Engagement: Are fund managers avoiding the hard questions?

It's tempting for them to go for quick wins to demonstrate a company’s sustainability improvements and avoid divestment

Engagement has long been central to effective stewardship, and in recent years there’s been a growing focus on the effectiveness of dialogue between companies and their investor base.

The Financial Reporting Council has been at the forefront of this, recommending that investors report on engagement outcomes for the first time in its 2020 iteration of the Stewardship Code.

The Financial conduct Authority (FCA) has gone further in its recent consultation on sustainable fund labelling. In the scheme’s proposed ‘sustainable improvers’ category, the FCA is recommending that fund managers will be able to select any asset for inclusion provided that those assets have the “potential to become more environmentally and/or socially sustainable over time, including in response to the stewardship influence of the firm.” This puts engagement, and specifically engagement outcomes, front and centre in a way that the industry has never seen before.

Look out for more on this in ESG Clarity’s digital magazine out next week

Although this new focus on outcomes is laudable in principle, we need to stop and think about any unintended consequences. In the quest to demonstrate positive results, there’s a risk investors may stop asking companies the hard questions such as “what are you doing to prevent labour abuses in your supply chain? in favour of easy requests such as “please can you provide more health and safety data in your annual report?”. The latter will elicit a speedy and positive response, and the investor can claim an engagement outcome. But the former is a much more fundamentally important question to ask and a far harder problem to address.

At the time of writing, it’s unclear what action fund managers would be required to take if a company in a “sustainable improvers” fund made little progress on sustainability over successive years, but surely at some point the fund manager would need to sell the holding in order to retain the fund’s sustainable label.

It would be tempting – and not too difficult – for a fund manager to create a quick-win engagement to demonstrate a company’s sustainability improvements and in doing so avoid the need for divestment.

Common framework needed

This suggests that the industry would benefit from a common framework on what constitutes good engagement, one that does not penalise investors that are willing to take on entrenched and difficult ESG issues in their conversations with company management.

It’s pleasing to see that more investors are becoming adept at using milestones to mark out incremental progress around multi-year engagement programmes. At Castlefield we have been taking this approach on net-zero engagement, for example. Last year we focused on long-term target setting, this year we’re upping the ante and asking more searching questions on detailed planning for the transition to a low-carbon economy.

On a related note, we also need to recognise that cause and effect can be difficult to demonstrate when it comes to engagement. In an ideal world, companies would take immediate action on all the points investors raise but unfortunately that is not always the case. It takes time for busy management teams to take issues onboard and act. But through ongoing conversations, and as part of a wider ecosystem of consumers, NGOs and government all reiterating the same messages, we can gradually steer companies towards more sustainable business practices.

Many years of engagement experience tell us that environmental and social change happens within a company when a tipping point is reached, i.e. when companies are asked repeatedly, by many different stakeholders (and especially the ones with financial influence – i.e. investors) to take action on a specific issue.

It can be hard to pinpoint the role that one individual actor has played in forcing change to happen. That poses a problem for investors keen to demonstrate linear engagement outcomes but in many instances that might be an unrealistic expectation. Far better for investors to be transparent with clients and others, and explain their involvement without claiming sole credit for the result.