Skepticism surrounding ESG and responsible investing persists, but this sentiment has abated as a growing body of academic research supports that the integration of ESG factors into investment analysis can drive alpha. Even the most ardent of skeptics can usually concede that integrating ESG aspects into their day-to-day decision-making process is a very important risk mitigation tool. In fact, many investment management companies have been applying social and governance factors for years, just not necessarily labelling them as “S” or “G.” For example, analysts considering a target company’s workers relations or managers shorting companies where the CEO is also the chairman are both indicators of poor corporate governance.

The ”E” component is relatively new but has gained considerable momentum in the drive to achieve net-zero goals. The issue of energy security has resurfaced because of Russia’s invasion of Ukraine and led to accusations that the green agenda has been abandoned. On the contrary, while the fallout from the war has increased oil and gas prices in the short term, the crisis has the potential to be the catalyst for a full-scale change as to how Europe (and the world) sources its energy and will potentially accelerate the move from carbon-intensive energy sources, as renewables resemble a cheaper and more secure alternative.

In this interview, Lawrence Usher of Deloitte and Rebecca Palmer of Waystone Governance, examine ESG trends and discuss recent developments in associated regulations to assist in navigating this ever-evolving landscape.

Lawrence Usher (LU): Is ESG a choice or a necessity?

Rebecca Palmer (RP): ESG is no longer a choice; it is a necessity for long-term success among managers looking to capture a greater share of the growing allocation to ESG as estimates suggest that such mandated assets could make up half of all managed assets in the United States by 2025. Taking into account the institutionalization of investors and the collective pressures they have exerted on investment managers, considering ESG aspects in your day-to-day decision-making process, is now more often a prerequisite for attracting inflows, managing risks, and creating long-term value. The consideration of ESG factors will become increasingly critical to the success of businesses across all sectors and is not just limited to investment funds.

The profile of ESG will continue to rise and become more relevant over the next few years as the next generation take control of companies and are left to deal with societal challenges (from gender and race equity, to pay equality and social mobility) and the consequences of climate change on businesses and society as a whole. Millennials and Generation Z are more concerned with a well-run company that is mindful of the social environment they are operating in and are often more concerned with putting social responsibility over profits.
 

LU: How is Cayman approaching ESG?

RP: As one of the world’s leading international financial centers, the Cayman Islands regulates an estimated 12,046 mutual funds and 14,679 private funds sponsored by investment managers across the globe. Thus, Cayman has a key role to play in promoting responsible investing. With that in mind, the Cayman Islands Government is currently working on a legislative framework for the implementation of ESG criteria for Cayman’s financial services industry.

Mutual funds and private funds with more than one investor are regulated by the Cayman Islands Monetary Authority (CIMA). As these funds are typically sponsored by investment managers located overseas, the regulatory nexus is to the funds, rather than the investment managers, which differs from other jurisdictions such as the UK, where it is the investment managers that are regulated.

While is it is not yet known how the new legislative framework will look, it seems likely that any regulation will be directed at regulated funds, given both their significance and the regulatory nexus.

On 13 April 2022, CIMA released a circular on ESG and sustainable investing, which noted:

“Sustainable investing is a complex and developing subject and the expectations and practices around ESG-related risks are also quickly evolving. As such, there is a growing need for regulated funds to better understand the impact of ESG-related risks in their implementation of this investment strategy. At a minimum, those charged with governance of regulated funds should have clear roles and responsibilities in managing and mitigating the risks from climate change and other ESG-related risks in line with the fund’s set investment objectives and should start establishing reliable approaches for identifying, measuring, monitoring, and managing material ESG-related risks. Additionally, funds are required to ensure clear and ongoing disclosures in the context of their reporting requirements.”

The circular also noted that, as part of its supervisory mandate, CIMA will continue to undertake reviews and assessi available information, such as best practices undertaken in other key financial jurisdictions, with the aim of developing a suitable regulatory and supervisory approach for climate-related and other ESG-centric risks.

As a fiduciary, I wholeheartedly endorse the stance taken by CIMA as it relates to those charged with governance. It is imperative that both fund directors and investment managers have a clear understanding of ESG and that the associated policies are fit for purpose and are in place with an appropriate level of oversight.
 

LU: The United Nations Principles for Responsible Investment (UNPRI) recently released a piece on tax transparency outlining the concepts of tax fairness and encouraging investors to adopt and embed fair tax principles as part of their responsible investing mandates. How do you see Cayman responding to this?

RP: The outcome of the Cayman Islands’ tax neutrality, as it relates to the financial services industry, is to allow for a single layer of taxes to be paid in the onshore jurisdiction where the investor is tax resident. A retiree withdrawing their pension may pay taxes in their country of residence on that income, however, it is widely accepted that it would be unfair and inefficient for the investment fund in which they are invested to also pay taxes and potentially reduce their pension even further. The system of double tax treaties aims to prevent the double taxation of an individual’s savings. However, it can be cumbersome and overly bureaucratic. In the case of the Cayman Islands, an additional layer of taxation is considered unnecessary. If we think about the purpose of taxation, it is principally to generate revenue for the provision of services and to support community needs. The Cayman Islands is fortunate to have a highly educated population, high employment rates, and a small population such that it can support its local community, without the additional tax revenue sources necessary in other jurisdictions.

The Cayman Islands has a robust regulatory environment that combats tax evasion. The Cayman Islands enacted The International Tax Co-Operation (Economic Substance) Act on 1 January 2019, as part of Cayman’s obligations as a member of the OECD to address Base Erosion and Profit Shifting (BEPS). The Cayman Islands is one of more than 90 countries that agreed to implement the Common Reporting Standard (CRS). The Cayman Islands Tax Information Authority (TIA) is responsible for ensuring CRS compliance and enforcement  and has extensive powers to levy hefty penalties for noncompliance.

As a jurisdiction, the Cayman Islands promotes tax transparency and has a robust regulatory environment to prevent tax evasion. As part of responsible investing practices, a company should review its tax practices and ensure that it is operating in jurisdictions that are complying with global norms such as CRS.

Aggressive tax practices do not align with responsible investing, and companies pursuing overly aggressive tax practices will continue to attract negative press, which will ultimately and adversely impact their share price.
 

LU: How important is the regulatory environment to the implementation of responsible investing?

RP: A robust regulatory and legal environment is essential to the effectiveness of financial markets, a sentiment that is echoed by our regulator, the CIMA’s mission statement: “To protect and enhance the integrity of the financial services industry of the Cayman Islands.” 

On most ESG due-diligence questionnaires, there will be sections that ask about anti-bribery and corruption policies. Such questions should also be asked of the jurisdictions in which investment funds operate. There is a renewed focus on anti-money laundering (AML) following the Russian invasion of Ukraine and the resulting significant increase and jurisdictional divergence in the sanctioning of individuals.

As a jurisdiction, Cayman takes AML very seriously and has enacted stricter AML regulations than many of its competitive jurisdictions. For example, some jurisdictions only require the identification of ultimate beneficial owners with at least a 25% stake, while in Cayman that threshold is significantly lower at 10%. Cayman is, however held to a higher threshold than other jurisdictions, being deemed a major financial center by the Financial Action Task Force (FATF).

On 25 February 2021, the FATF reported that Cayman is compliant or largely compliant with 39 of the 40 areas of technical compliance; this was further upgraded in October 2021 to be compliant or largely compliant with all 40 FATF recommendations – a significant achievement as some larger jurisdictions have areas that are deemed non-compliant or only partially compliant.

Cayman has a strong regulatory environment that goes hand-in-hand with responsible investing mandates and remains the world’s leading domicile for alternative investment funds.
 

LU: What challenges in implementing ESG do managers of Cayman funds face?

RP: Managers face different pressures dependent upon the needs of their investors, their investment strategies, and their regulators. As a result, investment managers face different challenges and are at different stages of their ESG journey.

ESG is not a one-size-fits-all and it’s important for an investment manager to consider their own investing philosophy and firm values, prior to developing their ESG policy. This should not be an off-the-shelf product, whilst it can be very helpful to work with ESG advisors or compliance consultants on developing an ESG policy, this should be bespoke to the firm.  Investment managers need to be able to clearly articulate their vision and how they are applying ESG to their portfolios, be that exclusionary or full integration.

Investment managers also need to clearly understand their investors’ evolving needs and ESG reporting should be geared to meeting those needs.

ESG data quality continues to improve, but I would be remiss not to note that coverage is still frequently limited to larger Western companies. There are currently no global norms on disclosures, and information that is used by ESG-ratings services is often self-reported and unaudited. 

For private equity and debt managers, there is no global consensus as to what information should be collected from portfolio companies and SMEs may struggle to meet the demands around collecting data on carbon emissions. There are, however, some great tools out there to assist with this.

A lack of ESG expertise is still a significant barrier to ESG investing, and it is often necessary to rely on external expertise to develop the necessary frameworks and policies.
 

LU: How are you seeing investors’ ESG demands evolve?

RP: It is now very common to see ESG forming part of the due diligence investors are performing on prospective investment managers. The extensiveness of this process can catch some investment managers off guard with a common reaction being, “We’re not an ESG fund. Why are we being asked this?”

As investors need to report back to their own stakeholders (e.g., university-endowment funds are coming under increasing pressure from their student bodies to ensure they are investing responsibly), they are seeking to collate the data they need from their investment managers.

ESG due-diligence questionnaires can number many pages, and it is helpful for investment managers, including those who are not running ESG mandates, to spend some time considering how they will address these questions. Even where ESG is not applied at the product level, investment managers should expect to be asked whether they have an ESG or responsible investing policy and be prepared to answer why there is not one in place.

Where there is an established responsible investing policy, investors are looking beneath the hood to understand how it is applied in practice. Appropriate oversight and senior level engagement is expected.

Side letters are another area where investors are increasingly including specific ESG criteria and requesting specific ESG metric reporting.

LU: Inclusion and diversity is a central component of ESG. What best practices are you seeing?

RP: Many leading investment managers have become signatories to the Institution of Limited Partners Association’s (ILPA) Diversity in Action pledge. The ILPA has also updated its due-diligence questionnaire to enhance the questions asked around diversity, equity, and inclusion together with a useful diversity metrics template to assist investment managers in collating data. Investment managers should expect to answer questions on their own diversity statistics and what they are doing to promote an inclusive culture. Investors increasingly expect to see family leave policies and a code of ethics that covers discrimination and to understand how recruitment process addresses diversity in the workplace.

If we take gender diversity, women still have a long way to go to come even close to the number of investment or finance executive roles that men currently hold. Deloitte counts itself among 100 Women in Finance’s (100WF) Leadership Council, and Odette Samson from Deloitte Cayman sits on the Global Advisory Council of 100WF. So it is great to see Deloitte’s commitment to the diversity agenda. 100WF’s guiding principle is Vision 30/40, with a goal for women to occupy 30% of senior investment roles and executive committee positions by 2040. A common industry complaint is that they cannot attract female candidates. Looking at the way in which job advertisements are written, evaluating internship programs, and using nontraditional methods of recruiting could address this. For example, those investment managers seeking to address gender diversity within their own firms can also look to advertise positions via 100 Women in Finance, a job board that is available to the organization’s 20,000 plus global members.

LU: Waystone has been operating as an institutional governance provider for over 20 years, as a fiduciary how do you see the G in ESG?

RP: Governance, perhaps unsurprisingly, is the most critical pillar within ESG. If the governance piece isn’t right, it will be almost impossible to gain traction on the E and the S.

Corporate governance provides a framework for achieving objectives and a system of policies and procedures that dictate corporate behavior. Governance provides the oversight to ensure compliance with laws and regulation, in addition to internal policies and procedures, and protects the interests of all stakeholders.

Bad corporate governance can lead to loss of trust, which can have a material impact of profitability as seen in among high-profile corporate failures.

Governance is not only a factor to examine as part of investment analysis, it is also a core component in any responsible investing framework; having those with the right expertise and knowledge at the table can make all the difference. The SEC’s risk alert issued in April 2021 highlighted observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding ESG investing. During examinations of investment advisers, registered investment companies, and private funds engaged in ESG investing, instances of potentially misleading statements regarding ESG investing processes were observed.

However, the SEC also found that where compliance personnel were integrated into ESG-related processes and were knowledgeable about ESG approaches and practices, these firms were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents. For those investment managers struggling to navigate ESG, working with an external advisor or compliance specialist can really make a difference. Having independent board directors with specialist knowledge on advisory or responsible investing committees, can be a powerful way to stay on course and avoid greenwashing.

LU: What are key developments that will benefit managers of Cayman funds?

RP: On 21 March 2022, the SEC released details of its much-anticipated proposal for climate disclosures. The proposal would require domestic and foreign registrants to report on climate-related risks and the impact of their businesses, plans to address those risks, and greenhouse gas emissions.

The SEC proposed rule amendments that would require a domestic or foreign registrant to include certain climate-related information in its registration statements and periodic reports, such as on Form 10-K, including:

• Climate-related risks and their actual or likely material impacts on the registrant’s business, strategy, and outlook;
• The registrant’s governance of climate-related risks and relevant risk management processes;
• The registrant’s greenhouse gas (GHG) emissions, which, for accelerated and large accelerated filers and with respect to certain emissions, would be subject to assurance;
• Certain climate-related financial statement metrics and related disclosures in a note to its audited financial statements; and
• Information about climate-related targets and goals, and transition plan, if any.

The proposed disclosures are similar to those that many companies already provide based on broadly accepted disclosure frameworks, such as the Task Force on Climate-Related Financial Disclosures and the Greenhouse Gas Protocols.

Asset managers listed in the US will need to comply with the new rules once finalized, but the impact of the new rules on the wider industry is substantial, as it will significantly improve the quality of available data. Investment managers integrating ESG risks into their portfolios will have reliable carbon data upon which to make informed decisions about risks and opportunities.

The SEC’s announcement was followed only a few days later by the IFRS Foundation and Global Reporting Initiative (GRI) announcing a collaboration agreement under which their respective standard-setting boards, the International Sustainability Standards Board (ISSB) and the Global Sustainability Standards Board (GSSB), will coordinate their  standard-setting activities.

This collaboration has the potential to significantly address one of the key challenges around inconsistencies in terminology and lack of convergence in sustainability reporting.

I’m personally excited to see the progress being made in the space and given the strategic priority now being given to disclosure consistency and assurance over key ESG metrics, I believe this further elevates the critical role that the audit profession plays – not only in keeping our financial markets safe but also the broader responsible investing agenda.