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July 22, 2009

UNEP Hones Legal Argument for ESG Incorporation in Investments in New Study
    by Robert Kropp

Report by the United Nations Environment Program Finance Initiative's Asset Management Working Group serves as a sequel to landmark Freshfields study, which established legal case for ESG criteria in investing. First in a two-part series. -- Whether asset managers have a fiduciary, and even legal, responsibility to incorporate environmental, social, and governance (ESG) issues into the investment decisions they make on behalf of their clients has long been a matter of debate. If the purpose of investing is to secure a financial return, can ESG criteria be said to be material? When seeking financial returns on behalf of their clients, what investment horizon should asset managers consider? Do asset managers place themselves at risk of being sued if failure to incorporate ESG criteria in investment decisions leads to losses due to such factors as climate change?

A report recently issued by the United Nations Environment Program Finance Initiative (UNEP FI) seeks to provide updated information on the legal ramifications of ESG criteria in investment management, as well as describe the growing support for such ESG initiatives as the Principles for Responsible Investment (PRI) among both asset owners and managers.

Entitled Fiduciary Responsibility: Legal and Practical Aspects of Integrating Environmental, Social and Governance Issue into Institutional Investment (Fiduciary II), the report argues that consultants may well have a legal duty to proactively raise ESG issues with their clients. The report also recommends that ESG issues be embedded into legal contracts between asset owners and asset managers.

Fiduciary II is but the latest stage of an ongoing effort by UNEP FI to make the case for incorporating ESG criteria into investment decision-making. In 2002, it formed the Asset Management Working Group (AMWG), which now includes 15 members and represents approximately $3 trillion of assets under management.

Dr. Julie Fox Gorte, who in addition to serving as Senior Vice President of PAX World Funds, is Co-Chair of the AMWG, said, "UNEP FI exists because over 170 banks, insurance companies, and asset managers believe that integrating ESG analysis in financial decision-making is crucial, for the proper functioning of financial markets and for the continued health of the planet and its societies."

Dr. Gorte continued, "Since 2002, the AMWG has issued a stream of reports that helped catalyze the incorporation of ESG issues into both buy-side and sell-side financial analysis, introduced the idea of integration into private equity management, and helped to launch the PRI."

One of the most important early reports, issues in June, 2004, sought to determine the business case for incorporating ESG issues into investment decision-making. Entitled Th e Materiality of Social, Environmental and Corporate Governance Issues to Equity Pricing (Materiality 1), the report found that "environmental, social and corporate governance criteria impact both positively and negatively on long-term shareholder value. In some cases these effects may be profound."

The report derived two far-reaching conclusions from the finding that ESG criteria do impact shareowner value. The first, that "research to determine the financial materiality of these criteria should use longer time spans than is currently the norm for financial analysis", is one of the central tenets of sustainability investing.

The second conclusion, that "Governments can reduce barriers to environmental, social and corporate governance analysis by mandating and standardizing the inclusion of these criteria in national and international financial disclosure frameworks", anticipates the growing call for mandatory reporting that we now see in the adoption of carbon pricing schemes in most developed countries.

While Materiality 1 conclusively established a business case for the incorporation of ESG criteria into investing, it did not address the legal ramifications of ESG incorporation to be considered by asset managers. In response to legal interpretations that in some cases suggested that investors were prevented from incorporating ESG criteria into investments, the AMWG commissioned the law firm of Freshfields Bruckhaus Deringer, which in 2005 produced a landmark report entitled A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment.

The authors of the report concluded that "decision-makers are required to have regard (at some level) to ESG considerations in every decision they make. This is because there is a body of credible evidence demonstrating that such considerations often have a role to play in the proper analysis of investment value." Therefore, according to the authors, the consideration of ESG criteria falls within the bounds of fiduciary duty.

Dr. Gorte said of the Freshfields report, "The report looked at the infrastructure of institutional investing in nine countries, and concluded that there were not only no legal impediments to integrating sustainability into institutional investments, but there were arguably and in some cases assuredly a requirement to do so. Institutional investors that failed to do so could be breaching their fiduciary responsibility."

The business and legal cases for ESG incorporation that were supported by these early reports helped lead to the formation by UNEP FI and the United Nations Global Compact of the PRI, which was launched in 2006. Today, the PRI includes 560 signatories, representing over $18 trillion in assets under management.

According to UNEP, the Freshfields report has been "considered by key opinion formers in the investment industry as the single most effective document for promoting the integration of ESG issues into institutional investment."

Fiduciary II, the report produced by the AMWG in June, serves as a sequel to the Freshfields report, and is intended by the AMWG to "provide a roadmap for fiduciaries looking for concrete steps to operationalize their commitment to responsible investment." The findings of Fiduciary II will be explored in the second of this series of articles.

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