ROGER URWIN: Well, a warm welcome from me. This is the section of the Sustainability: Aligning Organizational Goals to Pension Portfolios session. And we're going to focus on the legal framework.
So I'm Roger Urwin of WTW, and I'm delighted to be hosting this conversation with David Rouch of Freshfields. So David is widely recognized for his technical expertise in financial services law and regulation, and the practical side of that in conduct and culture. And that really does link neatly to this subject of sustainability and investing.
So he co-authored the Freshfields paper of "A Legal Framework for Impact." So that was about a year ago. And that in my view is one of the most important contributions to the legal framing of sustainable investing we have. So David, you're very welcome. Thank you for this opportunity. Let's dive in.
First, well done on what I see as an authoritative and really relentless bit of research. And I really do forgive you the 600-odd pages, as it were. But what were the main conclusions, and where did it break new ground?
DAVID ROUCH: Well, thank you for having me, Roger, and it's a pleasure to be here. It is relentless and it's very thorough. And there's a reason for that, and it's because we want you to be confident in what we're saying. We really want people reading this to know that we have gone into the weeds. And the feedback suggests that people are confident in what we're saying.
So what exactly were we looking at here? We weren't just looking at, can investors legally engage in ESG? What we were focusing on is whether investors can seek to achieve impacts, whether they can seek to change the behavior of the businesses in which they invest.
Now that's fundamentally different from the way ESG is currently practiced. ESG could be seen as an outside-in activity. It involves by and large investors altering their portfolio composition to try to deal with sustainability risks that are incoming. Investing for sustainability impact is outward-looking, and it involves an investor seeking to tackle the root causes of the risks by seeking to encourage businesses and other third parties to change their behavior in ways that reduce the risk.
Now there are two reasons that investors might want to achieve that sort of impact. They might want to achieve that impact because they think it is going to protect their financial position. And on the other hand, they might want to achieve that impact because they think it is important. They think that achieving sustainability outcomes is important as an end in itself.
Now I'm going to park that second one for the purpose of today's conversation. There's a load of stuff in the report on it, and if people are interested in it should look at it. It's a topic that creates massive confusion at the moment because as soon as you talk about sustainable investing, most people think this is about pursuing sustainability goals as ends in their own right. But a lot of what the report is about is highlighting the connection between sustainability goals and financial goals, the things that most investors are required to pursue.
Now the starting point for our analysis on this is really where portfolio theory has taken a lot of portfolio management over the last couple of decades. And essentially, it's taken it in the direction of diversification.
Now this is very important. It helps the portfolio, as we all know, manage the idiosyncratic risk that arises as a result of the behavior of individual companies so that if an individual company is particularly exposed to some sort of risk, diversifying the portfolio means that your company-specific risk is reduced. And I don't need to explain that to you. You're an expert.
But what diversification doesn't address is the risk to the performance of the system as a whole. Essentially, diversification means that the investor is perhaps not exposed to individual performance of companies, but it is very exposed to the performance of whole economies, whole sectors.
And by and large, that is where portfolio growth comes from. It isn't so much driven by individual investee performance. It is driven by the performance of the systems to which the investor is exposed.
Now to the legal question. Does the law require or permit an investor to seek to pursue a sustainability impact, to seek to try to improve the sustainability profile of the companies in which it invests of other third parties where doing so could help to reduce those sorts of systemic risks? And our research covered 11 jurisdictions, including the US, including Australia, the UK, EU. So all of the major investment hubs.
And the answer that we got consistently across all of those jurisdictions-- and this is quite remarkable to get such a consistent answer-- is that where there are sustainability threats to the performance of a portfolio, then an investor is likely to be under a legal duty to consider the nature of that threat and what, if anything, the investor is able to do about it. And that where pursuing positive sustainability impacts could be an effective way of seeking to address that risk, then they should be considering that as well and then acting accordingly.
In some cases, in some jurisdictions, you could describe that as a permission. In some cases it could even get to be as hard as a requirement, depending on how intense the risk is and the sort of steps that one could take and how effective they could be.
So that's really quite a remarkable level of consensus. There are all sorts, of course, of local nuances and slightly different takes on this depending on the investor type because different legal rules apply to all of them. But in broad terms, that was the conclusion.
ROGER URWIN: Fantastic. Very clearly expressed. Very complex, but a trail of really interesting findings. And I think a really significant conclusion about this point about this is permitted and could even be required in certain circumstances. Obviously, it's the it that I want to focus on because the it is really about conducting investment practices in a particular way to address these systemic risks that we're hearing much more about in the world.
Now the way that the big asset owners describe their challenge in my conversations is that they really do undertake a joined up view of the investment system and their investments, and they see how issues in ESG and in climate are critical to those systems. And so they want their strategy to be net positive to performance. Of course, they do. That's a fiduciary responsibility.
But sometimes they fear that local regulations or their lawyers' interpretations will not necessarily be supportive to that, will be sort of negative to this route. So could that be right? Could that be the circumstance that we're trying to deal with here? And is your report helpful in that regard?
DAVID ROUCH: Well, there's a lot in there to unpack, but the sort of headline answer to that is probably not, maybe, and it depends on the question. So by and large the law, the regulations should not be an impediment to this because the regulations are requiring investors to achieve financial returns. And therefore, where the step is reasonably intended and is credibly likely to help in protecting or enhancing value, then the law permits it.
The question of whether lawyers are likely to advise you that you can do it, it depends a lot on where the lawyers are in their thought processes on this because the legal market is not used to asking this question. And in particular, if the question asked by the pension fund or the asset manager of the lawyer leads them in the wrong direction, then the answer may be, well, no, you can't do it.
And a prime example of this is really where the question focus is on a specific investment and the specific investment opportunities looked at in isolation. And let us say that the specific investment decision looked at in isolation could be financially negative to the pension fund.
Well, looked at in isolation you might conclude as a legal matter you can't do it. And if you sling in the word sustainability as the reason for doing it, the lawyer is going to get even more nervous because they won't realize necessarily this is actually related to a financial goal.
If, however, you look at that decision in the context of perhaps a stewardship engagement program engaged in collectively, for example, as part of one of the zero alliances, and that investment decision is actually intended to further a much broader goal of seeking to achieve the internalization of some cost that the cost is currently being absorbed by the wider diversified portfolio, if you start looking at it from that perspective the answer becomes, well, actually, maybe you can do this.
So an awful lot depends on where the lawyer is coming from, whether they've-- [LAUGHS] sorry to be slightly arrogant about this, but whether they've gone through the thought process that we've set out in the report because most of the people who wrote this report had not been through that thought process when we started. So we went on a learning exercise, and the legal market I think is beginning to go through it. And it does depend crucially on the question that's being asked of them.
ROGER URWIN: Fantastic. Well, I do understand this point about things take time. Socializing findings like this take probably several years, dare I say, sometimes. And I've been interested to pick up on how many times your report gets referenced, and it's growing in momentum.
So I'm going to ask you to just look out a little bit further into the future really and ask whether or not you do see pension funds and other asset owners sort of playing a more significant but better proportionate part in fighting climate change. And obviously, we do have net zero ambitions among many asset owners and asset managers on pledges here.
And also, do you see this type of thinking about sustainability impact the instrumental sort, bringing about some other net positive outcomes? We could think about inequality. We could think about social justice and biodiversity I think in that respect. So I'm interested in your perspective. How much change might this type of thinking engineer over time?
DAVID ROUCH: Yeah. I mean, my sense is that investor focus on the impact they can have, the changes they can bring about in the area of climate change in particular, the momentum is definitely growing. And I think it's going to grow further as more and more people understand this sort of framework.
It has to. Investors don't have the whole solution to this. This is a systemic challenge. People sometimes say, oh, it's for the policymakers or it's for the operating entities or it's for consumers. The answer is it's for everyone, and investors are part of that. They were part of the whole process that got us to where we are, and they're going to be part of the process that gets us out. And as I said, my sense very much is that momentum is growing.
On wider sustainability challenges, biodiversity and inequality, social instability, things like that, I see evidence also there that investors are beginning to focus on those, as are regulators and governments. Biodiversity is the most obvious example of that. Antimicrobial resistance is another example.
The key question I think for investors is to understand the financial link. How could these risks impact the value of their fund over time? And of course, pension funds are long-term investors, So we're looking 20, 30, 40 years out. Is declining social stability likely to have an impact? Is biodiversity decline likely to have an impact? And I think investors are increasingly joining the dots, but it's much earlier days in those areas.
ROGER URWIN: And of course, the key word is that it's instrumental to financial value, as you point out. So thanks so much. I'm enclosing my personal thanks to you for this work because I think it really does invert the old view of lawyers as standing in the way of innovation. And I think this is great, innovative work in enabling this more progressive area of what people refer to often as universal ownership investing or 3D investing by another name. Risk return and real-world impact.
And I use a phrase quite a lot. The returns we need can only come from a sustainable system. We need to make sure the system is sustainable and the investors can work at that.
So really, David, more power to your elbow to spread this message more widely. Thank you very much for this. And we hope listeners found this useful. And please do have a look at some of the other sessions where we continue this discussion. Again, David, thank you so much for spending time with us.
DAVID ROUCH: Thank you, Roger. It's been a pleasure.
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