The world has altered. No longer are asset managers absentee landlords. They are expected to assume greater responsibility for the social and environmental consequences of their investment decisions, beyond purely financial returns, as engaged and vocal stewards of client assets.  

This is a sea change. Since the ascendancy of neo-classical economics in the 1980s, drawing on the theories of Milton Friedman, a mindset of growth at any cost has prevailed. Rewards for making nature and society invisible in economic value have been high. Many of the real costs of economic growth, ‘externalities’ with no immediate bearing on financial returns, could be ignored.

Fast forward and we now see a tsunami of interest in environmental, social and governance (ESG) issues and responsible investing. The experience of Covid-19 recalibrated how millions think of work and the value of labour. Climate change, formerly viewed as an externality to the fossil fuel industry, is increasingly internalised into business models across all industries. 

The investment industry is a mirror of the evolving values of civil society, and a potential agent of change. Interest in sustainability (at the corporate and investor level) is creating a concept of ‘value’ beyond financial assets. Natural and social inputs, like land and trees, health and education – long considered costs in economic models – have taken on shared societal-level value. 

‘Sustainable’ has become the desired outcome, ‘impact’ the consequence of our actions and how to mitigate their environmental and social cost. ‘Investing for good’ is not straightforward, however. The dangers and costs to society of smoking, known for decades, have led to tobacco stocks’ exclusion in many portfolios. Yet smoking continues and tobacco stocks historically delivered strong returns, helped by tax hikes that masked price increases and that created barriers to entry for new competition.  

Investing in an ESG or sustainable-labelled fund may aligned with an investor's values, but it should not be a substitute for direct action by consumers.  Similarly corporate sustainability disclosures cannot be a convenient fig leaf for lack of tangible changes in business practices.Asset management must move beyond using ESG as an abstract acronym and one-dimensional score. The next stage of responsible investing is collaboration beyond market share. Sustainable finance can support a new economic paradigm, backed by the guardrails of law and regulation, that reflects the evolving values of society.

Support for this idea appears in an unlikely source, Friedman himself, who knew that markets need boundaries. His famous 1970 New York Times essay told businesses to ‘make as much money as possible’, but, often crucially forgotten, ‘while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom’. 

Certainly, the investment industry has the potential to act as a powerful enabler of change. Impact investing may still be a tiny proportion of the total invested assets in the world, but has an outsized influence. Thinking is shifting away from inputs and outputs (associated with ESG) to real world outcomes and consequences.

The objective of responsible investing was never supposed to be an inflow of new assets into funds, but to be part of a more resilient, fairer and more sustainable way of doing things. Robust (but not necessarily better) long-term financial outcomes should follow because of the improved health of the overall economic system.

Asset management faces challenges on the real-world influence of ESG in investing. Climate-orientated strategies crammed with fossil fuel stocks with a correlation of nearly 1.0 with the S&P 500, for example. Finance is not a replacement for elected governments. Clear boundaries are needed between what can be delivered through investing responsibly and what is needed from policymakers.  

The use, or over-use, of ESG and related terminology as marketing labels rather than meaningful investment strategies has brought down the wrath of regulators. There have even been instances of police raids on asset managers suspected of misleading investors on their green credentials. From a tightening of the EU’s Sustainable Finance Disclosure Regulation (SFDR) to the UK’s Sustainability Disclosure Requirements (SDR) and the Financial Stability Board’s Task Force on Climate-Related Financial Disclosure (TCFD), we are moving into a regulated, rules-based environment. 

The impact investing market is estimated at US $715 billion globally and is growing rapidly. It has fostered a historically unseen level of collaboration in the investment industry between social entrepreneurs, academics, non-government organisations, activists, development finance and UN agencies. This collaboration has turned into new initiatives, such as the Institutional Investors Group on Climate Change (IIGCC), and helped recalibrate the thinking of asset managers, asset owners and banks.

The lack of environmental and social consequences in financial accounting is changing as a result. The Task Force on Climate-related Financial Disclosure (TCFD), for example, is being adopted globally, where companies and investors assess which of their assets are at risk under climate change projections. 

The creation of an International Sustainability Standards Board (ISSB), under the auspices of the International Financial Reporting Standards (IFRS) Foundation, will, in time, provide a consistent framework for understanding sustainability risks more fully in business models and remove the ‘invisibility of nature’ from financial disclosures.

Lawyers are also an emerging force in the sustainability movement. The landmark victory in May 2021 of climate activists against Royal Dutch Shell is set to have profound implications for perceptions of risks in carbon intensive industries, and has triggered a wave of similar ligation.

Acknowledging the legal status of nature is an important step towards being able to place tangible value on it that can be reported alongside traditional financial assets. The simple removal of the inaccurate and derogatory ‘non-financial’ from EU sustainability reporting is a welcome development.

‘Maximising returns’ still plays a role in a system that measures success by solely through the quantum of growth. Quality versus quantity of growth remains a difficult topic for investors to manage. But voting, engagement and public policy advocacy have exploded in the investment industry, and asset managers are becoming truly engaged owners of assets and the broader inputs into long-term shareholder value creation.

It remains an open question whether investor engagement can make a bad company good. ‘Own and engage’ may legitimise a passive approach even if it acts without sanctions. But the risk of divestment can imply the exit of an otherwise awkward shareholder. Either way, while engagement can clearly be powerful, helping ensure that management understand the perspectives of key stakeholders, we need to be clear that there are practical limits to what can be achieved. 

We need to be equally wary of outsourcing political decisions to private corporations. It is the business of elected politicians, for example, rather than private enterprise, to define the proper limits of greenhouse gas emissions. The last 40 years have seen an erosion of the developed world’s rules to limit the exploitation of society and nature. Activists turn to finance to punish companies, but finance’s role is to grow other people’s money – not to replace elected governments .

What to do? The Royal Society of Arts, in a 2021 sustainability report, used the analogy of a rainforest. Rainforests thrive on complexity and symbiotic relationships, from forest flowers to the giant trees of the canopy. Each has a role that evolves and adapts. So it should be with the investment world: a complex, adaptive system with symbiotic relationships forged on the understanding that no single approach should dominate.

Responsible investing is at a watershed. Asset management firms are committing considerable resources to broaden and deepen their activities. Climate change, human rights and antitrust abuses now regularly appear in discussions at trustee meetings and in stewardship reports. 

But the flow of new capital to pressing underserved or unmet social and environmental challenges remains pedestrian. To achieve the ambitions of sustainability impact, while delivering robust financial returns, the financial services industry must embrace a more collaborative approach with a plurality of solutions, with adaptation and regeneration at its heart.

Progress is happening. The concept of ‘value’ is extending beyond financial capital to embrace natural and social assets. For investment firms, this must neither be marketing nor an overlay divorced from their primary function of producing client returns. They will need to look inwards to determine their own intentional impact opportunities, and then look outwards to embrace the complexity of a highly interconnected and adaptive system.