Despite an increased focus on ESG, the Code has received criticism for providing less stringent requirements than an earlier proposal.

By Paul A. Davies and Michael D. Green

The Financial Reporting Council (FRC) has published the final draft of the UK Stewardship Code 2020 (the Code), which sets out standards for UK institutional investors to adopt when engaging with their investments. Effective 1 January 2020, the revised Code places a greater focus on environment, social, and governance (ESG) matters. The changes reflect increased public interest in ESG since the UK Stewardship Code was last updated in 2012.

About the Code

The Code contains an introductory section, followed by two sections that set out a number of principles for the investment community. The first section applies to asset managers and asset owners, while the second section applies to service providers. The Code’s consideration of ESG matters across both sections demonstrates the FRC’s view that these issues are becoming ever more important in the current investor landscape.

Revised Introduction

The introduction to the Code specifically states that environmental factors (particularly climate change) and social factors have become material issues for investors when undertaking stewardship and making investment decisions.

The FRC has also redefined stewardship in the revised Code as meaning “the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society”. The revised Code also clarifies that when applying the principles contained in the Code, signatories should consider environmental and social issues, including climate change, diversity, remuneration, and workforce issues.

New Principles

Two of the principles for asset managers and asset owners relate to ESG, including:

• Principle 1: Signatories’ purpose, investment beliefs, strategy, and culture enable stewardship that creates long-term value for clients and beneficiaries, leading to sustainable benefits for the economy, the environment, and society.
• Principle 7: Signatories systematically integrate stewardship and investment, including material ESG issues and climate change, to fulfil their responsibilities.

The section for service providers contains one ESG focused principle, which is:

• Principle 5: Signatories support clients’ integration of stewardship and investment, taking into account material ESG issues, and communicating what activities they have undertaken.

These principles operate on an “apply or explain” basis with reporting requirements, meaning that the more than 300 signatories to the Code will need to detail how they have complied with these principles, or otherwise explain meaningfully to the market any instances when a signatory in unable to comply or the relevant principle is irrelevant.

Proposed Version vs. Published Version

The FRC has made significant changes to the Code’s format since its previous proposal in March 2019. In particular, the March 2019 proposal featured seven “key principles” relevant to ESG that would have been mandatory for signatories to apply, including the Code’s new Principal 7 for asset managers and asset owners (integrating stewardship with investment approach, and taking into account ESG matters). Instead, this principle will operate on an “apply or explain” basis — marking a significant change from an ESG perspective. (See ESG Matters Incorporated Into UK Stewardship Code.)

The FRC’s previous proposal also set out a number of “provisions” that would have also operated on an “apply or explain” basis — including two proposed ESG-related provisions that have been entirely omitted from the final draft. These provisions explicitly encouraged asset owners and managers to demonstrate how ESG issues are considered, and called on asset managers to further guide individual managers on ESG engagement.

Next Steps

The revised Code has generally been well-received by the investment community, with many participants welcoming the inclusion of principles specifically relating to ESG. However, the new edition has received some criticism for a perceived “watering-down” of ESG stewardship compared to the proposed version released earlier this year. Consequently, the FRC will likely face pressure to strengthen the application of ESG in future versions of the Code.

Latham & Watkins will continue to monitor developments in this area.

This blog was prepared with the assistance of James Bee in the London office of Latham & Watkins.