this could change soon. Investors increasingly consider a company’s ESG credentials before investing. This action has led to greater scrutiny of ESG-related disclosures in annual reports and prospectuses, and an increased risk of investor and activist claims if disclosures are inaccurate.
We expect more investor class actions against companies that misrepresent their ESG credentials. Shareholder activism has risen, especially in oil and gas and finance. Activist investor groups (such as ShareAction) have given smaller ESG-conscious investors a greater voice and held firms accountable by proposing resolutions, publishing articles on issuer non-compliance with ESG regulations and guidance, and ranking countries and organisations (such as banks).
Climate Action 100+ and Follow This requested two climate change resolutions at BP’s 2019 AGM. One resolution proposed that BP include, in its annual report starting in 2019, a progress report describing how its business strategy is consistent with the Paris Agreement on climate change, supported by relevant capital expenditure, metrics, and targets. This resolution passed with 98% of shareholders’ support, demonstrating the importance of ESG credentials and public disclosures to investors. Barclays, BHP Group, and Royal Dutch Shell have also had shareholders request environmental resolutions. Although not listed in London, activist investors replaced ExxonMobil board members as a sign of global shareholder activism on climate change.
Litigation or regulatory enforcement can cause a rapid drop in a company’s share price, prompting shareholders to sue to recover their losses. “Securities litigation” originated in the US but has increased in the UK in recent years, partly due to third-party litigation funding and insurance, as well as active claimant law firms and claims management companies seeking out these types of claims.
Such claims can be made under section 90A of the Financial Services and Markets Act 2000 (“FSMA”), which states that if an issuer makes a false or misleading statement or a dishonest omission in published information (other than listing particulars or prospectuses), it can be liable to investors who need to prove they acquired, continued to hold, or disposed of shares in reliance on the statement or omission. As of this writing, this section is largely untested in UK courts in relation to ESG matters, and it is unclear how easy it would be to prove reliance (other than by reference to a sustainable investment’s fund or other ESG-conscious investor’s documented ESG goals or principles) and accurately quantify the investor’s loss. The very fact of a claim (rather than damages) may be damaging to a company’s reputation, so businesses must tread carefully in this area.
2.6 What are ESG proponents’ top concerns?
Inconsistency is an ESG issue. As an example, there is no universally agreed definition for each component of “E-S-G,” which hinders effective ESG legislation and enforcement in the UK and globally. While efforts are being made to improve this situation, the varied requirements under the legislative framework (which is fragmented, as noted in question 1.1) and the differing guidance suggestions on reporting and disclosures often result in inconsistent ESG disclosures. Inadvertently excluding or including issuers based on ESG reporting can result (especially if an algorithm or programme is being used to review ESG disclosures).
“Greenwashing” is another ESG concern. Due to inconsistent regulations and guidelines and a lack of enforcement actions (and shareholder claims) regarding ESG disclosure, many companies may have overstated their ESG efforts. ESG-rated companies may have a business strategy that harms society. Some consider this greenwashing. Media reports have historically focused on “greenwashed” products or lines, not entire companies (as described at question 2.4 above in relation to ASA bans). Larger, less ESG-conscious companies may be required to disclose how they consider ESG factors. Fund managers use the UN’s SDGs to describe some investments as “sustainable” or “ESG-conscious” without proving their positive impact. Certain funds are called “ESG funds,” but they simply exclude tobacco and arms (with very few excluding fossil fuels), rather than analysing investments’ “E-S-and-G” credentials. Investors can be confused by “sustainable investing,” “impact investing,” and “ESG investing.” This product classification has helped UK fund managers and investors avoid greenwashing to some extent.
Difficulties assessing an issuer’s ESG credentials can hinder ESG investment. Technological advances are helping analysts in this area by requiring global ESG issues in investments (such as access to clean water, or alignment with the Paris Agreement on climate change). A large portion of UK “sustainable investments” are passive tracker funds that follow the FTSE 100, which is dominated by oil and gas companies. Passive, sustainable investment funds are unlikely to make a significant impact on investors’ ESG goals and can be used to overstate ESG credentials. Some investors argue that a fund invested in finite natural resources (such as oil and gas) cannot be an ESG investment, while others claim that, as many traditional fossil fuel companies look to diversify and become more sustainable, investing in these companies is actually helping this process of change and is therefore the definition of an ESG-conscious investment (many disagree with this view). Inconsistency hurts ESG advocates. The FCA published an analysis of greenwashing in July 2021, but it has not adopted the EU’s SFDR or announced proposals for a UK regime.