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ESG: Hardwiring ESG into the system

Growing_ESGOnce niche, ESG investing has increasingly become part of the mainstream. Fiona Rintoul reports.

Blackrock’s announcement in October that it is to launch a range of environmental social and governance (ESG) exchange-traded funds (ETFs) in the US and Europe was something of a bellwether for the asset management industry. A new chapter has begun whereby ESG investing is a normal part of an asset manager’s job.

“In the last five to 10 years, we have seen an acceleration in the broader market when it comes to ESG,” says Adrie Heinsbroek, head of responsible investments at NNIP. “This acceleration has meant that ESG integration is becoming a standard feature in most RFPs [requests for proposals] for new mandates, which is important for its wider acceptance.”

Such developments no doubt propelled the recent BlackRock move. Though the company stopped short of rolling out ESG criteria across its entire range of active investments, its chief executive, Larry Fink, did predict that sustainable investing would be “at least equivalent to core investments” in the future.

All well and good. But are we underestimating the challenges of implementing ESG?

Given the dangers associated with climate change and growing awareness of them, many people will agree that saving the planet from environmental damage and promoting social improvements are good things. However, translating those impetuses into a coherent ESG investment strategy is not always easy.

“The main obstacle is really that ESG analysis is challenging,” says Lisa Beauvilain, head of sustainability and ESG at Impax Asset Management. “To do it well is hard work.” And it is work that perhaps takes investment managers outside their comfort zone. “Its value comes from non-financial analysis and know-how,” Beauvilain adds. “There are overlays and screens, but the value they offer is limited.”

Of course, things that are worth doing do tend to be hard work. And if you get ESG analysis right, the potential rewards can go beyond being able to sleep at night into competitive advantage.

“We believe that structural integration of material ESG issues leads to better-informed investment decisions and that companies with sustainable business practices are more successful,” says Masja Zandbergen, head of ESG integration at Robeco.

“We have been integrating ESG for many years and see that this provides our investment teams with an extra lens on issues the market is not pricing in yet.”

Zandbergen cites the example of data privacy on the internet. Robeco picked up on it at the end of 2014, she says. This was long before others started thinking about it and the market pricing it in.

“We had a head start and a lot more information than others did,” she adds. “Having one team only profiting from this information does not make sense.”

Proactive
ESG can also be viewed as an asset manager’s responsibility – both to its clients and to the companies in which it invests. As a long-term holder of companies, Robeco believes it needs to be active and tell them where they believe they can improve on sustainability and governance. Awareness of its social and environmental responsibilities as an active asset owner across many asset classes helped to drive NNIP to embed ESG.

“The fact that we can act in accordance with these responsibilities, in a way that enhances investment returns, means we are creating value for clients and for society at large by proactively committing to responsible investing,” says Heinsbroek.

For these companies, the idea is to create value and make a difference at the same time. Creating value by helping companies to improve rather than simply generating alpha by making the right picks is certainly an attractive concept. But active ownership isn’t a synonym for ESG, and not all managers follow a philosophy that prioritises an active approach or long-term investments.

“Integration is a journey and different asset managers are at different points in that journey,” says Beauvilain. “Your style of investment and the time horizon that you invest over matter here, so too the expectations of your investors.”

The increasing number of ETFs that integrate ESG criteria is evidence of demand for ESG exposure on the passive side of the business. Here, the need for standards and clarity in ESG analysis – currently sorely lacking – is perhaps more pressing than on the active side, where an individual approach can be a selling point. “The industry needs better issuer disclosure as well as more insightful data,” says Daniel Ung, head of smart beta ETF strategy at SPDR. “Much of the available ESG information is of poor quality.”

Ung also points out that ESG is most common in public markets. However, that does not necessarily reflect investors’ entire portfolios.

“As investors look to apply ESG in their investment processes, it is equally important to harness the ESG potential of investments in non-public markets, such as private equity, and for that to occur, data availability and a standardised approach are crucial,” he says.

Several organisations are attempting to tackle the data issue; Ung cites the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI) and the Governance and Accountability Institute (GAI). But it is not just a question of more data.

Zandbergen believes there is enough data and information around. The problem is they were never intended to be used in mainstream investments and definitely not as an alpha driver. The focus was “more ethical”.

“Portfolio managers actually need research that makes the ESG information relevant for them to use in their process,” she says. “If you cannot give them that, ESG integration will be a box-ticking exercise.” There is the question of education, too: “How can you expect people in the financial industry to take sustainability into account if they have not been trained to do so in school?”.

Harmonisation
Another issue is lack of harmonisation at the global level. Ung points out that, for equities, the Swedish pension fund AP3 looks at ESG investing in a different way to that of the Canadian Pension Plan Investment Board. Regulators also have different approaches.

“Continued fragmentation of regulatory efforts around the world pose a challenge, as common standards are not yet being employed as they have been over the years in reporting of financial metrics,” says Chirag Patel, head of State Street Associates EMEA.

Beyond the issue of finding the right data to implement ESG lies the issue of having the data to prove it works. “Works” means two things here: (1) has a positive impact on the environment, society and corporate governance; and (2) delivers outperformance – or at least not underperformance.

The contribution or otherwise of ESG to performance is a much-debated topic that has produced a wealth of studies that sometimes contradict one another. However, Beauvilain highlights one arresting statistic: it is estimated that about 80%-85% of the value of the S&P 500 is from intangible assets.

“You are moving beyond the numbers and your risk analysis framework should capture that,” she says.

Measuring the positive impact of companies on the planet and society is, if anything, an even more challenging business – and one that Heinsbroek says will generate debate among asset owners, regulators and non-governmental organisations.

He believes improved transparency at the company level – combined with more data sources and the standardisation of measurement methodologies – is the way forward.

“Improved transparency might have several implications on the company’s financial profitability to be taken into account by portfolio managers,” he says. “For example, by measuring the CO2 emissions or water consumption of a company, they can gauge how efficiently it is managing costs.”

This would perhaps require an end to the reliance on self-reported data to questionnaires and industry bodies that Ung deplores.

“Company-disclosed information is sparse and disparate across industries and regions,” he says. “The reliance on self-reported data allows companies to disclose favourable data or opt out completely.”

Meanwhile, Patel notes that there is a growing body of literature evidencing the impact of many ESG attributes on portfolio performance over the longer horizon.

“Perhaps the area where we have seen the strongest evidence of impact, even over shorter periods, is in the meaningful shifts in behaviour that have been achieved through concerted engagement campaigns by investors in areas such as environmental damage mitigation and progress on diversity and inclusion goals,” he says.

ESG may not be easy to implement or to measure, but it now seems beyond doubt that it will be part of the entire asset management industry’s future, regardless of style or asset class. In the past 12 months, Beauvilain has seen a dramatic change in the level of sophistication around sustainability and ESG, with investors, wealth managers and pension schemes asking increasingly astute questions.

That means managers must get ready, both to profit from the opportunity and to ensure they are not left behind.

“Looking ahead, I think this trend will continue and it will wash out box-ticking – managers will need to do the work and engage if they are to deliver meaningful value and the resource that they allocate to this area is likely to increase,” says Beauvilain.

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