Speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, delivered at the LSE in London.
Speaker: Edwin Schooling Latter, Director of Markets and Wholesale Policy
Event: LSE conference, London
Delivered: 23 March 2019
Note: this is the speech as drafted and may differ from the delivered version
- Effective stewardship is important. Long-term thinking and shareholder engagement helps markets function well.
- Whilst progress has been made towards more effective stewardship, the overall evidence on whether and how stewardship is happening is mixed.
- We will consider how to build upon the baseline for stewardship established by implementation of the Revised Shareholder Rights Directive, in the context of the FRC’s revision of its Stewardship Code.
I would like to start by thanking the LSE for hosting this excellent event, and the organisers for giving me the opportunity to speak on behalf of the FCA.
You will have seen that we recently published a joint FCA-Financial Reporting Council (FRC) discussion paper on stewardship, and a consultation paper on implementing the Revised Shareholder Rights Directive (SRD II). We welcome feedback on these documents and I will touch upon some of the issues they raise.
There seems now to be unprecedented interest in stewardship, perhaps driven in particular by increasing interest in how companies and investment firms manage environmental, social and governance (ESG) risks. A number of related initiatives are taking shape. For instance, we are currently reviewing feedback to our discussion paper on climate change and green finance. And the FRC is meanwhile consulting on a revised Stewardship Code. The European Commission also recently reported political agreement between the European Parliament and EU Member States on new disclosure requirements related to sustainable investments and sustainability risks.
Let me be clear at the outset about what is at stake here. We know that UK asset managers currently manage assets worth nearly £8 trillion. If we can make stewardship of these even marginally more effective, the benefits to investors and to wider society could be significant.
Links to the conference theme
Stewardship dovetails neatly with many of the issues considered at this conference. We have already seen papers on how ownership may affect control and the impact of strategies such as passive investing and high frequency trading. Stewardship speaks to debates about how market quality and effective corporate governance and economic growth interact. Research presented here finds that financial market quality plays a central role in determining the overall level of economic performance.
But quantification of cause and effect in this area is difficult. We recognise this. We welcome further research in this space. This conference is part of this effort and its findings will help to inform the direction of this work and, potentially, future policy actions.
What we mean by stewardship
Effective stewardship requires asset owners and asset managers to have a clear purpose that has clients’ and beneficiaries’ interests at its heart.
This purpose should drive investment objectives and investment strategy, and flow through to how institutional investors engage with issuers, exercise oversight and challenge, and hold issuers to account. Investors that take a long-term perspective will have an interest in how non-financial developments will impact financial returns over time. Such investors can seek to influence a company’s strategy through engagement and challenge, rather than solely through their buy and sell decisions.
There is evidence that investor demand for stewardship is increasing, especially in relation to ESG. For instance, the latest annual report on Principles for Responsible Investment, sponsored by the United Nations, records a 12 per cent increase in asset owners reporting according to responsible investment principles.
Advances in the availability and analysis of data can help shine a brighter light on how companies behave in respect of ESG objectives, raising awareness of what might be perceived to be ‘poor’ practices. This potentially widens the population of those who can access information on companies that issue securities as well as the financial service providers who hold those securities in their investment portfolios, allowing them to look for – and ask for – investment strategies consistent with their preferences.
My focus today is on the broad scope of stewardship activity – that is, oversight of how issuers manage ESG and other risks, both when those risks have a bearing on the issuer’s financial prospects – as they often will – but also when their impact may be non-financial, for example externalities they impose on the environment, the economy and society. This is a broader scope than looking only at investments in specific sustainable or ‘green’ products – by which I mean products designed according to particular sustainability, or ‘green’, criteria.
I don’t dwell on such products here. I note, though, that there are both signs of significant demand for such products, and plenty of further scope for innovation and growth in their provision.
According to the Investment Association (IA), and despite many new launches, the proportion of ethical funds as a percentage of total UK funds under management still remains at less than 2 per cent. In these funds, there are probably particularly high expectations as to how asset managers fulfil a stewardship role over the issuers of assets in the fund. But stewardship is important across a much wider range of funds than these.
Why stewardship is important to the FCA
Effective stewardship is important to achieving the FCA’s objectives – markets that work well, consumer protection, market integrity and competition that works in the interests of consumers. In our view, long-term thinking and shareholder engagement helps markets function well. It acts against short termism and can provide a vehicle to hold issuers to account if they pursue potentially value-destroying short-term strategies.
Directing investment towards sustainable value creation should generate higher returns and more positive societal outcomes, benefiting consumers both as investors and as stakeholders in wider society. Over time we hope that a proportionate and balanced regulatory framework, in conjunction with the FRC’s Stewardship Code and the right set of incentives, will help to create the conditions for a market for stewardship to develop.
This does not mean that every firm needs to exercise stewardship in an identical way, or at the same intensity. Firms optimise their stewardship activities from their private perspective. They have different priorities, strategies and objectives and allocate different resources to stewardship.
Guided by the preferences of their clients and beneficiaries, they will also have different positions on the pursuit of social objectives. There should be sufficient clarity about a firm’s purpose and investment strategy for clients and beneficiaries to know what they are signing up to, and to choose which firms are most likely to meet their objectives and concerns. Some asset owners and asset managers may choose not to engage actively in stewardship. Provided this is clearly disclosed to their clients, this will not be a breach of current regulatory standards.
Stewardship in practice
Let us consider what progress has been made – particularly in the past decade – towards more effective stewardship.
The IA reports that asset managers hold equities for 6 years on average. While this average reflects a blend of assets under management, including passive funds, and is less than what we might call a long-term investment time horizon of 10 years or more, it does suggest that asset managers often hold equities for more than short-term gain. Over 70 per cent of asset managers report that most institutional clients expect them to exercise active stewardship.
Disclosures under the FRC’s Stewardship Code and the PRI confirm that signatories have indeed developed and implemented stewardship policies.
And there have also been important initiatives by the IA and the Pensions and Lifetime Savings Association (PLSA). In a 2016 report on stewardship practices, the IA and PLSA point to examples of engagement with companies. These include engagements related to governance, capital allocation and ESG more broadly. In one example, active engagement resulted in a company taking a more strategic approach to phasing out hazardous chemicals. In another, a company was encouraged to pursue a more stable financial strategy, which led to a change in its acquisitions strategy and the repayment of debt.
The establishment in 2014 of the Investor Forum has also been important. Recognising that investors’ engagements with companies are likely to be more influential the larger the investment stake they represent, the Investor Forum has launched a range of collective engagement initiatives.
Why stewardship does not always happen
The overall evidence on whether and how stewardship is happening is, however, mixed. The recent Independent Review of the FRC, led by Sir John Kingman, criticised what it saw as a process-oriented approach to submissions under the Stewardship Code. The review expressed concerns about a lack of evidence of real outcomes and too much ’boilerplate reporting‘. This suggests that current stewardship disclosures may not always be sufficient to distinguish reported stewardship from meaningful stewardship. Indeed, recent research for the Edelman Trust Barometer suggests that UK institutional investors may lag in embracing stewardship relative to some other markets.
This appears counter-intuitive, since the UK was the first to introduce a Stewardship Code in 2010 – a standard which has since been adopted in over 20 countries. It begs the question as to whether there are significant barriers and impediments to effective stewardship:
Costs and free-riding
Stewardship has characteristics of a public good: if one investor influences outcomes positively by engaging with an issuer, all investors benefit. But active engagement with issuers takes time and resources. There is a risk, then, that some may free ride on the stewardship activities of others.
There are also cultural and structural features embedding short-termism in investment decisions and issuers’ strategies. Asset manager behaviour may be influenced by the fact that they are often rated and selected on their short run performance and peer-group rankings. This may make it difficult for them to prioritise longer term goals, which may cascade down to short termism in companies.
Information and complexity
Increasing complexity also presents challenges. There can be multiple parties in the chain of intermediaries. Service providers such as proxy advisers and investment consultants play a prominent role. The geographical dispersion of UK investors’ asset holdings and holdings of assets issued by UK companies also adds complexity.
Steps towards effective stewardship in the future
In our discussion paper, we ask ’what effective stewardship entails; what the minimum expectations of financial services firms which invest for clients and beneficiaries should be; what higher standards the UK should aspire to; and how these might best be achieved'. Rules to promote disclosure on life insurers’ and asset managers’ engagement and investment strategies under SRD II establish a baseline for stewardship actions. They improve transparency across the institutional investment community and support market discipline.
But we need to consider carefully if and how we build on this baseline. We want to avoid crowding out nascent innovation and competition in stewardship, or imposing costs that would weigh on efficiency. At the same time, we want positive incentives for firms and institutional investors. Our discussion paper and consultation paper are part of considering what can be done to create the right conditions and incentives for effective stewardship.
There are several areas that could be relevant to this question.
Meaningful and accessible disclosures on firms’ stewardship activities
The proposed disclosures by asset owners and asset managers will only be effective if clients and beneficiaries can extract meaningful information from them about the quality of stewardship. Some might argue that there is a role for regulators to assess these disclosures. But these disclosures are designed to inform investors’ choices, not for regulators. Some of those involved in supporting investor choices may have commercial incentives to develop metrics and insights based on the disclosures. This will only happen if clients and beneficiaries place a sufficiently high value on good stewardship for it to be a factor in their own choices, ie market discipline will work because end-investors favour firms that share their values and hold issuers to account on matters that they care about. Perhaps the growing interest in ESG matters is a sign that clients and beneficiaries do place increasing value on these matters. As the impact of climate change becomes increasingly visible, it seems likely to me that this investor demand for evidence of good stewardship will grow.
Firms’ governance, culture and institutional structures
I have also pointed to potential incentive challenges. I question whether stewardship is too often a siloed activity carried out by a segregated corporate liaison team. Such teams can have the benefits of focus and expertise. But their impact will depend on how their expertise is integrated with a firm’s investment strategy and decisions, and the extent to which it is supported by a firm’s wider culture, governance arrangements and institutional frameworks. Perhaps improvements in the quality of stewardship would accelerate if there was innovation and change in some of the key drivers of firms’ and individuals’ incentives, such as the composition of performance benchmarks, the criteria used in asset manager selection and remuneration policies.
Access to the right information from issuers
To exercise effective stewardship, investors need to be able to understand how an issuer’s corporate strategy promotes sustainable, long-term value creation. And they need sufficient access to issuers to engage constructively and influence outcomes. We will consider carefully the scope and quality of issuers’ disclosures and how they support stewardship. We note here the good work that has been done by the Task Force on Climate-related Financial Disclosures, as well as continuing work in the EU on companies’ non-financial disclosures. But it is too early to declare job done. For example, recent evidence suggests that the proportion of smaller companies making good or detailed disclosures about shareholder engagement has decreased over recent years.
A supportive regulatory framework
More generally, it will be important to ensure that there are no impediments to effective stewardship elsewhere in the regulatory framework. For instance, we have sometimes heard concern that engagement between investors and issuers on ESG matters is inhibited by concerns about falling foul of rules on sharing inside information. Another possible concern is that investors acting collectively in their engagements with issuers are deemed to be ‘acting in concert’.
These are understandable concerns but we think that with reasonable consideration it is entirely practicable for individual and collective investors to engage with issuers without breaching requirements of market abuse regulations or competition law. We stand ready to discuss with stakeholders who might have concerns in this regard.
In my talk today, I have set out some views about what stewardship is, why it is important to us and how far effective stewardship seems to be taking place.
I have touched on several possible areas of further investigation to help create the conditions for more effective stewardship in future. Better disclosures, such as those we propose in our consultation paper, may be a step towards addressing remaining gaps, alongside other new requirements under the FRC’s revised Stewardship Code, and in EU legislation. Informed by stakeholder engagement and responses to our discussion paper, we will need to think carefully about how these can interact with the wider regulatory framework and market practices to create the right conditions and incentives for effective stewardship.
The interest in these matters, the insights, and the research contribution of those here today can all make an important contribution to achieving that aim. So, I thank you all for your attention, your analysis and your assistance.