Regulatory and fiduciary duties

Are institutional investors and financial intermediaries legally required to consider ESG factors when making investment decisions? Must any additional non-financial principles and objectives be considered?

Investment managers owe fiduciary duties to investors. Broadly, the law permits investment managers to engage with ESG risks in their decision-making within those duties but does not legally require them to consider ESG factors.

A key example of this fiduciary duty is the duty owed by trustees of pension funds (known as superannuation or super funds) to their members. Section 62 of the Superannuation Industry (Supervision) Act 1993 (SIS Act) requires superannuation trustees to act honestly, to properly invest funds, to ‘act in the best interests of the beneficiaries and to exercise a prescribed standard of care, skill and diligence and to give priority to beneficiaries where there is a conflict of interest’.

The financial services prudential regulator, the Australian Prudential Regulatory Authority issued Prudential Practice Guide on Investment Governance (SPG 530), explaining that it sees ‘no inherent conflict in super funds excluding investments on ethical grounds and complying with their fiduciary duties’. SPG 530 allows that a registrable superannuation entity (RSE) – which are regulated superannuation funds, approved deposit funds or pooled superannuation funds – may adopt a responsible investment strategy and if it does so must ‘demonstrate appropriate analysis to support its formulation (including being mindful of exposing the interests of beneficiaries to undue risk)’. SPG 530 states that an RSE licensee may take additional factors into account where there is no conflict with the requirements of the SIS Act, including the requirement to act in the best interests of beneficiaries. Thus, the RSE licensee may offer an ‘ethical or sustainable’ investment option to beneficiaries.

In practice, the fiduciary duty of acting in beneficiaries’ best interests requires investment decisions to include due process and competence, which may require showing that the trustee has identified and assessed ESG risks  and to show it has adopted specific measures of stewardship towards these risks.

Voluntary standards and best practices

What voluntary standards and best practices are commonly followed in your jurisdiction with regard to integrating ESG factors and other non-financial principles into investment decisions?

Many Australian funds promoted as being ESG- or impact-related rely upon the UN Principles of Responsible Investment. In addition to providing advice and policy advocacy, investor groups such as the Responsible Investment Association Australasia (RIAA), the Australian Council of Superannuation Investors (ACSI) and the Investor Group on Climate Change offer voluntary codes, practices and certifications around ESG investment.

For example, product issuers and investment managers may voluntarily certify with the RIAA’s Responsible Investment Certification Programme. To achieve this certification, a product issuer or investment manager must meet strict disclosure requirements and agree to make publicly available specific details of its product or service to help investors make an informed choice. Applicable standards may require certain investment sectors to be ruled out (such as tobacco and weapons) and for active stewardship to be applied.

ACSI has an Australian Asset Owner Stewardship Code, which aims to increase the transparency and accountability of stewardship activities in Australia. Currently, 16 superannuation funds – including the country’s largest – are signatories to the Code.

Although the standards and practices may be voluntary, the Corporations Act 2001, the Corporations Regulations 2001 and regulatory guidance from the conduct and securities regulator, Australian Securities and Investments Commission (ASIC), places on investment managers a binding responsibility to select, retain or realise an investment consistently with their advertising and disclosures. To remain compliant, they may be required to engage and influence investee companies on environmental and social issues, and divest and invest in the sectors disclosed, in addition to remaining a signatory to or member of the applicable standard or code.

Measurement, reporting and disclosure

What voluntary and statutory measurement, reporting and disclosure frameworks are followed in your jurisdiction with regard to ESG and other non-financial factors?

Section 1013DA of the Corporations Act requires financial product issuers to disclose in a product disclosure statement how labour standards or environmental, social or ethical considerations are taken into account in selecting, retaining or realising an investment. ASIC’s Regulatory Guide 1013DA Disclosure Guidelines RG 65 prescribes how product issuers can meet these obligations. Regulation 7.9.14C of the Corporations Regulations requires actual disclosure on this issue, whether or not these matters are taken into account. The Corporations Regulations and RG 65 together require that the product issuer make it clear which labour standards or environmental, social or ethical considerations are taken into account, and the extent to which they are taken into account in selecting, retaining or realising an investment.

The RIAA’s voluntary Responsible Investment Certification Program requires certified products and services to meet strict disclosure requirements relevant to its licence category and make publicly available details of its product or service (whether a superannuation fund whole of fund, investment management service or investment product).

Disclosure extends to annual and continuous disclosure of matters relevant to investors and shareholders by disclosing entities, public companies, large proprietary companies and registered schemes under the Corporations Act. These entities must prepare financial reports and directors’ reports. Subsection 299A(1) of the Corporations Act provides that the directors’ report must contain information that shareholders would reasonably require to make an informed assessment of the entity’s operations, financial position, business strategies and prospects for future years, which is known as an operating and financial review (OFR).

In 2019, ASIC updated its Regulatory Guide ‘Effective disclosure in an operating and financial review’ (RG 247). RG 247 provides that an entity’s discussion about its future prospects should include a discussion of the material business risks that could adversely affect the achievement of those prospects. ASIC has incorporated climate change into the risks that must be discussed and will monitor and supervise disclosures by directors and companies. It also encourages the use of the Taskforce on Climate-Related Financial Disclosures (TCFD) Recommendations in this regard.

According to ACSI’s 2019 report ‘ESG Reporting by the ASX 200’, TCFD is being steadily adopted by the top 200 publicly listed Australian companies and is becoming the emerging market standard for climate risk disclosures. Beyond climate risk, more than 60 Australian Stock Exchange (ASX) 200 companies now use UN Sustainable Development Goals in their reporting, with a 30 per cent increase in ASX 200 companies using them. To a lesser extent, Integrated Reporting is employed.

Entities listed on the ASX are required to consider the ASX Corporate Governance Council’s Corporate Governance Principles and Recommendations (Principles and Recommendations). ASX Listing Rule 4.10.3 requires listed entities to publish a corporate governance statement that discloses the extent to which the entity has followed the Principles and Recommendations. Although they are not mandatory, in an approach known as the ‘if-not-why-not’ approach, the statement must identify any recommendation not followed and the period from which it was not followed, and provide the reason and what (if any) alternative governance practices were adopted in lieu. Recommendation 7.4 of the Principles and Recommendations states that a listed entity should disclose whether it has any material exposure to environmental or social risks and, if it does, how it manages or intends to manage those risks.

ACSI’s voluntary Australian Asset Owner Stewardship Code (which has most of Australia’s larger superannuation funds as signatories) requires Code signatories to disclose their approach and outcomes regarding the following stewardship activities: voting, engagement, policy advocacy and the selection, appointment and monitoring of external asset managers.

Finally, the Modern Slavery Act contains a national reporting requirement for Australian entities or entities carrying on business in Australia with annual consolidated revenue of A$100 million or more. Companies, partnerships, trusts and superannuation funds are included in the definition of ‘entities’ for the purposes of the Modern Slavery Act. The legislation requires entities to issue annual modern slavery statements disclosing the risks of modern slavery occurring in operations and supply chains, the actions taken to assess and address those risks and how the entity assesses the effectiveness of those actions. The definition of operations is broad and includes investments if those form part of the activities of the reporting entity.

Ratings, indices and guidelines

What ratings, indices and guidelines are used to benchmark adherence to ESG principles and other non-financial factors in your jurisdiction?

Some investment managers that issue and market ethical and sustainable funds in Australia provide investment returns that track the performance of indices that incorporate ESG. Services such as MSCI offer indices to help institutional investors benchmark ESG investment performance. Any such tracking of an index must be adhered to by the investment manager in the manner publicly disclosed, as required by the Corporations Act.

Incentives, benefits and financial support

Are any fiscal incentives or other benefits available in your jurisdiction to encourage institutional investors and financial intermediaries to integrate ESG and other non-financial factors into their investment decision-making?

Fiscal incentives focus on the charitable sector. Funds known as ancillary funds link donors to organisations that can receive tax deductible donations. Such organisations are known as deductible gift recipients (DGRs). There are two types of ancillary funds: public ancillary funds and private ancillary funds. Public ancillary funds are established as DGRs and are used as vehicles for public philanthropy, to provide opportunities for donors to obtain tax deductions, and to obtain income tax exemptions on income earned by the fund. Private ancillary funds are used to further philanthropic objectives in a controlled and enduring way, enabling income tax deductible giving, the ability to retain control over which DGRs receive distributions and income tax exemption for income earned by the fund. They may be eligible to be DGRs but are not always. Unlike public ancillary funds, private ancillary funds cannot receive donations from the public.

Impact investing

In addition to ESG factors, what considerations and practices are commonly integrated into impact investment strategies?

The highly anticipated Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Financial Services Royal Commission) was published in February 2019. The report identified widespread conduct by many large financial institutions, taking place over many years causing substantial loss to customers. The conduct included breaches of the law and conduct falling short of community expectations. The Financial Services Royal Commission Final Report highlighted the importance of governing and managing conduct risk. Investment strategies may thus integrate remuneration management practices and employee grievance standards, including whistle-blower policies, the laws for which were overhauled in 2019 when whistle-blower protection provisions in the Corporations Act were amended.

Given research showing a strong correlation between financial performance and cognitive diversity, investment managers often also analyse diversity metrics in their portfolios.

Finally, safety statistics is a key area of focus for Australian investors including lost-time injury frequency rates, total-recordable injury frequency rates, fatalities and consequence management.