Sustainability – Theory & Practice
Everywhere I have travelled or lived, I have always tried to understand the place, the history, and the people. When I visited Cuba a few years back, I talked to locals about the revolution, the Castros, Che Guevara, socialism v capitalism, and the current state of the Cuban economy.
There is no shortage of books to read on this but there is nothing like experiencing a place and hearing the real-world stories. Talking to a local about the economic system in Cuba, he gave a blunt assessment. ‘Everything is theory; it does not work in practice’. Having lived through it, I am sure he saw the promises and the outcomes.
Does Cuba’s economic position bear witness to the failure of socialism as an economic system? Or is it merely a reflection of a system doomed to failure under the oppression of their superpower neighbour? That is another discussion. But what he said sums up the challenge with economics and finance in general – turning theory into something practical and real.
Sustainable Economic Policy
In Europe, sustainability has become a driving force behind regulatory policy in the pursuit of sustainable economic development. The theory that shaped economic policy over previous decades failed to account for negative externalities – such as climate change, environmental destruction, resource depletion, and social issues – and now regulators are reacting.
Since regulation is reactionary, the fire continues to blaze even as efforts are being made to put it out. The smoke alarm is only ever installed after all the damage is done. For example, the 2008 financial crisis prompted a raft of new regulation to ensure a more robust financial system. We found out the hard way that a financial system without adequate rules can become a house of cards.
Finance is the grease that keeps the wheels of our economic system moving and so European regulators are focused on connecting finance with sustainability. The commission’s action plan for financing sustainable growth includes far reaching legislation that will place requirements on financial market participants – including financial advisors – to explicitly incorporate sustainability.
The Theory Behind the Plan
The theory behind Europe’s action plan on sustainable growth is straight forward. By connecting finance and sustainability they hope to create a virtuous cycle where capital flows to sustainable investments which in turn reduces our impact on the planet. A cycle that will continue and ultimately transform Europe’s economy and ensure a healthier planet.
However, there are three big assumptions associated with this plan to reorient capital flows:
- Investors – individuals, pension schemes, endowments etc. – understand their sustainability preferences or they are at least interested in working towards defining these preferences and incorporating them into investment strategy, alongside their risk and return preferences.
- Capital Allocators – advisors, consultants etc. – have the knowledge and skills to adequately ascertain a client’s sustainability preferences and in turn align them with the appropriate sustainable investment options, which they also need to be able to understand.
- Investment managers responsible for delivering ‘sustainable investment options’ genuinely follow through on their stated mandate with respect to sustainability and the application of Environmental, Social and Governance.
Disclosures Regulation
The most recent regulation that financial advisors are coming to terms with is the Sustainable Finance Disclosures Regulation (SFDR), which is a major part of Europe’s financing sustainable growth strategy. The key objectives of the regulation are to priortise sustainability disclosures at an entity and product level, increase transparency and reduce information asymmetry.
Regulators believe that with the right information investors will make more informed decisions, with consideration paid to sustainability. It is also hoped that increased disclosures around sustainability will reduce greenwashing – the practice of mischaracterising the sustainability credentials of an organisation or an investment product. Only time will tell whether it achieves the desired effect. Across the fiduciary chain – investors, advisors, investment mangers, company executives – every part as a role to play in taking sustainability seriously.
For example, financial advisors can take the view: ‘It is not our responsibility. It is the job of the investment manager’. This argument does not hold up because the role of an advisor is to align client preferences with suitable investment options. How can an advisor deem an investment fund to be suitable if they don’t understand the investment strategy and at a minimum, an overview of the holdings to ensure the fund manager is investing in line with their mandate?
Irrespective of the increased requirements arounds sustainability, advisors have a responsibility to understand the investment strategies of the underlying funds they put clients into. Understanding how funds integrate sustainability, promote ESG characteristics, or invest to meet a specific sustainability objective require an additional set of questions within the fund selection process.
Financial Advisors
Over the last year I have been working with financial advisors who have participated in the Responsible Investment Advisor (RIA) course, through the Responsible Investment Institute™. A recurring message has been the challenge of coming to terms with the increased regulation. The vast majority of advisors recognise that sustainability is important, but the feeling on the ground is that regulation is more overwhelming than practical.
Even though SFDR has been on the agenda for awhile it felt relatively rushed as the March deadline drew closer. There is still some confusion around the reporting requirements and fund classification. There is also a sense of fear in terms of what they might be signing up to, with concerns around the resources available to integrate sustainability into their practice in a meaningful way.
The website disclosures, pre-contractual disclosures and reporting requirements set out in SFDR are a means of putting some accountability in place. They are not perfect, and the guidance could be better, but advisors should not be overwhelmed. This is an opportunity to lead and move ahead of regulation, rather than reacting piecemeal to ever increasing requirements around sustainability.
Staying ahead of Regulation
I started my career as a stockbroker in San Diego before moving to Merrill Lynch in 2006 where I worked as a financial advisor. That was over fifteen years ago but the fundamentals in terms of building an advisory business are the same. The process is paramount. But it is not static. It can be continually refined and improved upon.
All of the courses I have developed – through the Responsible Investment Institute – have been designed with the real world in mind and to help advisors practically incorporate sustainability into their advisory practice. Four key areas that advisors should be focusing on are:
- Knowledge Level – Develop your knowledge and expertise on the incorporation of sustainability within investments and the application of ESG. My view has always been that advisors sell knowledge, not products. You have to be willing to invest time.
- Investment Policy – Test and augment the existing investment process and key frameworks. It is advisable to have a responsible investment policy at a firm level and an effective process will allow for the development of client specific policies.
- Product Specifics – Increase engagement with managers, develop and implement consistent frameworks for categorisation, assessment, monitoring & reporting. Getting this right will help you to avoid falling victim to greenwashing. The key is understanding the impact of investments.
- Client Preferences – Increase client engagement on sustainability, seek to understand client preferences and ensure easy access to a wider array of disclosures. Traditional suitability questionnaires will need to be adapted.
The essence of the regulation is about ensuring that individuals are more informed, investment policies are transparent, investment products fulfil their mandates and that the stewards of capital are more competent at ascertaining client preferences and selecting appropriate solutions.
Conclusion
Financial advisors should be preparing for a regulatory environment that will continue to place sustainability at the core of regulation. The challenge for advisors is that the theory does not always relate directly to how things work in practice.
I understand the challenges, but I also see the responsibility advisors have in terms of helping clients to invest for a secure future. Unless sustainability is taken seriously within business and investments, all long-term financial goals will be compromised.
Advisors who can see the bigger picture in terms of the direction the advisory business is taking – with respect to the importance of sustainability – will be best placed to remain ahead of changing regulation, but also, they will be best positioned to grow their advisory practice.
Meaningful action can turn theory into practice.
End
Vincent McCarthy, CFA