The role of environmental, social and governance (ESG) issues in modern day portfolio management cannot be downplayed. Flows into strategies explicitly incorporating ESG factors have accelerated, with global assets under management (AuM) now estimated to be at USD360 billion (as of 2017), while the number of ESG funds doubled between 2013 and 2016.1 In addition, more asset managers and asset owners are signing up to the UN Principles for Responsible Investment (UN PRI), an initiative whose circa 1,800 signatories collectively run around USD73 trillion, an AuM increase of 300 per cent since 2011.2
ESG: A business priority for asset managers and asset owners
The market for sustainable investment is growing3, and a number of well-known sovereign wealth funds (SWFs) and public sector pension funds are becoming more vocal about the matter. One of the most established institutions to champion this investment approach has been Norway’s USD960 billion SWF, Norges, which confirmed it would withhold investment from companies it felt had unsatisfactory ESG practices.4 More recently, Norges proposed scaling back exposures to equity indexes which include companies with weak shareholder control and voting rights.5
ESG is being driven by a confluence of factors. Investor attitudes to ESG have altered amid large-scale demographic changes as younger investors are entering the market through policies such as auto-enrolment. The mind-set and priorities of these younger investors are different to previous generations, as evidenced by a Schroders’ study conducted in 2017, which found 86 per cent of millennials said sustainable investing was important to them versus 67 per cent of baby-boomers.6
ESG integration also grew following the emergence of studies, which demonstrate positive correlations between better corporate performance and good ESG practices. As one example, the MSCI ACWI ESG Universal Index, a benchmark with an ESG bias, outperformed the parent index by 39 basis points (bps) over the five years leading up to June 2017.7 Meanwhile, a report by Boston Consulting Group (BCG) found that companies which outperformed in ESG boasted higher valuation multiples and margins than those organisations which scored badly in ESG.8
There has, however, been criticism that ESG data does not stretch back far enough to provide actual historic and conclusive evidence of outperformance. While ESG data does have its limitations, so too does financial data, and these constraints have been factored into the overall analysis. ESG data is, however, seen as being forward looking and it is providing investors with metrics about future risks, such as the physical impact of climate change.
Policymakers guiding the market
Policymakers have catalysed the expansion of ESG considerations in financial services. The UN Sustainable Development Goals (UN SDGs) outlined 17 ambitions which it wants achieved over the next 15 years, while the Paris Climate Agreement (COP21) aims to prevent global temperatures from rising above two degrees Celsius this century. The supranational consensus around these objectives has helped drive private capital into investments focused on sustainability.
Financial market regulators have played a role too. The Financial Stability Board’s (FSB) voluntary Task Force on Climate Related Financial Disclosures (TCFD) is prompting change, and more companies – both financial and non-financial – are signing up to it.9 The TCFD encourages companies to disclose their climate related financial risks, and this information is increasingly being asked for by asset managers.
Fund managers should consider having a viable ESG strategy and reporting policy in place to meet the future expectations of clients and regulators
Meanwhile, Central Bankers have warned the dual challenges of climate change and an abrupt transition to a low carbon economy could threaten the financial system. At a recent meeting, Central Bankers said they were contemplating introducing carbon stress tests at banks.10 That climate change is now qualified as a financial and even systemic risk has been noted by institutions with long-term liabilities and holdings, and it is resulting in some investors instructing managers to divest from assets which do not meet their long-term sustainability criteria.
The EU is pushing ahead with proposals around sustainable finance, including greater disclosure requirements on how investors incorporate ESG factors into their investments.11 France has taken a lead on the issue, through its Article 173, which obliges asset managers and asset owners over a specified AuM threshold to disclose how they have integrated ESG into their businesses, and demands firms publish their carbon footprints12.
ESG and post-trade: The Challenge
Fund managers and investor approaches to sustainable investment are variable, in large part reflecting the market and lack of standardisation. There are a range of sustainable investment styles. Whereas some asset managers or asset owners may prefer to screen out negative stocks such as alcohol, tobacco or weapons from their portfolios, others prefer impact investing or sustainability themed investing, such as buying green or social impact bonds.
As sustainable investment is not harmonised, disclosing ESG metrics to clients (and eventually regulators) can be quite difficult for managers, particularly as more clients insist on receiving greater transparency and bespoke reporting. The abundance of ESG providers offering their own proprietary metrics and measurements has made reporting a harder exercise too. Even within organisations like HSBC, there are a number of different ESG reporting frameworks, which ultimately need to be consolidated if disclosures are to become more standardised.
Integrating ESG factors into a portfolio can be challenging and will require asset managers to conduct regular pre-trade checks to ensure they are in compliance with their ESG mandates and the terms described in their prospectuses. Furthermore, fund managers will also need to validate their ESG criteria to clients. Asset owners in turn will have to make sure they are using consistent metrics when measuring ESG across all of their underlying investments.
As such, there is now a growing demand from clients to monitor the investment activities of their sustainable investment funds, and measure portfolios against ESG benchmarks. Nonetheless, improvements are being made across the industry and in post-trade services to develop institutional-standard ESG reporting toolkits.
ESG: What the future may hold
The significance of ESG factors within wider portfolio management is growing, and it is an issue neither regulators nor investors are unlikely to waiver or backpedal on. Fund managers should consider having a viable ESG strategy and reporting policy in place to meet the future expectations of clients and regulators. It is also the responsibility of providers to deliver solutions that can support customers’ complex and nuanced ESG-related investment requirements by offering comprehensive data assurance and reporting services.
2 Twitter feed of UN PRI
3 Financial Times (July 16, 2018) Rise of green investing triggers rethink on disclosure
4 Bloomberg (June 27, 2017) World’s biggest wealth fund refuses to be silenced
5 Bloomberg (June 27, 2017) World’s biggest wealth fund refuses to be silenced
6 Schroders (2017) The global rise of sustainable investing
7 MSCI Investing for the long run: ESG and performance drivers
8 Boston Consulting Group (October 25, 2017) Companies that lead on societal impact reap financial benefits
9 Task Force for Climate-Related Financial Disclosures (March 22, 2018) Euronext, FSMA, NBB and Belgian Ministry of Finance Show Joint Support for the TCFD Recommendations
10 Financial Times (April 9, 2018) Central bank chiefs sound warning on climate change
11 Financial Times (March 8, 2018) Brussels sharpens focus on sustainable investment
12 ipe.com (1 February, 2016) France aims high with first-ever investor climate-reporting law
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