As socially responsible investment rises up the agenda, our panel of experts discusses the state of the sector, the evolution of ESG standards and future trends.
Vicki Bakhshi (head of governance and sustainable investment, BMO GAM)
Ema Crabtree (head of sales, Continental Europe, BNP Paribas Securities Services)
Paul Lee (head of corporate governance – stewardship, Aberdeen Asset Management)
Peter Lunt (responsible investment senior analyst, USS Investment Management)
Alex Struc (head of ESG portfolio management, Pimco)
Funds Europe – Are ESG strategies increasing in popularity and if so, among which investor segments?
Emma Crabtree, BNP Paribas SS – They clearly are. We recently conducted a global survey of institutional investors and found that ESG investing is going to double in size over the next two years.1
There are so many drivers to this. Institutional investors can see that ESG enriches the overall risk measurement and management process. And then at the beneficiary or retail level, attitudes have changed, with the next generation of consumers increasingly concerned about environmental impact and equality.
Alex Struc, Pimco – Demand is increasing all along the chain, from retail investors to pensioners.
Asset owners representing beneficiaries are under regulatory and consumer pressure to promote and align investments with the wider interests of their beneficiaries and this probably explains the shift from screening investments on socially responsible criteria, to active behaviour manifesting in risk management, integration and corporate citizenship. These are all aspects of a more active ownership.
Take the healthcare sector as an example. People who work in healthcare don’t usually want to contribute or invest in areas that make health issues worse.
And likewise, companies themselves understand that aspiring to sustainability is now part of the nature of their fundraising. It is also relevant to business continuity because there are a number of marker trends, such as climate change, that could disturb business models within the management’s own lifetime.
Peter Lunt, USS IM – For evidence of the increase in popularity of ESG, look at how in June, Japan’s Government Pension Investment Fund came out boldly with a broad ESG thematic agenda and committed a substantial amount of funds to the selected strategies.
High-net-worth investors are also increasingly going down the impact-investing path.
On top of this, in my home market, Australia, a report published every year looks at how the numbers stack up: it’s all pointing upwards. It is the case that more investors are selecting responsible investment strategies or asset managers are providing greater disclosure on their stewardship and ESG activities.
Paul Lee, Aberdeen – Australians are a great example of a market that’s been thinking about these issues for a long time; similarly Scandinavia, the Netherlands and Canada.
The UK has been slower but a lot of institutions are now driving in a similar direction.
The French experience is very telling. There is government pressure to think very specifically about climate change impacts and we and all our peers are now measuring climate impact across our funds. In future, this information won’t just be shared with French clients but with clients in all other countries, too.
Vicki Bakhshi, BMO Global AM – There is higher interest in funds that have ESG integrated within them as part of their risk management processes. This goes along with interest in specialist ESG investment products that have either exclusions or positive impacts.
Three risk management drivers are behind this. One is certainly the growing academic evidence for the positive ESG impact on positive performance. Second is the desire to just do the right thing, particularly for younger investors.
And thirdly, there are regulatory drivers, such as the Stewardship Code in the UK that encourages investors to act as long-term owners, not traders. Many countries in Asia, Japan being one, have developed their own stewardship codes too.
Funds Europe – Should ESG factors be considered as mainstream investment risk factors, such as geopolitical and interest rate risks?
Struc – My view is that ESG factors should be considered just like any other investment risk, particularly for a pension fund as they have very long-tail liabilities that mean issues around climate change and health costs relating to tobacco are all going to manifest within a fund’s investment horizon.
Actively engaging and stewarding members’ assets or directing capital returns to try and profit from opportunities stemming from climate change is within investors’ fiduciary duty.
Lee – The investment horizon is the key point. Often what are considered as non-financials are really just ‘not-yet financials’; you don’t know what’s going to happen and what the result will be, but you do know something expensive may well happen if your time horizon is long enough.
Crabtree – Yes, ESG factors are fundamental to risk management and particularly when investing for the long term. You can’t make decisions based purely on short-term financial criteria. Recent news stories have proven that a negative ESG event can have a very real impact to a company’s balance sheet. It is becoming more and more essential to understand if a company’s policies are filtering through to their business practices and ESG data is a great gauge to measure this activity.
Struc – I would say that ESG factors already are mainstream. Banks, for example, already document, monitor and budget for social and governance risks as part of their cash-flow analysis, and environmental risks have already become part of the balance sheet analysis for utility companies and miners.
[Bank of England governor] Mark Carney’s communication on climate change has introduced a useful metric: physical risks versus transitional risks.
Put simply, physical risk is something that catches you unaware and too late. Transitional risks are where a risk is already known and embedded in regulation, meaning this type of risk becomes part of an asset manager’s fundamental analysis.
Bakhshi – In some market conditions, short-term economic factors will dominate, for example when there’s political uncertainty or economic instability. But as soon as you start to extend out the time horizon, the whole ESG discussion becomes much more interesting, because the longer the time horizon, the more those risks may actually come through and materialise.
Geopolitical risk is an example of where ESG factors blur with conventional investment factors. Our sovereign bond team in emerging market debt looks at geopolitical risk but also at ESG factors which include risk of corruption. Is that ESG or not? Who knows? But it’s a material risk that we’re looking at as part of the geopolitical risk set. ESG can yield extra data that’s not already out there and which may not be priced into the market.
Funds Europe – Can ESG strategies be profitable for the firms that offer them?
Crabtree – There is a concern that ESG spells additional costs – the specialists, the data and analytics – particularly for asset managers who are providing ESG investing. I think asset owners are concerned too about the costs. But these costs will reduce as the data and technology improve. The same was said about Smart Beta analysis when it first began, more data points, more speciality knowledge, but in the end, when it was done correctly, it led to better returns.
Bakhshi – There is a cost to ESG. If we want not just stewardship but good-quality stewardship, then you have to invest in good-quality people, and in the time and resources needed to travel and meet companies. There are also data costs, so we shouldn’t pretend that this comes for free if we really want to do it thoroughly and properly.
Having said that, yes it is profitable. We have more than €1.8 billion in responsible funds range. Investors come in directly on the back of our ESG capability and there are an increasing number of markets where you won’t even get a foot in the door if you cannot demonstrate ESG in your process. It was the case in the Netherlands and Nordics, but now it’s the same with France, too, where a firm will not get through an RFP process without a good ESG approach.
But you also find firms where, after they take an ESG approach because the market has made them, they find a benefit, such as the extra data that is useful in pricing. ESG becomes something that once they have had to do it, they then find they want to do.
Struc – To understand the potential for ESG to be profitable, you could consider two areas of demand away from the more well-known equity aspect.
There is a great pent-up demand for ESG fixed income. We have seen that investors will make a separate allocation to fixed income if a proper ESG process can be demonstrated. There is a huge growth area there.
Also, in some countries there is an alignment of public and private capital, but there exists an ESG gap created by public policy that is often filled by private demand. Private capital acts in a transformational way. That is an additional unit of investment flowing in.
Bakhshi – There is also demand for ESG equity and bond products to be packaged together, in other words multi-asset solutions, particularly in the UK market where investors are looking for more consistency across their portfolios.
Lee – Investors can and are willing to pay for standalone engagement activity as a separate service. I find this surprising, though it is an interesting dynamic. A fund will pay for separate engagement services and still pay their fund managers for standard investment management. Yet one assumes as a fund manager that we are already stewarding assets and that it’s a valuable service already integrated with our fund management activities.
Bakhshi – Demand for those kinds of services is growing. You might assume that as the industry advances its ESG and stewardship capability that those services would no longer be needed. Yet what’s happened is the expectations of asset owners have probably risen faster than the speed of stewardship progress within asset management. Many asset owners are frustrated because asset managers tell them that stewardship is happening, but there is precious little transparency about exactly how asset managers are doing this. There are questions about the quality of stewardship: is it about writing a few letters to boards, or are genuine, meaningful face-to-face dialogues with companies taking place? That’s why those services still exist.
Funds Europe – Investors from Scandinavia are trying to set standards for ESG. How far away are we from establishing industry standards and what is their likely form?
Crabtree – It’s a journey, just as it was with performance data and VAR [value-at-risk]. It takes time to come up with standards that everyone agrees with and we’re a very long way from that.
Bakhshi – There is a confusion surrounding ESG due to the different styles of responsible investment, which all have different objectives. To try to conflate those into a single label would be potentially misleading to investors.
We do need best practice on stewardship, best practice on climate change, and on what ethical screening looks like, but we can’t put all of those into a single rating.
There are labels out there, and there are more being developed now, but no one label can describe all responsible investment.
Lee – Morningstar and MSCI have ratings systems and they’re asking some of the right questions. But the issue is a work in progress.
Funds Europe – There is an abundance of data when looking at ESG factors, but the quality of the data varies and it can be difficult to extract the most important information. Do you foresee any new technologies or analytics that can support data analysis?
Lunt – Big data techniques and artificial intelligence may be able to pull together what is to the human eye disparate data and offer something quite meaningful in terms of real investment insight – but right now there exists a more intuitive approach which, although supported by quantitative approaches, identifies ESG factors which are thought or expected to be material risks.
This is all well and good but it doesn’t actually tell me what is or maybe a material factor affecting the performance of a company.
Crabtree – Asset servicers see this as a massive opportunity. We think data is going to improve because the focus is shifting to putting data into context thanks to analytics and scenario analysis. At BNP, we’ve developed our own solution – ESG Risk Analytics – and we’ll continue to work on solutions that can support the industry. We can see some quite exciting developments in analytics such as the use of computer science, big data and artificial intelligence. And there will be greater transparency from investee companies, which will improve data.
Bakhshi – Much ESG data is historical, backwards-looking data, so we would like to see a trend for forward-looking scenario planning, asking question about future risks.
The Taskforce on Climate-related Financial Disclosures is pushing towards this and it’s for asset managers to try to look at our portfolios and see how those portfolios might be positioned in five and ten years. If governments really do follow through with the Paris agreement, what does this mean for the companies we invest in?
The European utilities sector has seen value destruction as a result of not doing forward-looking analysis and not anticipating the shift towards renewables, not looking long term enough to see how their businesses would be affected.
That’s not easy, and at the moment corporate data doesn’t really exist for investors to do that in a high-quality way, but that is absolutely where we need to get to.
Lee – What we need is more data from companies on the factors that matter and the Sustainable Accounting Standards Board is the best attempt yet at highlighting what those factors are. We would then need to be reporting on the impacts on our own portfolios to our clients. We’re inching towards all of that, but it’s still a work in progress.
Funds Europe – What needs to be done in the industry to encourage positive change?
Crabtree – The banking industry has to provide the technology to support asset owners and I think particularly for pension funds, which have the beneficiaries but not the resources to develop their own technology and analytics. There’s also real potential for innovation with technologies such as blockchain in support of green energy. Most importantly though, the industry needs to help educate investors on what ESG means, and what the end goal of incorporating ESG data means in relation to their strategy.
Lee – Clients are asking better questions, but I think there’s still more improvement to come, meaning the level of questioning has to improve to aid discrimination between the good and the not so good. We really need that to happen so that the marketplace can start to function better.
Bakhshi – End beneficiaries increasingly want to know how their money is invested on an impact level, whether that impact is positive or negative, just the same as when they buy coffee or cars. The industry’s not doing that well enough now and it’s incumbent on us to be more transparent.
We’re publishing impact reports for a couple of our funds now; there’s still lots of work to do and I think that’s where we need progress.
Struc – Education on the topic has to improve and we have to be more precise and interpret how ESG leads to positive change. Investors should also ask companies for additional disclosure of how business activities support sustainable development goals.
Lunt – ESG can and should be considered as a legitimate investment risk and legally as a fiduciary duty. But we need to prove the value of ESG factors or ESG thinking in terms of risk-adjusted returns in one form, and the more we articulate that it does actually add something to the investment process.
1 Great Expectations for ESG. What’s Next For Asset Owners and Managers? BNP Paribas. May 2017.
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