Analysis: UK Stewardship Code becomes a de facto ESG Code — but it needs teeth

The new UK Stewardship Code introduces ESG expectations as the new normal for investors and renders the previous version, the 2012 revision, unrecognisable.

From its roots as a purely ‘G’ [governance] code for investors focused on achieving active ownership of equities and other securities, the scope of stewardship as defined by the revised code has now been expanded, adding the ‘E’ [environment] and the ‘S’ [social] to the ‘G’ foundation.

The Financial Reporting Council’s definition of stewardship now is that it is the “responsible allocation, management and oversight of capital to create long-term value” for a wide range of stakeholders, including society.

The Code now reads somehow as an ESG Code. Under Principle 7 (partially called ESG integration) investors are effectively expected to report how ESG issues have been prioritised to assess investments. That includes tenders and mandates.

Principle 4 not only recognises climate change as a systemic risk that investor signatories need to take into account, they should also explain how they have worked with other stakeholders in the promotion of well-functioning markets.

That’s consistent with the apparent twilight of the Shareholder Value Primacy model as well as the sudden realisation by the US Business Roundtable this summer about the true purpose of the corporation.

The stakeholder-centric notion of business and economics is something that will also apply to investor signatories (Principle 1 pairs purpose and governance), which is also a natural consequence of article 172 of the Companies Act, as well as the latest edition of the Governance Code.

The FRC’s Code has other innovations. It emphasises disclosure of resources to conduct stewardship and – crucially – incentives (Principle 2).

That could open the door to a discussion about one of the Achilles Heels of the whole system: should investment managers be rewarded only on the basis of companies’ share price, which in turn puts pressure on management to keep them high even to the detriment of other stakeholders?

Principles 9 and 10, include “buy, sell and hold” as examples of how the outcomes of engagement and collaborative engagement inform investment decisions, are a reminder that divestment belongs in the stewardship tool kit too.

While there is nothing on stock lending (beyond a reference to empty voting mitigation), Principle 12 ups the ante on voting disclosure. It expects signatories to provide a link to their voting records and to explain the rationale behind them at least for important decisions (including opposing a shareholder resolution).

There is Principle 12 a nod to the goals of the Association of Member Nominated Trustees’ Red Line Voting Initiative, as signatories are expected to “disclose their policy on allowing clients to direct voting in segregated and pooled accounts”.The new “ESG” Stewardship Code should not come as a surprise, though. The FRC had already shown its cards in previous consultations (Responsible Investor coverage).

Faced by the unstoppable new normal in fiduciary duty and investment trends, the FRC couldn’t have ignored all these developments and has wisely captured the market sentiment. The only piece missing is an explicit mention of the UN Sustainable Development Goals (SDGs).

“The Financial Reporting Council has captured the market sentiment.”

If the financial and banking crisis brought about the first Stewardship Code, after the 2009 Walker Review identified shareholders sleeping at the wheel (with their rest only disturbed by having to cash in dividends), perhaps the new Code is the result of the climate crisis.

But even if the Code works on an “apply and explain” basis (rather than “comply or explain”), given its voluntary nature concerns will remain over whether it is worth the paper it is written on.

Then there’s the question of whether the FRC – soon to morph into a new body – is being condemned to repeat the mistakes of the recent past. Because, if no one monitors signatories’ actual performance against the code, as opposed to compliance with it, does it mean that trees are falling in the stewardship forest unheard?

The Kingman Review of the FRC stated the following about its weakness as a regulator, spread too thin across different tasks: “The Stewardship Code, whilst a major and well-intentioned intervention, is not effective in practice.”

The UK Business Secretary, Andrea Leadsom, has already urged institutional investors to sign up. Nonetheless, it is worth recalling that Kingman stated:

“The government should also consider whether any further powers are needed to assess and promote compliance with the Code. If the Code remains simply a driver of boilerplate reporting, serious consideration should be given to its abolition.”

Pending the implementation of the new regulator ARGA (Audit, Reporting and Governance Authority), it is not clear who would be vested with such powers.

It’s not widely known that the government could have created powers to require institutional investors to disclose how they exercise voting rights, all thanks to a little-noticed section of the long-standing Companies Act.

Section 1277 of the Companies Act 2006 allows it to do so — but it has not been brought into force, sparing asset managers the inconvenience of publishing their voting records. The ball is now in the government’s court to ensure the success of the new “ESG” Stewardship Code.