Our panel discusses the rise of ESG investing post-financial crisis, the right level of scrutiny and developments in an ever-changing landscape. Chaired by Romil Patel in London.
Jane Wilkinson (head of sustainable finance, Luxembourg Stock Exchange and member of the European Commission’s Technical Expert Group on Sustainable Finance)
Anu Narula (head of the global equity team, Mirabaud Asset Management)
Honor Fell (vice president manager research, Redington)
Adam Laird (head of ETF strategy, Lyxor)
Andrew Burchill (co-founder, Marketing Alpha Partners)
Funds Europe – Are ESG criteria yet accepted as part of mainstream risk assessments by portfolio managers and if not, what is the barrier?
Anu Narula, Mirabaud – There is definitely a lot more understanding of what E, S and G mean compared to 20 years ago. What we see now are different levels of implementation. At an initial stage level we are seeing exclusion or negative screening, often around areas such as tobacco, alcohol or defence. Then the next stage is around positive screening, looking for companies that focus on these criteria. We believe that active management works well with ESG, because it requires an in-depth knowledge of the company and due diligence to be aware of the risks and controversies. Governance has always been important for active managers, but it is the E and the S part that have gained momentum and become more integral to the investment processes in recent times.
In terms of barriers, there are objectives that need to be met in order to make ESG real for companies, rather than a box-ticking exercise. When I speak to potential clients for the first time, often there is still a question on whether ESG hampers returns. We do not believe that it does – it has the potential to improve longer-term returns. Another challenge that needs to be overcome is reporting standards where there is a big disparity.
Honor Fell, Redington – There is a big spread across geographies and asset classes. For example, the answer we would expect from an active equity manager with a concentrated portfolio about how ESG risks are understood and integrated into the investment process, is likely to be different from a US high yield portfolio manager. What good looks in each asset class is correspondingly different. Over the last couple of years, we have been understanding the nuances between different asset classes and benchmarking managers compared to their peers. We see an increasing trend towards managers taking ESG into account: there is definitely more adoption of using ESG data, but a mixed bag depending on the asset class.
We are definitely seeing a shift, partly because of improved marketing and people realising they need to talk about this, and partly due to real change in the industry perception of ESG.
Adam Laird, Lyxor – Investors have very different motivations for ESG compared to ten years ago where some of these portfolios attracted investors who were looking to benefit from government subsidies with premium given for new energy products. We are now in a position where a lot more of the screening decision is being done on the basis of fundamental beliefs, rather than just short-term profit hunting, and that is a positive for the sector. There is still a bit of work to be done around making sure that people know the right benchmarks to be considering and ensuring that investor expectations are properly managed.
Andrew Burchill, Marketing Alpha Partners – Post-financial crisis there is further evidence that suggests ESG investing can add value. There are a number of well-known surveys out there that support this. I am also interested in what is happening in Asia because in the early days, ESG was more focused on developed market equities. That has all changed now and there is a lot more attention on fixed income, and in emerging markets that is a particularly interesting and possibly a frontier area.
Jane Wilkinson, Luxembourg Stock Exchange – Indeed, Asian markets and fixed income represent a real opportunity for ESG investors today. China, for example, is the leading green bond issuer now. This is policy-driven and the Chinese government is saying: “Companies – look at all your projects and activities – focus on green projects and issue green bonds.” The Chinese, in terms of the rules that they are setting and their frameworks, are actually more advanced than many other countries – they have a very detailed taxonomy of what can be invested in, what the underlying assets are allowed to be for a Chinese green bond, and they also have guidelines for external reviewers to follow a certain process.
The challenge with China though is that they have a different definition of green to what we have in Europe. Making coal power plants energy-efficient or cleaner is acceptable as a green investment, because a key focus for China is on pollution control, which is a more immediate issue for the country as opposed to CO2 emissions. For international investors investing in Chinese green bonds, they just need to be aware of such differences.
Funds Europe – What are the most essential tools for an asset management company embarking on an ESG strategy?
Narula – There needs to be the right level of rigour, so actually allocated capital, dedicated resources and specialists to make it real. We like the idea of a third-party ESG provider and bringing that in with bottom-up research because it is very hard for people to do everything. The next level is really about engagement and having regular meetings with companies – similar to those from an investment and fundamental point of view – to stay on track and to execute and deliver. We have got a 100% voting record. There are about 1,000 different areas of voting that have been done for our two funds over the last year, so these are the starting blocks.
Wilkinson – Data tools are the key – there are many fund managers collecting data from different sources, whether that be from third-party ESG providers like Anu said, or specialist due diligence and ESG risk data services, or their own proprietary research. But is there really a difference between launching a new ESG strategy versus launching a new thematic sector strategy which has not much to do with ESG? Adam, when Lyxor launched the gender-focused fund, did that take more time to design the product than some other kind of product that you were designing?
Laird – It is undeniable that investors in these strategies are more critical. If we are launching a general thematic fund and worked with an index provider to come up with a strategy that includes a range of stocks and some of them end up veering from the general theme, often investors will forgive that. If, however, an ESG fund does not adhere to core beliefs, then people are much more likely to walk away. Just look at the problems that the Church of England faced when they were investing in [short-term loan company] Wonga a few years back as an example of the uproar that can be caused by one foolish investment or one unanalysed decision. You know ethics are an aspect people take really seriously.
Wilkinson – It is a bit unfair. Managers are making so much effort to go the extra mile because they believe there is more value in an ESG strategy; but just because they are putting their neck a bit more on the line, the risk is higher.
Burchill – It is almost an asymmetric risk. You’re damned if you do, damned if you don’t. You will be under the microscope much more than you would have been with a plain vanilla approach of some description. But that indicates this values or principles-based approach towards ESG is growing.
Fell – The other reason is that the definition is still not 100% clear and the industry is still figuring out what the right answers are. Redington surveyed all of our top-rated managers earlier this year and 45% of them said they had made changes to the way they think about ESG or the way that the firm’s governance recognises ESG, and so this is an area that is clearly evolving.
There are physical things, such as what is in your process, what the infrastructure is like, access to the ESG ratings and is it really easy for the portfolio manager or analyst to see it? In that same survey 75% of managers said ESG data is available on their systems but it is also important to ask how obvious it is, whether the risk team puts it in their reports, whether analyst commentary contains ESG and what behavioural barriers need to be overcome if people are changing their processes.
Funds Europe – Are ESG ratings on client portfolios a new tool with an income stream or a basic service?
Fell – This is a really important question – where should you charge extra for ESG ratings and where should it be part of mainstream analysis? That is a pretty hot debate at the moment. If you are calling ESG risks a risk like any other that you manage, it is difficult to then justify a bolt-on with an extra fee for many of the activities in the industry. We include ESG ratings as standard for all fund research. We have both a basic level of ESG reporting we deliver to all of our clients, and a more in-depth offering for clients for whom this is a particular emphasis.
Funds Europe – Do pension funds come across any common difficulties when implementing ESG and how can they deal with them?
Fell – It is a timely question given the recent Department for Work and Pensions (DWP) investment regulations consultation, which is aimed at clarifying the fiduciary duties of pension trustees and how the SIP (Statement of Investment Principles) plays into this. The DWP consultation is useful in that it clarifies the ESG risks that are financially material, and it would suggest that there should be a much greater use of the SIP in order to document what trustees’ beliefs are around ESG and then to track progress against those beliefs.
One of the things that was earmarked in that consultation is the confusion amongst the trustee body about what they should do and what they can do in this area. Hopefully that will be clarified by this consultation and by the new regulations.
Wilkinson – This is an important development in the UK, and there is Europe too.
Fell – Yes, there is also the EU regulatory recommendations off the back of the EU High Level Expert Group’s report on sustainable finance. Both are a really good catalyst for consultants to pick up this issue with pension fund trustees and other institutional investors.
Funds Europe – In an ESG survey we asked how institutions rated it, and how they rate each individual factor. E got 40%, G got 40%, and S only got 20%. Why is the ‘social’ aspect lagging?
Wilkinson – The question is, what are ‘social’ issues? It is such a diverse area, whereas the environment is talked about on the news as a regular topic therefore it is much more embedded in the day-to-day life. Social issues, however, by the man on the street, are still only associated with charity. Finding a common definition for social aspects is even more complex than for environmental aspects.
Burchill – From my perspective over the last ten years, it is the E and the S that have come to the forefront and I believe they will become more prominent.
Funds Europe – Millennials are much keener on a social impact, but measurement is a problem. But when you do not have the benchmarks, how do you measure it? You obviously need to measure success or failure – and that is the problem, you need something to measure against.
Burchill – This involves demographics as well because the baby boomer generation peaked in about 2005 and the millennial generation has stepped into the breach. In 2016, Bank of America Merrill Lynch reported that millennials had got the highest proportion of assets invested in ESG or ESG-oriented strategies in the US and have the greatest interest in adding to these strategies.
They are coming from a low base, but that is just going to grow and grow.
Funds Europe – At what point does an environmental issue turn social?
Fell – The DC Investment Forum did some interesting work, they did a number of interviews with DC members, and the big headline that I picked up when I went to their conference was an overwhelming impression of the people sitting there being interviewed saying: “I never knew I owned that,” and: “Of course I thought my investment manager would be thinking about controversial weapons and I would not be invested in them.”
The question about when is the environmental and social aspects are important is a really tricky thing for an asset manager to consider, but we should not assume that the end investor is really considering it at all.
Funds Europe – “Whilst ESG has slowly been climbing up the trustee agenda for some time, it’s still far from where it needs to be. It’s going to be hard for pension trustees to ignore these issues for much longer.” (Ralph McClelland, Sackers law firm in relation to UK Parliament Environmental Audit Committee report into pension scheme adoption of climate change risk). Are pension schemes really ignoring these issues?
Burchill – I do not believe that pension funds are ignoring these issues. The largest funds have got some very sophisticated approaches towards implementation of ESG. That is not to say that smaller funds may not find it a little more challenging, but again it is horses for courses, different institutions are moving at different speeds. So, no, I actually disagree and I would say that on the contrary pension funds in this country are actually making good progress.
Adam Laird – No, it is not being ignored, but we are being a little bit hopeful here as it is not at the level it needs to be. Whenever I look at flows of ETFs across Europe, it is still very low. There is adoption there, but it is just taking time.
Fell – For a defined benefit pension fund or for the default strategy of a defined contribution pension fund, the discussion is not about morals, it is about securing the financial returns for the beneficiaries and therefore taking ESG risks into account where financially material.
Having said that, it is interesting that in the DWP consultation there is the suggestion that trustees could be required to state how they take member views into account. They do not have to do anything about it in their investments, but they should understand what member views are and have a discussion, and that is particularly important in the self-select options for defined contribution schemes.
My point is that it is really about the financial aspects. I agree that pension schemes are not ignoring these issues, but it goes back to measuring and how can we get better at understanding the risks. Then we can give pension fund trustees better options to manage those risks, to measure them and then to report back. They are not ignoring it, but it is an evolving area and I would agree that we are not doing nearly enough. So, some hope and some pessimism.
Funds Europe – Moody’s recently said that ESG reporting rules under the ‘EU Action Plan on Sustainable Finance’ were “credit-negative” for asset management firms due to operational costs. Are we in danger of ESG becoming yet another regulatory drag?
Burchill – No. The demand for ESG-related strategies is coming from clients, it is not something that the industry has dreamt up.
Wilkinson – It is true, it is the investors that are asking for this, and more are asking. Before I joined the Luxembourg Stock Exchange, I was working with clients and asset managers who had had a pension fund and other institutional investor assets withdrawn from their portfolios because they had not implemented proper ESG strategies.
ESG is clearly becoming mainstream. This is when you need to start putting in place more robust structures and regulations to protect investors who are interested in increasing their exposure to ESG products, as well as to guide asset managers who are extending their product range. Maintaining market integrity whilst facilitating growth is key at a time like this. If we start going really fast and there are no basic rules to enable investor protection and maintain integrity, that is when we start having real problems. As ESG investing becomes mainstream, a structure is required to protect those who are being pulled along.
Burchill – Maybe this is over-egging it, but it is all about professionalising this segment of the industry, which has come a huge way in the last 20 years.
Fell – France and the impact of Article 173 really appears to have pushed some people that were just thinking into actual action. My view on regulation is, if it is literally ticking boxes then it is going to be expensive and nothing changes, so it is how everyone treats the regulation. It is about whether we just adopt it as a box-ticking exercise, or we try to improve and to change.
Wilkinson – The European Commission has recognised that this is a topic where they really need to consult industry specialists to find the right solutions to financing sustainable growth in Europe. They started with the High Level Expert Group on Sustainable Finance that published its final report in January this year. The report included a number of recommendations, all targeted at contributing to the Commission’s objectives of increasing capital flows into sustainable investments, managing financial risks linked to ESG factors and enhancing transparency and long-termism – the Commission has taken those very seriously. They have been very busy in the first half of this year issuing their sustainable finance Action Plan in March (referred to by Moody’s), followed by a legislative package proposing regulations covering adaptations to MiFID II and IID, sustainability taxonomy, disclosures and benchmarks, and all with an ESG-related theme. And the Commission’s willingness to make this work is also one of the reasons why they have put the Technical Expert Group on Sustainable Finance in place – to have representatives from different parts of the financial sector contributing to making their Action Plan practicable and pragmatic.
Laird – The Climate Bonds Initiative consultation taking place on green bonds and the green bond certification is a positive example. We run a green bond fund, and it is one of the things that we have been very conscious of, the fact that a bond could be issued with green credentials for environmental projects when it is launched but over the life of the bond, the projects could be shelved or have cash re-diverted. We are working with the Climate Bonds Initiative. They verify our portfolio to make sure that the green projects are maintained throughout the life of the bonds.
Narula – We see a bit more client demand, and we do see often now where the client is not necessarily asking, but we talk about how we do things. They are definitely curious, open and interested, whereas maybe a few years ago that was not always the case.
Funds Europe – What do you expect to be the most salient ESG development over the next two years, and what would you like to see as well take place in this space?
Burchill – I would like to see greater adoption of ESG principles and I hope that government is relatively flexible and hands-off in terms of the legislation, because I am sure that greater legislation will be coming at some stage, particularly as ESG take-up increases. It will undoubtedly grow over the next five to ten years and we are about to reach a tipping point, but we are not quite there yet. ESG now is firmly ingrained in many portfolios and I am sure that its onward march is inexorable.
Laird – The one area that I am quite excited about is more non-equity ethical options and the growth in that space. Traditionally it has been very equity-focused and that has been difficult for investors to get balance in their portfolios. Although green bonds have gone some way towards that, there is still a dearth of options really in the non-equity space, so that is a big area that I am watching out for.
Wilkinson – Aside from what is going to come out of Europe and legislation, we are also going to see an enormous growth in different products that are available for different markets and investor types. Investors and their advisers are going to need to pull all this together and will need help to navigate through all these various products. Stock exchanges are a natural go-to choice to provide unbiased and neutral information to the market, particularly those with a clear sustainability focus like the Luxembourg Green Exchange.
Fell – My two things are firstly data and reporting, and secondly customisable products. Data reporting from companies – whether it is driven by stock exchanges, investors or government regulation, is only going to improve. Coupled with that, the ability to get data from other sources such as big data e.g. consumer sentiment to build up a picture around ESG is only going to increase. Hopefully it means that reporting to institutional investors and retail investors is going to get better, which will allow us to make more informed decisions.
On the more ethical side we will start to see products where individuals can add in their personal tilt based on beliefs. It is a reasonably low cost way of getting a personal ethical portfolio.
Narula – The ESG tide will continue to gather pace and maybe we will see it flow from institutional into wholesale and retail, and perhaps some of the gaps we see in ESG implementation and demand between continents will converge a little bit. We see in Asia, particularly in areas like China, where regulatory change can get implemented very fast, there is the potential there for quicker change.
The problem about reporting is a key point and I suspect there will be more ratings providers and the next step may be needing somebody neutral to monitor and filter through them all. Clearly, there is an explosion in data and it forms one of our investment themes. A lot of people could put this together quite quickly so I expect ESG to be integrated more into business process. It is becoming part of the DNA of the companies we meet, but even the laggards are being asked about it so they need to catch up fast.
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