By Rosemary Boot and Robert Jennings, Members of the Chapter Zero Steering Committee and investment company Non-Executive Directors, in collaboration with FTI Consulting

How might the climate challenge impact your investment company over the coming ten years? The past decade has, undoubtedly, been transformational. With the coronavirus call to arms, the next decade looks set to be even more so.

With the financial industry reflecting wider society, it is a point not lost on the investment company industry. As the generational transfer of wealth begins, the ESG revolution is taking firm hold, led by climate change concerns.

Over recent years investors have poured money into stocks and portfolios with an ESG focus. More than 500 ESG funds were launched last year alone. Investors are also asking more searching questions about how portfolios behave and are being actively managed. It is a theme that cannot be ignored.

The trend is creating an alphabet soup of acronyms to describe different forms of ESG disclosure. Not surprisingly, many companies, asset managers and academics are left scratching their heads. With whole business models challenged by a low carbon transition, the subject is becoming a boardroom issue for businesses of all shapes and sizes.

How should investment company boards respond?

First, understand clearly your investment mandate. This is where clear communication with the investment manager is critical.

A fund that invests in listed equities will face very different questions to an infrastructure or real estate fund which invests in unlisted debt or equity with potentially concentrated investment exposures. For the former, where you can trade in and out of stocks, questions might focus on how to switch from high dividend, high carbon companies to lower yielding firms that have strategies to address climate change, alongside the revenue impacts that follow. It also raises key questions about engagement or divestment strategies, alongside scrutiny of voting records.

For the latter, more illiquid investments, questions abound about screening techniques used and details of the manager’s control of board appointments and remuneration arrangements. Or, scrutiny may fall on the covenants within long-term loan or debt agreements, including stipulations to meet certain environmental criteria, or diversity targets. For property focused companies, the location of investments and how energy certificates are analysed, or the tenant and landlord relationships managed, become key questions.

What is consistent is that the board must demonstrate an understanding of the material risk in its investment portfolio. It must demonstrate active risk mitigation steps and investment mandate compliance. Boards must also make clear their expectations of managers in relation to climate risk, among other matters.

Second, recognise that only by having the right expertise around the boardroom table can informed discussion begin. A good place to start is the professional development of current board members. Use board strategy days to discuss core themes. Make climate change a point on the regular boardroom agenda. Or, actively seek ESG skills during the normal course of the board rotation process. Recognise that for many, this is a journey and one that will take several years to run its full course.

This is where Chapter Zero can help. Its purpose is to enable Non-Executive Directors (NEDs) in UK boardrooms engage effectively in a strategic debate about the climate challenge. In just over a year it as become a board-level community of more than 900 members, with 47 FTSE100 and 97 FTSE250 boards having at least one director in the network.

In April, the ‘Directors’ Climate Journey’ was launched, which sets out eight steps to help NEDs respond to the climate challenge. In June, Mark Carney, UN Special Envoy for Climate Action and Finance and former Governor of the Bank of England, discussed the role of the board in the transition to net zero. His main point? The question increasingly being asked of companies whatever sector is: “What’s your plan for the transition to net zero?”.

Third, be ready to adapt reporting and risk management processes to meet this increased scrutiny. As a board, try and be clear about how you intend to deploy capital for change. A constructive way to begin is through open discussion with your investors. From here, an effective ESG framework can be developed.

Given the diversity of the investment company world, approaches will vary considerably. Effective ones currently in use include negative screening processes in the investment due diligence phase to ESG scoring systems that demonstrate portfolio transition over time. Ultimately, boards will need to use their judgement to decide whether the investment manager’s approaches satisfy investors’ requirements.

With the pandemic pushing these issues even more to the fore, demonstrating how organisations create sustainable value for stakeholders will become increasingly important.

Never has it been more important for firms to measure, monitor and communicate their progress on varying indicators of sustainable or responsible business practices. Look no further than the Financial Conduct Authority’s recent proposal that all main London-listed companies (apart from investment companies, for now) must make climate-related disclosures as prescribed by the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures — or explain why they cannot. It is becoming vital that boards understand the impact of climate change so they can make better informed and more strategic decisions.

In ten years’ time, you will not regret taking action today.

Further details of Chapter Zero’ goals and forthcoming activities, as well as enrolment information for membership, can be found on www.chapterzero.org.uk.