Sustainability Impact in Investor Decision-Making

David Rouch and Juliane Hilf are partners at Freshfields Bruckhaus Deringer LLP. This post is based on their Freshfields memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); and Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here).

In A Legal Framework for Impact: Sustainability Impact in Investor Decision-making, published by Freshfields Bruckhaus Deringer LLP in July for the United Nations Environment Programme Finance Initiative, the UN PRI and the Generation Foundation, we look at the adoption of positive sustainability outcomes as goals of institutional investment management and how far the law supports it.

The issue

The goal most associated with institutional investment management is earning a financial return. But earning money is obviously not the only goal we have for our lives or for our world. It exists alongside broader goals concerning the quality of the social and natural environment we inhabit, or at least its sustainability.

There may have been a time when it was possible to approach the goal of earning a financial return largely in isolation from the others. In reality, however, financial and economic systems are part of wider social and natural ecosystems, the health of which is vital to broader goals. Financial and economic systems can help these ecosystems flourish. However, they also depend upon and can adversely affect them. They can both strengthen and undermine the systems on which they rely.

The impact of laws on how people behave depends, among other things, on what those laws say, but also how they are understood and followed in practice. Both are affected by prevailing beliefs about the way things are. If it has been assumed that investment could be approached as no more than an exercise in generating financial return, detached from its social and natural environment, then it is not surprising if laws and the way they have been understood have reflected that. [1]

But if it was once possible to approach the goal of earning a financial return in isolation from other valued goals, that time is not now. The interdependence between financial and economic activity and the systems on which it relies is ever clearer. Systemic stress is partly the result of economic activity and, if not addressed, will create risks to economic systems and all who rely on them. Solutions require a system-wide response: collective action, coordination and cooperation.

Consequently, there has been an increasing focus on the financial community, including the investment sector, as a source of solutions and on the issue of whether finance law needs to change to achieve sustainability-related goals. In part, that is a matter for political processes. However, there is a question whether the investment sector already needs to be more focused on addressing sustainability challenges, even if only to achieve its own financial purpose.

Investing for sustainability impact as a response

Investment activity within the scope of ‘investing for sustainability impact’, or ‘IFSI’, has been identified as a way for the investment sector to do just that.

IFSI is not used in the report as a term of legal art. Nor is it intended to add to the alphabet soup of the sustainability world. Rather, IFSI is used as a ‘conceptual net’ to describe any investment approach where investors intentionally seek to influence what investee enterprises and other third parties do in assessable ways that help to address sustainability challenges. To bring their influence to bear, investors could use any means available to them including their powers of investment and divestment, stewardship and policy engagement. Investors engaging in IFSI are therefore concerned with two sorts of related sustainability impact.

  • The impact on social and environmental sustainability of business enterprises, and the impact of policymakers and others on the operating environment for enterprises and investors.
  • The influence that the investors themselves can have on the sustainability impact of enterprises, policymakers and other third parties.

This is different from many existing forms of sustainable investing which focus on integrating sustainability factors into investment decisions but do not necessarily involve intentional influence of this sort. Growing evidence suggests that this more purposeful investing is what many individual investors want from those managing their investments.

The report looks at whether the law requires or permits IFSI, providing a coherent framework for investors considering their position. It covers legal analysis of pension funds, insurers and mutual funds (‘asset owners’) and their investment managers in 11 jurisdictions, including the world’s main investment hubs. It also identifies options for policymakers wishing to facilitate IFSI.

Does the law require or permit IFSI?

Essentially, for the investor-types and jurisdictions covered by the report, to a significant extent it does although there are variations. The report makes an important distinction between IFSI intended to achieve an investor’s financial objectives (‘instrumental IFSI’) and IFSI intended to achieve positive sustainability outcomes as ends in themselves in parallel with seeking to earn a financial return (‘ultimate ends IFSI’). The legal position is different for each. An example of the first would be targeting sustainability impact goals which can be expected to help reduce systemic sustainability risks to investors’ ability to achieve their financial goals.

Instrumental IFSI

Financial return is commonly the primary goal of institutional investors, so the legal position is most clear where a sustainability risk bears on investors’ duties to pursue financial goals. Here, where an asset owner or its investment manager concludes, or on the available evidence ought to conclude, that one or more sustainability factors poses a material risk to its ability to achieve its financial investment objectives, it will generally have a legal obligation to consider what, if anything, it can do to mitigate that risk. Where sustainability impact approaches can be effective in achieving those financial objectives, the investor will likely be required to consider using them and act accordingly. Investors also talk of addressing sustainability factors that present risks of this sort as being necessary for long-term value enhancement.

It is also possible to envisage cases where an investor seeks a return consistent with its financial objectives by investing in and working with a number of enterprises to tackle specific sustainability challenges in order to achieve an increase in their value.

Ultimate ends IFSI

The scope for ultimate ends IFSI is more limited, but there are instances in most jurisdictions, for example, where some asset owners have discretion to pursue sustainability objectives provided adequate financial returns are achieved, where beneficiaries have indicated that they want this, and in some cases where the asset owner is a corporate insurer.

IFSI and collective action

Collaboration with other investors is likely both to reduce the costs and enhance the prospects of a successful sustainability outcome and therefore of achieving the goals of instrumental and ultimate ends IFSI investors. This may well weigh in favour of a decision to act. Investor cooperation at some level is clearly permitted in all jurisdictions (although there are legal rules that need to be complied with) and significant collaborative ventures are already underway, such as Climate Action 100+ and the net zero alliances. Whether or not collective action is possible, the activities of other investors or third parties could also be relevant in deciding whether to act if, for example, they increase the prospect of the goal being achieved.

In understanding how any action has helped an investor to discharge its duties, the focus of a court would likely be on the logical and evidential credibility of the investor’s explanation for the difference it has made in the context of the collective action as a whole more than the precise quantification of the individual impact or benefit of its involvement: the essence of collective action is that the sum is intended to be greater than its parts and for any one investor to benefit from a sustainable system the system as a whole must be sustainable.

IFSI and delegation to investment managers

Asset owners delegating to investment managers need to satisfy themselves that the activities of the manager are aligned (or at least not inconsistent) with their own goals and duties to beneficiaries.

The importance of an investor’s practical circumstances

Whether institutional investors conclude in practice that IFSI is legally required or permitted will also depend on the circumstances in which they act; for example, an IFSI approach might, in principle, be attractive in a given case, but there could be too much uncertainty as to outcome or cost to adopt it.

In addition, prevailing market features, such as current portfolio theory or commonly used performance benchmarks, may reduce attention to sustainability factors in investment practice. If so, investors need to ensure that this does not lead them to give sustainability factors insufficient weight in their decisions.

Facilitating IFSI: what can be done?

Since the behaviour produced by legal rules depends on what those rules say and the circumstances in which they are applied, we identify options for policymakers wishing to facilitate IFSI that tackle both. They are possibilities for consideration, not recommendations. They do not cover wider interventions in primary economic activity or fiscal policy (which can also fundamentally affect investment decisions), although policymakers will undoubtedly want to consider these.

Options include:

  1. changing investors’ legal duties and discretions and how they are understood in ways that facilitate IFSI (such as allowing the pursuit of sustainability goals as long as financial return goals are prioritised, and a presumption in favour of investor collaboration in tackling sustainability challenges);
  2. changing the circumstances in which rules are applied in three broad ways: (i) building the enabling environment for IFSI (e.g. by ensuring the availability of decision-useful corporate sustainability data); (ii) promoting in-depth research to establish whether market features (such as prevailing investment theory, the terms on which investment managers are appointed and stock lending to short sellers) may lead investors to underweight sustainability factors and steps to address this if so; and (iii) strengthening market discipline (e.g. through product labelling and governance rules for sustainability-branded products and ensuring that investors’ sustainability preferences are properly reflected in the investment process).

The complete publication, including footnotes, is available here.


1Mark Carney, Value(s): Building a Better World for All (William Collins 2021); David Rouch, The Social Licence For Financial Markets: Reaching For The End And Why It Counts (Palgrave Macmillan 2020).(go back)

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