Net Zero Asset Management And The Fiduciary Duty Dilemma

By Tom Gosling, Executive Fellow of Finance, London Business School

In August last year, I wrote an article highlighting a looming challenge for Glasgow Financial Alliance for Net Zero (GFANZ) signatories between their fiduciary duty to clients and their commitment to align their investing and financing activities with the goal of limiting global warming to 1.5^oC with little or no overshoot.

A few weeks later, the Financial Times started reporting on threats made by US banks to quit GFANZ following an attempt to toughen membership requirements relating to coal financing. A group of US Attorneys General then wrote to BlackRock challenging them on their membership of the GFANZ sub-group Net Zero Asset Managers initiative (NZAMI), while Texas lawmakers extended their attack to a broader group of asset managers.

Legal firms see the prospect of fees as financial institution general counsels become increasingly nervous.

What’s going on?

Political theatre and lines of attack

Some of this is pure politics. Politics in divided societies thrives on wedge issues and ESG (Environmental, Social and Governance) has been weaponized by the Republican right in the US.

The first line of attack has been to position ESG within a narrative about wealthy metropolitan elites imposing a social agenda on ordinary Americans without a mandate. This accusation is largely without foundation. As implemented by the asset management industry, ESG has overwhelmingly been about risk management, not impact. Climate change is a risk. It creates a physical risk for company assets, a business risk for profit streams, and a transition risk in the event of a toughening public policy response. Governance risks include topics as dry as board composition, and audit quality and independence. The idea that investors should ignore these important issues is patently absurd; incorporation of ESG factors into investment decisions will carry on (even if asset managers don’t shout about it as much).

The second line of attack is about anti-trust. Here, the idea is that bodies like NZAMI are cabals engaged in anti-competitive activity. I’m yet to be persuaded that there is real legal liability here, but there is certainly scope for vexatious action. And this concern is clearly playing a role in the trend for US asset managers to go a bit wobbly on NZAMI (although much less so in Europe).

The third line of attack is more nuanced and relates to fiduciary duty. The issue is that fiduciary investors should be investing with the sole goal of maximizing financial returns for their beneficiaries. Investing to achieve a targeted climate outcome may conflict with this primary duty. Although this particular argument has received less attention, it is in my view among the most important, and is the one being seriously considered in private across the asset management industry. It also goes to the nub of the dilemma for NZAMI signatories.

1.5^oC and the fiduciary duty dilemma

Governments show little appetite to do what is required to limit global warming to 1.5°C with no or limited overshoot. Yet NZAMI signatories have committed to align their investments with this scenario.

Investing based on what is an increasingly unlikely scenario creates significant problems of fiduciary duty for asset managers as it likely results in misallocation of clients’ capital: overinvestment in assets benefiting from a quicker transition and underinvestment in assets benefiting from a slower transition. This could have economically significant impacts for clients.

It is sometimes argued that diversified asset managers and asset owners should act as “universal owners”, using their influence, through the investment process, to act on climate on behalf of their beneficiaries as a supplement to, or replacement for, government regulation. This is problematic, as I’ve explored in detail previously. Setting aside whether it’s actually possible for investors to achieve much in the way of results through such action, there’s also the problem that not all investors have the same interests or attitudes. Stock market assets are dominated by rich people in the rich world, who are much better placed to navigate the perils of climate change than the poor in developing nations. Limiting warming to 1.5^oC with limited or no overshoot is not unambiguously what they would all see as being in their best interests. Without a clear mandate, or regulatory requirements, asset managers cannot presume to use their clients’ money to further this goal.

The bigger the impact the bigger the risk

So-called universal owners cannot control the trajectory of climate change, even if they can influence it. In my recent paper with Professor Iain MacNeill of the University of Glasgow Law School, which will be published in the Capital Markets Law Journal shortly, we analyse various common 1.5^oC-aligned investment strategies. We show that the more likely a strategy is to nudge the world towards a 1.5^oC outcome, the more likely it is to give rise to potential risks and costs in more plausible climate scenarios compared with investing in the market portfolio.

The simple intuition is that the world is not on course for 1.5^oC for a reason: it is not currently the most profitable path. Even if limiting global warming to 1.5^oC is optimal for global welfare, there is no reason to think it is optimal for financial market returns.

Where an asset manager has an unambiguous mandate from informed clients who are prepared to bear this trade-off to help fight climate change, then all well and good. But most asset managers are not in this position for most of their assets.

Where next for NZAMI?

Behind the scenes, thoughtful investors and asset owners are grappling with this reality and looking for a way forward that fulfils their obligations as fiduciaries for client assets. Committing to invest in line with a goal you have no control over and the pursuit of which some clients may not see as being in their interests is problematic, as many are concluding.

This does not mean that investors cannot fight climate change. For instance, investors can make products available that have genuine climate impact and market them authentically to those investors who are prepared to bear the risk and return trade-offs that may be required to deliver that impact. And they can lend their expertise to governments to rewire the financial architecture to maximize the flows of capital to the most challenging areas of mitigation and adaptation. These areas, already being pursued on in good faith by members of NZAMI, should become its main focus.

A need for modesty

Overall, investors should be honest with clients and modest about the limited impact they can have on climate change. They should resist using climate change as a marketing tool to increase assets under management and increase fund fees, because the biggest legal risk of all probably does not relate to fiduciary duty or anti-trust. Rather it relates to greenwashing: the inconsistency between claims made by asset managers and the real-world climate impact of the investment strategies they adopt. This gap is easy to demonstrate and courts are unlikely to be sympathetic to the asset management industry.

This is what should really be making those lawyers hungry or fearful, depending on whose side they are on.

Tom Gosling is an Executive Fellow in the Department of Finance at London Business School, where he contributes to the evidence-based practice of responsible business by connecting academic research, public policy, and corporate action. Tom has 20+ years of experience as a board adviser and is a leading independent authority on corporate governance and responsible business. He was a senior Partner at PwC, where he established and led the firm’s executive pay practice. Tom is also a Fellow of the European Corporate Governance Institute and sits on the UK Financial Conduct Authority’s ESG Advisory Committee.