1. The legal system could become increasingly used to enforce ESG goals set out by companies and funds

In May 2021, the District Court of The Hague in the Netherlands issued a ruling against oil giant Royal Dutch Shell (RDS), ordering it to cut its CO₂ emissions by 45% compared to 2019 levels.

One key finding was that the company’s “significant” CO2 emissions contributed towards global warming and “dangerous climate change” and posed “serious and irreversible consequences and risks for the human rights of Dutch residents”.

The court also ruled that Shell’s corporate strategy for net zero energy transition “largely amounts to rather intangible, undefined and non-binding plans for the long term (2050)”.

The case, brought by Friends of the Earth alongside six other bodies and 17,000 Dutch citizens, represents the first time a company has been legally obliged to comply with the Paris Agreement.

It suggests there is a gap between what RDS thinks it should be doing in terms of its climate goals and what environmental campaigners believe is necessary. This raises the prospect of asset managers or advisers becoming entangled in legal proceedings if such a disconnect appears between what they claim an ESG investment will do and what it achieves in reality.

2. Judicial frameworks already exist

In the UK, Sections 90 and 90A of the Financial Services and Markets Act 2000 give investors the right to sue public companies that publish untrue or misleading statements or because of a ‘dishonest delay’ in them making information available. This could also be applied in respect of responsible investing claims.

In Europe, the Sustainable Finance Disclosure Regulation (SFDR) imposes mandatory ESG disclosure obligations for asset managers and other financial market participants, requiring them to provide prescriptive and standardised disclosures on how ESG factors are integrated at both an entity and product level.

Products that fall under Article 8 of the SFDR will promote environmental or social characteristics but do not have them as their overarching objective, whereas the ‘darker green’ Article 9 funds specifically have sustainable goals as their objective; for instance, investing in companies which aim to reduce carbon emissions. The SFDR applies to any ‘financial market participant’ that conducts business directly or indirectly in Europe or with an EU-based entity.

The Markets in Financial Instruments Directive II (MiFID II) will integrate sustainability factors into client-suitability assessments from August 2022.

The Task Force on Climate-related Financial Disclosures (TCFD), comprising 32 members from across the G20, has four pillars related to governance, strategy, risk management and the measuring of ESG metrics. Each is designed to ensure companies are running their businesses in a way that takes account of ESG factors. The UK government’s Green Finance Strategy paves the way for mandatory disclosure in line with TCFD by 2025.

Investors also need to navigate the Non-Financial Reporting Directive, which covers the publishing of a firm’s diversity strategies and goals, as well as its employee-related policies and frameworks for combating social-responsibility issues.

3. Investors taking legal action over ESG breaches will become increasingly common, experts warn

Simone Gallo, managing director at sustainable investment adviser MainStreet Partners, says: “You could imagine a client of a private bank claiming that their portfolio was not sustainable enough, or that a fund had a small exposure to something deemed unsustainable, and this resulting in legal action.

He predicts “more private actions, or those brought by regulators or countries” because “there will be way more disclosure at the product level, and there will be data, so it will be easier to investigate whether an ESG investment has matched its claims”.

Arun Srivastava, a partner at law firm Paul Hastings, agrees because there are “hard legal frameworks”, it would be “much easier to bring a claim”.

A fund manager could be liable for legal action if it fails to properly monitor the progress of its underlying holdings regarding ESG targets, says Arun, “especially because… investments have to continue to be compliant, and managers have to provide ongoing reporting.”

Until now, the vast majority of legal actions relating to investments centre on a financial loss. However, some experts suggest that claims could soon be based purely on an investment’s ongoing ESG credentials or success.

“It doesn’t have to be a failed investment for there to be a claim,” says Arun. “It could be a multitude of other factors, such as greenwashing or misrepresentation.” He adds that if a company that a fund is invested in is fined for an ESG-related reason, this could be construed as the fund failing in its ESG promise.

Legal actions have already successfully been brought against UK-based firms due to the actions of their offshore subsidiaries in other jurisdictions; a legal route that has now been confirmed by the UK Supreme Court.

David Rouch, a partner at law firm Freshfields, says while legislators and regulators appreciate that an investment manager’s aim is to make a financial return, the ESG factor is increasingly interlinked.

“If an asset owner concludes or … ought to conclude, that one or more sustainability factors are jeopardising its financial objectives, it will generally have a legal obligation to consider what, if anything, it can do to mitigate the risk, and then having considered it, act accordingly,” he says.

4. Companies should assess how their investments are performing in relation to ESG

A legal framework for impact, a July 2021 report by Freshfields and the UN-backed Principles for Responsible Investment, states that “many sustainability factors also concern the long-term health of social and environmental systems on which businesses and financial markets depend: these factors therefore potentially constitute a risk to whole markets and the investment return on all portfolios that are exposed to them”.

Any investment not meeting its ESG goals could present a financial issue further down the line. If a company is not reducing its emissions as quickly as it said it would, it is arguably contributing to adverse environmental conditions that could hamper its ability to operate.

It is therefore imperative for fund managers and financial advisers to constantly monitor how their investments are performing in relation to their ESG promises.

“Fund managers and advisers will have to demonstrate that they have a system in place to review products from an ESG point of view,” says Simone Gallo.

This pressure upon fiduciaries to conduct their own due diligence is heightened by the fact that the world’s largest rating agencies analyse companies differently when it comes to ESG.

In a recent article in the Journal of Portfolio Management, academics Elroy Dimson, Paul Marsh and Mike Staunton argue: “Responsible investors require data to underpin their stock and sector selections. Regardless of the rating agency, bond ratings for a particular issuer are broadly similar. This is not the case for ESG ratings. Companies with a high [ESG] score from one rater often receive a middling or low score from another.”

Commenting on this inconsistency, Aviva Investors’ Peter Fitzgerald says that investment managers should “do the work and not try to simplify a complex topic to random scores and, worse still, blanket exclusions”.

5. Companies that break their ESG promises risk significant financial and reputational costsTom Cummins, a partner at global law firm Ashurst, warns of the potential consequences for companies that fall short on their ESG expectations: “Something we have always said to clients is that when you look at ESG litigation, you can’t look at it through a narrow lens,” he says. “There could be reputational issues, it could affect your ability to access capital, it could negatively impact customer relationships, and even your ability to recruit young staff.”

Simone agrees that reputational damage could be one of the biggest liabilities for firms whose ‘green’ credentials are questioned. He cites the example of German asset manager DWS, whose shares fell 13% in a day after it emerged that US and German authorities were investigating claims made about ‘greenwashing’.

Legislation such as the SFDR does not incorporate any direct penalties on companies not fulfilling their ESG commitments, with breaches likely to fall under existing regulations in individual jurisdictions. But in the UK, for instance, a proposed Amendment to the Modern Slavery Act could see breaches being dealt with by fines and imprisonment. In the US, the increased demand for ESG attestation has led to the publication of a roadmap which will help auditors guide clients in how they should approach ESG disclosures, as well as support organisations with clearer reporting.