The evolution of ESG
Over the past 15 years the integration of Environmental, Social and Governance (‘ESG’) considerations into the asset management industry has seen exponential growth as stakeholders become increasingly conscious of the impact of their investment decisions on the world. The first initiative towards ESG was undertaken by the United Nations who invited some of the world’s largest institutional investors to develop the Principles of Responsible Investment (PRI). These principles that incorporate ESG issues into investment practice were launched in 2006 with the aim of developing a more sustainable global financial system. The PRI global signatory base has grown from 63 signatories in 2006 (with $6.5tn AUM) to 3,038 signatories in 2020 (with $103tn AUM), representing majority of the world’s professionally managed investments.
In addition, various initiatives have also been implemented by other organisations / frameworks, enabling the widespread adoption of ESG factors by asset managers / owners. These key initiatives accelerated the ESG evolutionary process and continue to do so.
Recent performance by ESG focused funds has made it evident that considering ESG implications when making investment decisions is not only a necessity for a sustainable future but ESG investments are also outperforming non-ESG investments and are more likely to do better in the longer term. Asset managers are increasingly embedding ESG factors in all processes of fund management. Aligning investment objectives and strategy with ESG policies and managing investor expectations, are becoming top priority as managers implement responsible investing. With the EU’s SFDR regulations imposing new disclosure requirements for asset managers from March 2021, both at a product and manager level, managers are shifting greater focus towards factors such as ESG data integration, screening of assets, producing sustainability reports, introducing ESG focused KPIs and so on. Given the onerous compliance requirements, larger managers may see themselves appointing a separate committee to implement and oversee ESG focused investment policies, as the ESG regime continues to grow.
Tax and ESG
Tax and ESG share a critical interrelationship. Taxation acts as a key tool to influence societal behaviour. It is a key cost to investors / asset managers when making investment decisions and provides funding to government authorities to facilitate ESG initiatives. The relationship between tax and ESG at an environmental, social and governance level is critical in understanding the link between policy and behaviour.
There are two distinct areas of overlay between taxation and ESG. The first being tax incentivisation / penalisation to encourage businesses and individuals to be more environmentally and socially responsible in their actions and investment decisions, for example, tax incentives under the cycle to work scheme, capital allowances for the purchase of electric cars for employees, tax reliefs for making charitable donations or setting up a charitable trust. Also, government initiatives announced in the 2021 UK budget, such as the establishment of the new UK Infrastructure Bank to fund public and private projects and the introduction of green bonds are all steps in this direction. The second and more significant area of overlay lies in the governance aspect of ESG and businesses ‘paying their fair share of tax’. As highlighted above, a number of initiatives are being undertaken in this regard towards increased transparency and compliance, discouraging aggressive tax planning practices. The OECD’s ongoing work towards greater transparency and tighter anti-avoidance has brought the consideration of the board / senior management’s attitude towards tax risk and tax planning strategies to the fore, emphasising its importance as part of their responsibility towards corporate governance and ethical behaviour. The requirement for certain UK businesses to publish their ‘tax strategy’ showcasing their attitude to tax risk and tax planning is also a step in this direction.
There has been a clear shift in attitudes of both businesses and authorities in the past decade in making a more conscious effort to include sustainability and ethical integrity factors when making decisions, thus making it imperative for managers to integrate ESG as part their tax strategy / policies.
Next steps for ESG and tax integration
As the consideration of ESG becomes a key tenet of every successful asset manager it is important to embed ESG factors into its tax practices. Managers should perform regular tax risk reviews to understand the inherent tax risk in their business and address any specific risk areas where required, bearing in mind the governance factors under ESG. Doing so enables the senior management of a business to develop a clear tax strategy and policy framework within which to operate and implement as part of their wider ESG program. Furthermore, businesses should also consider the availability of any tax incentives for any environmental and social initiatives the business undertakes / wishes to undertake to provide an even greater impetus to their ESG actions.
Further actions managers can take to integrate ESG factors into tax include developing a culture of general awareness among staff in relation to tax risk, bringing the review of the tax risk profile of a business under the boards / senior managements oversight at regular meetings, keeping abreast of latest developments and preparing for compliance with upcoming tax disclosure requirements under the ESG metrics and regulations.
As the global shift towards sustainability continues and financial systems evolve it is evident that ESG factors will increasingly take centre stage in every asset manager’s decision-making process. Tax risk management is a key aspect that must considered by boards / senior management as part of their ESG implementation process and embedded in their culture. A manager’s attitude towards tax will be seen as a reflection of their attitude towards society in general and therefore businesses having clarity and transparency over their tax risk profile is the first step towards ESG integration as we move towards a fairer and more sustainable future.