As ethical investing moves firmly into the mainstream, it raises questions on how financial planners can give clients confidence that their portfolio is aligned with their values. Miriam Fine speaks with the team at Australian Ethical on the importance of increasing accountability from investment managers in their ethical practices.

In spite of significant changes in the global economy and investment markets in 2022, the focus on better investment outcomes for people and the planet is still growing. Returns from growth assets may be more scarce than they have been for some time but that doesn’t mean investors are allowing ethical concerns to take a back seat. According to new research from Australian Ethical and Investment Trends, 46 per cent of investors bought or sold investments in 2021 based on ethical, or environmental, social, or governance (ESG) factors. This is a material increase on the 40 per cent of investors recorded in the equivalent period in 2020.

The Turning values into action: A new era of purpose-driven investing report also shows a sharp increase in awareness among investors. In 2021, awareness of ESG/responsible investing was at 61 per cent, rising to 75 per cent in 2022. That’s three-quarters of investors who now have ethical investing on their radar. In taking a closer look at the intentions of investors in this group, the report highlights untapped demand for ESG investment options and advice. 33 per cent of survey respondents are ‘next-wave ESG investors’ – those who have not selected investments based on ethical or ESG factors but plan to do so or are interested in learning more.

This has significant implications for the role of financial planners in having conversations with clients about ethical options. The report also points to a notable gap in access to ESG-specific advice for investors who have yet to make their first move to include ESG options in their portfolio. 71 per cent of next-wave ESG investors who received investment advice in the last 12 months did not discuss responsible investing with their planner but would like to. The role of expert advice is even more important when we consider how many investors are in the dark when it comes to ESG investment opportunities. 43 per cent of next-wave ESG investors said awareness of products was their number one barrier to making responsible investment choices.

The ethical agenda in advice

As a companion report to the investor view, Responsible investing: A new frontier in client engagement & advice delivery looks at the rise in ethical investing through the financial planner lens. By surveying financial planners on their levels of engagement with the ESG investing needs and preferences of clients, Australian Ethical and Investment Trends have revealed a step change in behaviours.

“We know from the report that more planners are embracing responsible investing than ever before, with nearly one in two providing advice on ESG investments, up from one in five in 2016,” says Leah Willis, Head of Client Relationships with Australian Ethical. “With three in four investors now aware of responsible investing and record amounts of money pouring into sustainable and ESG funds, ethical investing has cemented its place in the financial vernacular of investors and financial planners.”

The report defines the one in two ‘ESG financial planners‘ as those ‘who have determined clients’ responsible investing requirements during fact find or discovery conversations, or provided advice on ESG investments in the last 12 months.’ Of these financial planners, approximately half their clients (48 per cent) have talked with them about their responsible investing preferences and goals, up from 38 per cent reported in 2021. In a country where floods have played havoc with lives and communities in 2022, it’s not surprising to see renewable energy (53 per cent), climate change (51 per cent) and fossil fuels (51 per cent) at the top of the agenda followed by human rights (33 per cent).

“Among many important issues, climate or environment is the most urgent and pervasive issue in society today and investors are concerned,” says Leah. “Environmental issues are of primary concern with 54 per cent of ESG investors either buying or selling investments in the past 12 months based on this. Specific issues include ocean conservation, preventing climate change, renewable energy, sustainable agriculture and reducing carbon emissions.”

“But it isn’t easy for advisers to address these issues in portfolios,” she adds. “Climate and reducing carbon emissions is complex, as we stand here today in a global energy crisis and considering the enormous impact the transition poses to many of our leading companies, sectors and whole communities. This will be an interesting, exciting and challenging area for investors and advisers to navigate over the coming decade as portfolios transition to a low-carbon future.”

Best interest and other benefits

With growing demand for ESG conversations with clients, financial planners need to meet the market on this issue in order to remain competitive. But financial planners are also being proactive on ESG and ethical investing for reasons that are not purely commercial. The majority of ESG financial planners are motivated to engage with clients on their ESG interests and goals in order to properly perform their best interest duties (61 per cent) and to ensure their clients’ investments align with their values (68 per cent).

“For planners adopting ethical conversations they are realising the business benefits of better client engagement, building better rapport, enhancing their value proposition and attracting more clients,” says Leah. “Planners have a fiduciary duty to ensure their clients are financially secure in retirement but equally they are required to understand a client’s ‘values’ or ‘ethics’ so they ensure their investments aren’t at odds with their personal views.

“It is no longer good enough to provide returns at any cost – a rising consciousness around investments means clients are looking to invest in companies that support a more sustainable future with a growing expectation that these companies will benefit in the long term from being responsible well managed businesses.”

Understanding ethical options

Leah goes on to say how effective many financial planners have become in making ESG questions an integral part of due diligence during the advice process. “Successful planners in this space have embedded ethics or values in their initial client conversation or fact-finding,” she says. “Incorporating ESG-related questions into the risk profile questionnaire gives planners a clearer understanding of a client’s appetite for responsible investing and any concerns early on and is a great way to start the conversation as opposed to uncovering issues late in the portfolio construction phase.”

However, it’s at this stage that many financial planners find themselves challenged by a growing number of ESG investment options with limited tools, standards and frameworks available for matching products to client’s preferences. In spite of their considerable skill in financial advice and their best intentions to select products on the basis of a client’s wishes to avoid harmful practices and support positive outcomes for environment and society, many financial planners have concerns about making the wrong choice. In fact, 34 per cent of ESG financial planners say the biggest challenge when delivering responsible investment recommendations is greenwashing.

“We have seen a record number of ESG, sustainable and ‘green’ options launch over the past few years in response to the growth in the sector and giving investors more choice than ever before,” says Leah. “The real challenge for investors is understanding the approach and outcomes a fund provides to ensure it lines up to their expectations of what responsible or ethical means.

“ESG is being used to some degree interchangeably with responsible investing, but ESG integration is one approach which incorporates ESG information as risk factors to inform stock valuation. However it’s also been clear for some time that investors want to invest in line with their values. So while many ESG investors believe their money is going toward improving environmental and social solutions while earning returns, a fund using only ESG integration may include harmful stocks in the portfolio and can give consumers a nasty surprise.

“I think this is confusing for investors but also whilst there are systemic issues (like climate change, the biodiversity crisis, modern slavery) that can impact the stability of financial markets, responsible investors need to be thinking beyond how ESG issues impact the financial performance of a company. Looking at how a company’s activities impact the real world and asking – are those impacts ok – independently of financial performance.”

Transparency and universal standards

What can often make things tricky for financial planners when understanding the ethical nature of their investment recommendations is the lack of standards in labelling investment strategies. While there is likely to be progress made on this in the near future thanks to concerns from the regulator, it’s likely that financial planners will need to continue to use their own research and judgement to determine whether the approach of fund actually delivering what their clients want and expect in terms of responsible investment holdings and impacts on ethical and sustainable outcomes.

“No doubt there is confusion and demand from investors for more clarity around the green labels that have exploded in recent years – responsible, sustainable, ethical, impact,” says Leah. “For some time, the EU sustainable taxonomy has led the discussion on developing labels and categories for responsible investing but has proven challenging. More recently we have seen announcements from the Securities and Exchange Commission (SEC) in the US, Australian Stock Exchange (ASX) and Australian Securities and Investments Commission (ASIC) with guidance on greenwash and the alignment of a products label with its outcomes – at face value – this calls into question the rise in green-marketing practices by many products.”

“This shows that labelling isn’t a simple or straightforward task,” she adds. “While you want to provide investors with confidence in their product choices and avoid greenwashing, you don’t want to stop product innovation when so much capital is required to help drive change in critical areas of society.”

While acknowledging that greater clarity on labelling for ethical investing products is an important goal, Dr Stuart Palmer Head of Ethics Research at Australian Ethical, says that it’s unlikely that a single universal standard can be effective for such a complex and rapidly evolving market. The objective is reasonably clear – regulators are working towards bringing the same rigour and consistency to sustainability claims and sustainability labels as financial claims and labels,” he says. “The path to achieve this objective is less clear. Non-financial characteristics of investment products are multi-dimensional. Think of it in terms of the impact which many are seeking through their investment choices: There are countless ways the world can be different as a result of an investment choice, and there are many different ways of narrowing down and categorising the impacts that matter to particular stakeholders. This narrowing and ordering is the work of sustainability and impact standards and frameworks, but we shouldn’t expect them to all do it in the same way.

“In New Zealand, for example, regulators have chosen to take ‘a holistic view of integrated financial products’ rather than focusing on specific labels and categories such as ethical, responsible, socially responsible, sustainable, impact, green etc. They are taking a principles–based approach rather than decreeing prescriptive definitions and taxonomies. They are concerned that a prescriptive approach would need to be constantly updated to reflect evolution of societal norms and expectations.”

Defining stewardship

While regulators and regional and global bodies such as the International Sustainability Standards Board (ISSB) continue their work in developing frameworks and labels that investment managers will be required to adhere to, how can financial planners give their clients assurance that their investments are making a positive difference in the world? Looking for products with both negative and positive screening is a good start. These options should demonstrate that portfolio holdings have been selected on the basis of corporate behaviours that do less harm and more good in the world.

This approach of allocating capital to effect change is certainly a step in the right direction. But for clients who want to know that their financial choices are having a more powerful impact, it can be worth considering an investment approach that engages with solutions to the major challenges of climate change, and abuse of human and animal rights.

“While ethics-driven capital allocation is critical, we know that on its own, our ethical screen is not enough to achieve the economic and social transformation we need to get to a future where people, animals and the planet prosper,” says Amanda Richman, Ethical Stewardship Lead at Australian Ethical. “Investor stewardship is an important tool that investors can use to directly have real world influence. Investor stewardship leverages capital to influence investee companies, the economy and society.

“At Australian Ethical, responsibility for investor stewardship is shared between the investment team and the Ethics Research team but with different objectives,” she adds. “Our investment team is focused on lowering the risks and improving the returns of individual holdings and the portfolio. In carrying out ethical stewardship, our ethics research team is focused on reducing the negative and increasing the positive impacts of companies and achieving systemic change. It can be targeted at investee companies, but its remit is much broader, including companies outside the portfolio, other investors, governments including regulators, standard-setting bodies, industry associations and other organisations.”

For financial planners seeking investment managers active both in ethical screening and stewardship, the good news is that this segment of the market is growing. In their 2022 Responsible Investing Benchmark Report, the Responsible Investing Association for Australasia (RIAA) ranked 74 investment managers as. The report also found that the widest gap between Responsible Investment Leaders and non-leaders is in the areas of stewardship and ESG integration and allocating capital to target sustainability outcomes.

Action and accountability

Not only does the RIAA Benchmark report consider engagement and stewardship activities in its scorecard, it also places high importance on reporting and outcomes. “There is a lot of healthy skepticism about investor engagement,” says Amanda. “Its impacts are often indirect, difficult to measure and difficult to directly attribute to positive outcomes. It can also take time between starting an engagement strategy and seeing real world impact. Unfortunately, investor engagement is also an area that is ripe for greenwash. Some can use it to excuse continued investment in fundamentally unethical businesses without being accountable to effecting change within those businesses.”

With this in mind, it’s encouraging to see that investment managers are increasing their transparency and accountability when it comes to engagement with investee companies. According to the RIAA findings, This improvement in the accountability of investment managers through this kind of reporting should go some way to addressing concerns about greenwashing in the industry.

Source: Australian Ethical x Investment Trends 2022 ESG adviser report.

Enriching client conversations on ESG

This enhanced reporting and accountability is likely to be welcomed by financial planners having a growing number of responsible investing conversations with clients. Greater transparency of underlying investments and demonstration of investment impact are the top two tools financial planners are looking for to support them in giving clients the assurance that their portfolio choices can be linked to positive real-world benefits.

Providing data and narrative that goes beyond an investment manager’s activities to capture the actual outcomes resulting from ethical stewardship has become an important focus for Australian Ethical and their Ethics team. From their advocacy initiatives in the financial services sector aimed at defunding fossil fuels to portfolio exclusions in response to human rights abuses and engagement with regulators to protect young people from the harms of social media use, they are setting an example of how ethical stewardship can shift the dial on the most pressing ethical issues.

“Our objective for engaging in ethical stewardship is to achieve positive real-world outcomes,” says Amanda. “We need to assess whether our efforts are achieving anything or if we need to change our approach. We therefore seek to prioritise reporting on progress towards real world outcomes over reporting on our level of activity. These real-world objectives are reflective of what needs to happen for the world to address systemic challenges. They are ambitious. They are beyond what our activities alone can achieve, and therefore outside of our full control.

“It will also take time to achieve them. We do not expect to see material progress for a number of years. Even if they are achieved, it will be difficult to attribute that success to our efforts. We know that achieving change at the scale and pace we need cannot be done by any one individual or organization. We need multiple voices using multiple sources of leverage, and positive feedback loops between different players. It takes an ecosystem of people in different roles with a genuine desire to make the world a better place.”