The rise of green and social capital – ESG-related trends for Australian private funds

Introduction

Environmental, Social and Governance (ESG) is not a new concept for private funds. Most institutional investors and fund managers have had ESG policies in place for many years. However, in recent times there has been a shift in the market in terms of the level of focus on ESG issues and how they are being addressed.

This shift has been accelerated by:

• Legal developments and increased regulatory scrutiny of ESG issues, both within Australia and globally, as governments and regulators focus on climate change, renewable energy, sustainability, social issues and governance;
• Institutional investors’ increased requirements for managers of funds of all types to address ESG considerations and increased appetite for investment into ESG-oriented funds; and
• Demand for capital in new or expanding areas, driven by ESG considerations, such as energy transition, renewable energy, natural resources and social capital.

Responding to climate change and its impacts is one significant driver of these developments. Others include addressing inequality and improving diversity and inclusion.

At the same time, there is now widespread (although not universal) recognition that the pursuit of ESG initiatives is consistent with (and necessary for) sound economic performance by funds generally, as well as an increasing number of fund managers looking to devise ESG-oriented funds offering competitive economic returns.

Below is a brief survey of some of the key ESG - related trends we are seeing for private investment funds in Australia, with a focus on trends relating to environmental or sustainability matters.

Australian legal and regulatory developments

To set the scene, there has been a myriad of legal and regulatory developments, both in Australia and internationally, which are informing those key trends.  Fund managers and investors have rarely had so many developments to keep abreast of. For example, ASIC Chair, Joe Longo recently commented that ‘[ESG] issues are driving the biggest changes in financial reporting and disclosure standards in a generation^[1]”.

Some of the key Australian developments most relevant to our survey include:

• (Enforcement Actions) Enforcement actions by regulators, including by ASIC, to deter “greenwashing” (i.e. the practice of misrepresenting the extent to which a financial product or investment strategy is environmentally friendly, sustainable or ethical).^[2] ASIC has been active, with the regulator announcing in May 2023 that it had undertaken 35 interventions as a result of its greenwashing surveillance activities from 1 July 2022 to 31 March 2023 – see the ASIC Media Release here and Report 763 here. As at the end of February 2024, ASIC had issued 17 infringement notices in relation to alleged ESG misconduct and had 3 greenwashing-related civil penalty actions before the Federal Court. ASIC has confirmed that greenwashing will continue to be an enforcement priority in 2024, and has indicated that it will continue to pay close attention to:
  • net zero statements and targets;
  • use of terms such as “carbon neutral”, “clean” or “green”; and
  • the scope and application of investment exclusions and screens.

See “ASIC enforcement priorities” media release and ASIC’s article “Red light for greenwashing”. The regulatory focus may have encouraged some issuers to elect to deliberately stay silent in relation to their ESG strategies and policies.^[3] However, ASIC Chair Joe Longo stated that “greenhushing is …just another form of greenwashing, and risks misleading by omission. Silence from firms and failing to engage isn’t the answer.” ^[4] On 29 March 2023, the Senate began an inquiry on greenwashing which is due for publication by 28 June 2024. This inquiry will focus on claims made by companies, the impact of these claims on consumers, regulatory examples, advertising standards and legislative options to protect consumers.^[5]

• (Climate, Nature and Inequality Reporting Regimes) Introduction of the Australian mandatory climate reporting regime proposed to commence on 1 January 2025 for certain entities, with phasing in of additional requirements until the complete regime is fully in place from 1 July 2030 - see here and here for further information. In March 2024, the legislation establishing the mandatory reporting regime had been tabled in parliament. Further, in June 2023, the first two International Financial Report Standards (IFRS) Sustainability Disclosure standards were issued (they are colloquially referred to as the ISSB standards). These standards stipulate an effective date for global adoption, including Australia, in the financial year beginning on, or after, 1 January 2024.^[6] Separately, the Taskforce on Nature-related Financial Disclosures (TNFD) has released its final framework for assessing nature-related risks and opportunities and reporting in relation to nature-related governance, strategy, risk and impact management, and metrics and targets. The framework builds on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) that forms the basis of the mandatory climate reporting regime – see here for further information. The TNFD is the precursor of an equivalent framework for inequality-related financial disclosures in the private sector (TIFD). The beta version of this framework will be released for consultation and piloting in 2024. Given the success of the TCFD on climate in encouraging voluntary reporting on emissions and climate-related financial risks and opportunities, the TIFD, if it follows a similar path, will change the equation again with social reporting – see here for further information.
  
  
• (Climate litigation) One of the key risks financial institutions face today is the complex legal and regulatory landscape that has developed to address the challenges of climate change. The targets of climate litigation have gradually diversified. Financial institutions, which may include fund managers and institutional investors, are increasingly being targeted for failure to disclose, or insufficient disclosure of, climate-related financial risks. There have also been several high-profile greenwashing cases commenced in the Australian courts. After the US, Australia has had the highest number of climate related cases^[7] – see here for further information.
  
  
• (Nature and Sustainable Finance related reform) The Australian government has in the last year been introducing a number of legislative and policy reforms to boost private investment in nature and sustainable finance markets, including the passing of the Nature Repair Act 2023 (Cth) that came into effect on 15 December 2023^[8] and the Commonwealth Government’s consultation on development of a Sustainable Finance Strategy^[9] - see here and here for further information.

Please see our website for more detailed articles on each of the above topics.

Many of the legal and regulatory developments are relevant to private funds of all types, while some are more applicable to ESG-oriented strategies.^[10] Many of the developments have a reinforcing impact where they may apply directly to managers and/or indirectly via impact on their investors. Although scepticism about ESG may seem to be increasing in certain quarters (especially in the United States), the breadth of legal and regulatory developments in Australia and internationally are such that they cannot be ignored.

Trends for Australian private funds

Some of the key ESG-related trends for private funds in Australia that we are seeing are:

• (ESG policy updates) Fund managers preparing refreshed or new policies for ESG and sustainability related matters for funds of all types.
  
  
• (Increased coverage of ESG in investment processes) Fund managers being more granular in how they are building ESG factors into their funds’ investment policies and transaction processes, with ESG factors being a mandatory item of consideration by their due diligence teams, investment committees and risk committees. Fund managers are increasingly ‘hardcoding’ ESG factors into their investment strategies, for example, by including or excluding certain industries, countries, or asset classes.
  
  
• (Greater influence over ESG aspects of fund investments) Fund managers seeking to have greater influence over ESG matters, reporting, compliance and risk management at the portfolio company level. Institutional investors are similarly seeking greater influence on portfolio construction through investors advisory committees and encouraging fund managers to have a presence on company boards and actively engage with senior management and sustainability teams to ensure the fund’s ESG policies are integrated into the portfolio company processes and business operations.
  
  
• (Changes to fund investment strategies) Fund investment strategies and mandates specifically catering for ESG factors, which may include:
  • refocussing existing funds on, or developing new funds for investment in, ESG-oriented sectors (e.g. renewable energy, agriculture, forestry, healthcare and social infrastructure); and
  • screening such as prohibiting or restricting certain sectors (e.g. fossil fuels).
• (Natural Capital emerging as a separate asset class) Development of new types of natural capital funds where the fund is geared towards nature-based solutions, emerging environmental markets (e.g. carbon, reef or biodiversity credits) and/or social impacts. This may involve adaptation of established fund types such as agriculture or forestry to take advantage of an adjacent social impact or environmental component. For example, the fund may seek to make available to investors, or otherwise monetise for their benefit, environmental credits generated by the fund’s primary investment activities. This is part of a broader trend of fund managers looking to devise ESG-oriented funds offering competitive economic returns. This trend may be supported by the Australian government’s efforts to bolster private investment in natural capital as demonstrated by its passing of the Nature Repair Act 2023 (Cth) to allow landholders to register and carry out certain nature restoration projects in exchange for biodiversity certificates, and the development of its Sustainable Finance Strategy.
  
  
• (Development of ESG-linked fee structures) Fund managers developing fee structures and incentives that are linked to the meeting of ESG targets to foster greater alignment between investors' and Fund manager’s ESG objectives.
  
  
• (Blended or multi-class structures to facilitate ESG objectives) Fund managers using classes within a fund to cater for ‘impact’ investing, where investors can elect to receive a lower economic return in exchange for the fund pursuing ancillary ESG-oriented activities (e.g. conservation and/or social impact activities).
  
  
• (Increased ESG disclosures and reporting and related demand for data) Increased ESG disclosures, including in relation to the investment strategy, due diligence processes and risk exposure, as well as ongoing ESG reporting to investors. Funds are seeking to differentiate themselves through enhanced reporting on ESG targets and outcomes as investors demand more comprehensive information to assess risks and opportunities. This increasingly requires an investment by fund managers in new technologies and methodologies to build ESG data analytics to ensure access to accurate asset-level data that can be shared with fund investors. Ongoing reporting that Managers provide to their investors is likely to increase given the mandatory climate, nature and inequality reporting regimes being enacted in Australia and coming into force from 2024.
  
  
• (Increased attention to greenwashing and climate risks in disclosure documents and due diligence processes) Managers of funds of all types preparing refreshed or new disclosures in offer documents and other investor facing materials, to address investor demand as noted above, to ensure adequate coverage of climate related risks and mitigate climate litigation exposure and to cater for the requirements of regulators in relation to greenwashing. Given regulatory scrutiny, Managers need to exercise caution to ensure that financial products marketed as sustainable are ‘true to label’ and that the investment strategy aligns with the product name.^[11] The Government proposes to introduce a labelling system for investment products marketed as sustainable as part of its Sustainable Finance Strategy. While it is understood this will focus on informing retail investors, the developments may serve to increase attention on product labelling issues more generally.
  
  
• (More detailed focus on ESG in investor due diligence) Institutional investors becoming increasingly granular in their investment due diligence questionnaires (DDQs). Investors are focused on both the ESG aspects of the fund’s investment strategy as well as its internal ESG processes, seeking to understand the fund’s:
  • management of ESG risks and opportunities by the investment committee and other bodies;
  • approach to managing material ESG incidents and their disclosure, and processes in place to prevent future occurrences; and
  • initiatives to improve the internal ESG credentials of the fund. Institutional investors are increasingly looking for funds that have in place a diversity, equity and inclusion strategy, monitor gender and ethnicity statistics internally and within other entities involved in the promotion and operation of the fund, and have a commitment to promote diversity within boards of their portfolio companies.
• (Australian financial services licence reviews and variations) Fund managers reviewing their Australian financial services licence authorisations to confirm whether they allow them to access environmental markets or products they might be wishing to expand into, and where necessary seeking licence variations. For example, certain types of carbon credits (e.g. Australian Carbon Credit Units (ACCUs) and eligible international emission units (EIEUs) are “financial products” for the purposes of the Corporations Act 2001 (Cth) and providing financial services in relation to ACCUs and EIEUs requires specific authorisations.

(Don’t forget the impact of international developments) While this article focuses on Australian developments and trends, fund managers (particularly those who are looking to raise capital from offshore investors or whose funds already have foreign investors or other foreign “touchpoints”) should be keeping a close eye on developments in other jurisdictions. Several other peer jurisdictions (including the EU, UK, Japan, Singapore, California and New Zealand) already have established mandatory climate reporting regimes. Canada is proposing to introduce its own regime in 2024. In March 2024, the United States’ SEC published its final climate disclosure rule for mandatory climate disclosures (with a whopping 886 page Adopting Release).  The rule immediately drew legal challenges from both liberal and conservative perspectives.  Regardless of the ultimate outcome of those challenges, the broader trend internationally is – like in Australia – towards greater disclosure and greater regulation. 

At this stage, there is divergence across jurisdictions – fund managers who are seeking to raise capital from foreign investors (or whose funds otherwise have touch-points in multiple jurisdictions) are already having to navigate multiple different requirements, taxonomies and reporting regimes.  Whilst the expectation (hope) is that eventually the requirements may coalesce around consistent global standards, for the moment two key challenges for global fund managers are: staying on top of the requirements and developing reporting and compliance regimes designed to address the different requirements across different jurisdictions.

From a trend perspective, we expect that investors increasingly will be looking to their fund managers to provide reporting and other information to assist them in meeting their own obligations in their home jurisdiction.  For example, European investors considering an investment in an Australian fund will be increasingly looking to the fund manager to provide reporting to assist them to manage their own reporting requirements in Europe.  Regular reporting designed to comply with Australian requirements may not meet their needs.  Similarly, as large Australian institutions who invest in offshore funds become accustomed to receiving a certain level of reporting and disclosure from offshore fund managers, they may increasingly demand that their Australian fund managers follow suit. That in turn may well “move the market” – even for “wholly domestic” Australian funds.  

Conclusion

The Australian private funds market has become increasingly focused on ESG issues, with fund managers and investors having to negotiate a wider web of legal, regulatory and commercial requirements. The days of ESG being addressed via a brief ESG policy are long gone, with ESG strategies, reporting and disclosure quickly becoming the new norm for fund managers, and investors having increased appetite for ESG-oriented strategies and products.

This has created opportunities for fund managers and investors. A strong ESG proposition can lead to growth opportunities for managers and facilitate the allocation of capital to new or expanding areas, such as energy transition, renewable energy, natural resources and social capital.

However, managers must be careful to ensure that their ESG proposition is realistic, achievable and verifiable (and that any exceptions or caveats are clearly and accurately disclosed), given heightened regulatory scrutiny of ESG issues and increased enforcement activities by regulators seeking to hold financial market participants to account on their ESG commitments.