Author: Maha Khan Phillips
By 2025, Environmental, Social, and Governance (ESG) assets are expected to account for around 33% of all global assets under management, or $53 trillion, according to Bloomberg. As we venture further into a world where ESG is more embedded into every part of the investment process, what are some of the considerations for portfolio managers? In this virtual roundtable, Professional Investor invited experts to provide their views on building successful ESG portfolios, creating better engagement and stewardship, achieving better disclosure and reporting standards, and addressing the challenges that remain.
Participants:
Gemma Corrigan, Head of Policy and Advocacy, Federated Hermes
Cindy Rose, Head of Responsible Capitalism at Liontrust Asset Management
Sylvia Solomon, ASIP, Board Member, CFA UK, and Director of ESG and Business Development at Equitile Investments
Paul Udall, Portfolio Manager, Climate Transition Strategy, Lombard Odier Investment Managers
PI: ESG awareness has come far in recent years. In your mind, what key challenges or obstacles still need to be addressed to support the integration of ESG factors into portfolios?
Sylvia Solomon:
The lack of common language, meaning and agreed upon definitions around ESG approaches remain a stumbling block. Additionally, non-existent audit assurance of ESG ratings creates a hurdle when incorporating ESG data, research and scores from third-parties. Applying the same set of factors to companies in different geographies and industries with diverse business practices can also be challenging. Companies have assorted business models; whilst some outsource large portions of their value chains, others vertically integrate. Furthermore, different regions have varying obstacles with regards to data quality, therefore, to compare like-for-like, metrics needs to be normalised. In turn, this impacts measurement against international standards and sector peers.
Disparate asset classes face contrasting issues, for example, private markets falling in scope with EU ESG regulations will be impacted by the mandate for public disclosures, which could affect capital raising activities. Navigating this complex and evolving landscape, requires continued in practice education on the numerous approaches to deal with data gaps that span industries and time periods for different asset classes and instruments.
This view is generally supported by firm responses, as when asked, investors regularly say greater transparency in ESG fund reporting frameworks and data availability would most encourage an increase in ESG integration.
Gemma Corrigan:
It has now been widely recognised that where relevant, ESG factors, with a long enough timeframe are material to risk and of value to investors. A company or other investment which fails to consider the impact it has on the environment or society, is at risk of destroying significant value or missing out on opportunities to create wealth for its investors.
The principal challenge today is one of greenwashing as the investment industry seeks to establish its credentials and the regulators demand excessive disclosure in an attempt to distinguish between genuine and superficial integrators of ESG. Whilst it is important for different institutions to invest in line with its values, it is equally important that as an industry we seek to improve the ESG performance of all investments. Investor stewardship is the answer here.
Going forward, the industry needs to complement its work on climate and address data gaps on topics like biodiversity, our impacts and dependency on nature, as well as the broader societal impacts. Social justice will be a massive issue, partly to facilitate a just climate transition and also to ensure that the pandemic and advances and reliance on technology do not exacerbate the already damaging inequality that exists.
Paul Udall:
I would like to see much broader take up of ESG reporting across Asia and the Americas where there are still big gaps in data and lack of awareness and training amongst investor relations teams, and of course senior management. Europe is a relatively small part of the global equity markets and for widespread integration of ESG we need to see better global reporting.
Cindy Rose:
Defining what ESG actually means remains a key challenge. ESG stems from Socially Responsible Investing (SRI), designed to give investors more connectivity with their investments. SRI used screens to ensure investors held what they wanted and gave them peace of mind. ESG retains the screening, the connectivity with investors, the ethics and compliance. However, ESG is more mainstream and has tried to change behaviour to improve social and environmental aspects.
But ESG offers more. It is financial, having impact on the balance sheet. It is about exposures (risks and opportunities). Every asset has its own set of exposures, making it is highly individualised. ESG could focus on how companies manage their key exposures, pointing to longer-term competitiveness and profitability.
It’s also important that we measure, analyse, and report on ESG elements in context.
Some of the market focuses on individual E, S or G areas and can use these as a proxy for the whole, ignoring the overall context. Careful analysis and measurement of an asset’s exposures in context can provide greater clarity on how it may act and perform over the longer-term.
PI: How can investors decarbonise their portfolios? Is it a case of divestment or engagement, active stewardship or all of the above?
Udall:
The first question to answer is what does ‘decarbonising a portfolio’ actually mean. Does it mean simply avoiding carbon emissions by avoiding heavy industry and investing only in asset light service sectors. We would argue this has limited impact on global greenhouse emissions and does not accelerated us towards net zero. I like to quote Mark Carney, who said to solve the climate crisis we need to go where the emissions are. All carbon dioxide and methane emissions today come from seven energy and land-use systems. Net-zero emissions can be achieved only through a universal transformation of energy and land-use systems. We support investing in those higher carbon companies and sector which are rapidly decarbonising via investment in low carbon technologies. Active stewardship plays an important part of that transitional investment to make sure the targets and incentives are aligned and progress is monitored and progressive.
Rose:
Decarbonisation of portfolios is possible but will take time, because most funds were not created with decarbonisation in mind. Funds with shorter investment time horizons can get a short-term boost from carbon intensive investments. Net zero commitments made by company leaders will not be completed under their watch.
Carbon data is improving but not yet completely accurate, while divestment may force carbon assets onto other people’s balance sheets. It is not a “real world” solution for companies to sell their carbon-intensive assets to other companies.
While some investors avoid companies because they do not meet their ESG process and criteria, others believe it is better to have influence over carbon assets rather than to have none at all to seek to help with the transition to decarbonisation (e.g. private companies, government controlled assets)
Engagement can help if done appropriately. Engagement is most effective where companies understand what investors want. Investors have to challenge companies on their actions, specifically explaining what they want their investments to do, why, and over what time period.
Proxy voting is also important. Not all climate related resolutions are created equal. Investors need to understand what resolutions mean and what impact they will have. Resolutions should be considered in the greater context of the company itself.
Solomon:
As a fiduciary investor that falls under the scope of Shareholder Rights Directive II and a PRI signatory, voting and engagement are co-integrated as part of our overarching approach to effective stewardship. We’ve adopted an ESG-themed voting policy, which commits us to supporting more ESG resolutions, to ensure that capital flows are directed to promoting positive ESG change. Our aim is for investments to demonstrably operate profitably in alignment with the UK 2050 net-zero pathway.
Without purposeful dialogue, ESG research may fall short in capturing anticipated changes as sustainability practices evolve. To augment data gathering and reporting, engagement with high-carbon emitters can effectively help companies; better devise decarbonisation strategies and benchmarks, set environmental targets, transition to a low-carbon model, and implement appropriate incentive mechanisms to ensure alignment with different stakeholders, thereby fostering a just transition.
Decarbonisation engagement opportunities present themselves across a spectrum of severity, therefore, we seek to be pragmatic. We consider engagement a powerful influence for change within companies yet recognise it is not always effective despite our best endeavours. Failure to improve standards may ultimately require a divestment. We seek to mitigate this problem by, whenever appropriate, communicating the rationale for our divestment to the investee company’s management.
Corrigan:
Active stewardship and investment in solutions will be crucial to drive real economy impact.
In secondary markets, divestment at best has an indirect positive impact on decarbonisation as boards of companies not desiring to be divested may as a result make changes to their asset allocation. In divesting, however, the investment manager may be taking carbon emissions off their books, but in reality, they are simply transferring the emissions to another owner.
The only way an investment manager can directly influence the level of emissions in the world is through effective engagement with their investees and advocacy with policymakers. Investors need to encourage companies to rebalance their capital allocation towards renewable solutions and governments, to ensure the right economic infrastructure is in place and that there are subsidies and incentives for immature technologies and business models which will be crucial for addressing climate change and lowering the green premium.
In addition, the investment industry needs to find a way where it can more effectively invest new money in new solutions oriented investments. Not all will be successful, but unless more capital is directed towards early stage technologies in the hard to abate sectors, it will be difficult for the economy to move to Net Zero.
PI: The current tragic situation in Ukraine has highlighted far-reaching consequences of unintended risks and impact of energy transition policies. Given underlying inflationary pressures have been exacerbated by being in a ‘war economy’, is the cost of being an ESG investor too great?
Corrigan:
Quite the opposite. The war in Ukraine has served to underscore the importance of each element of ESG.
In terms of the environment, the war has underlined the importance of energy security for the citizens of different nations and the crucial importance of a just transition to a Net Zero world. Further, events should lead to an acceleration of investment into renewables, as Europe and other parts of the world address concerns around energy dependence. It also again raises the vexed question on the role nuclear power will play and ensuring that any role is implemented with assured safety at the core.
Hydrogen will likely play a bigger role into the future, particularly with respect to industries and processes that are hard to electrify
Devastating as war is in the loss of life, the injury and trauma and loss of homes, places of work for those directly affected, issues of human rights are paramount. Whilst intertwined economies has not been sufficient of a deterrent to this war, such ties and agreement on basic human rights as well as best practice corporate governance and the eradication of corruption has to be something which we strive for and encourage as investors.
Solomon:
The confrontation in facing down the threat to democracy while also heading off climate disaster is nothing new; climate negotiations have carried on through decades of political upheavals, including contention among UN members. The Ukrainian crisis highlights the dependence of many countries on a single source of oil and gas, and further cements the fact there is no trade-off between resilience and sustainability. Notwithstanding current inflationary pressures, the long-term solution is obvious, the need to design an energy market that is not based on the cost of the most expensive fuel at any point in time.
Despite increased economic uncertainty, living through a war economy has a habit of enabling great innovation, forcing us to reshape and reprioritise goals in order to build resilience. When investment performance is measured holistically, rather than reviewed on knee-jerk reaction, investors are less likely to pivot away from playing proactive roles supporting projects that have strong environmental and/or social impact. Specific and targeted capital allocation in the clean energy sector, can help ramp up energy efficiency, and enable a just transition agreeable to most consumers. Although unequivocally dear in the near-term, the price of cutting dependency on fossil fuels is a cost worth incurring.
Rose:
If we keep with the understanding / definition that ESG is about the exposure levels of investments (both financial and ESG-related) and that it is important for investors to consider these exposures carefully when making investment decisions, then, in the context of the Russian invasion of Ukraine, there is no better time to consider these. This is for several reasons, including the fact that energy security of nations becomes increasingly important. Renewables and green energy offer a way for nations to secure long-time energy resources for their countries. This demand could accelerate what was already a need for and focus on renewables and greener energy sources.
Another factor is that supply chain disruption (as we have seen with Covid) can bring businesses and sectors to their knees. Understanding and investing in robust supply chains is pivotal for businesses to be competitive and successful for the next few years, at least.
Additionally, as the globe warms, there will be an increased focus on food (production), water (purification), and shelter, all of which require energy. The Russian conflict will only heighten the risks around not having energy security.
PI: How far have we come in creating consistent, shared disclosure and reporting standards, for example with the creation of the EU Taxonomy? What more should the industry be doing?
Rose:
We are just at the start of creating consistent information and achieving reporting standards that help investors understand what their investments are doing and how this compares with other funds / investments.
The EU Taxonomy and SFDR are reporting standards. They will help investors have much more information on what a fund holds. Whether the information that funds report on helps investors make improved investment decisions remains to be seen (reporting requirements begin this year.) The FCA has published a discussion paper on its SDR which also outlines minimum hurdles for sustainability / ESG type labelling of funds.
For a long time, investors have wanted a US GAAP like reporting framework for “ESG”, but it remains to be seen if this is the best approach. In the meantime, it would help investors to see more information from companies about their key exposures and how the company links the management of these key issues to pay, group strategy and KPIs. This would help managers and investors understand the exposures that its investments face and the steps companies are doing to manage these. It would also help demonstrate how important companies see these key issues, if they are linked closely to pay.
Solomon:
The EU Taxonomy and other recent regulations are a step in the right direction in establishing a uniform and credible standard, that allows economic parties to align with the transition to low carbon, resilient and sustainable pathways.
Several organisations develop and set comprehensive global standards, focused on identifying and evaluating ESG risk factors that are financially important to companies. These include industry groups such as the Task Force on Climate-related Financial Disclosures, Sustainability Accounting Standards Board, Greenhouse Gas Protocol Standards, among other sustainability reporting standards that are specific to business lines. Around the world, countries have distinct strategic priorities that hinder the harmonisation of ESG standards. Convergence of at least some of the national regulatory frameworks, principles, initiatives, metrics and reporting standards is essential to establish common environmental, social and governance priorities among companies, investors, and other stakeholders.
ESG risks and opportunities are largely long-term, perhaps even multi-generational; if quantified or understood correctly, provide a great opportunity for generating alpha. There is ample opportunity to design investment products that support specific climate-related or environmental projects, so proactive, and forward-thinking asset managers, can play a decisive role in this respect and are in a unique position to act as change agents.
Corrigan:
The UK and the EU have both set clear sustainable finance strategies with increased transparency as a key aim. The EU Taxonomy and SDFR are already driving increased corporate and financial disclosure. Other jurisdictions are also ramping up disclosure expectations, the ISSB and the potential for a ‘common ground taxonomy’ could offer a much needed baseline level of global comparability. This would support financial institutions’ disclosures, which are underpinned by data from the companies they invest in, lend to and underwrite.
The industry needs to support the work of the ISSB to enable greater harmonisation but we would challenge them to go beyond focusing exclusively on enterprise value to also measure a company’s value to society. A company’s impact on the environment, society, and its stakeholders also needs to be measured and appropriately managed as it could lead to financial liabilities and opportunities for companies over time.
The EU taxonomy was a step in the right direction but must maintain rigorous standard for what is defined as ‘green’ as opposed to transitional, or the framework will risk losing relevance up against more rigorous alternative labels. With the proliferation of regulatory requirements and labels, there is a growing concern that over disclosure could inadvertently leading to greenwashing.
Udall:
Since I entered the sustainable investment industry in the early 2000’s the progress has been slow but progressive and over the last five years I have seen an encouraging acceleration in disclosure, discourse and most critically the fundamental importance of diverting capital aware from unsustainable and destructive pathways. I would repeat my earlier comments that I would like to see a much wider global response beyond the European initiatives mentioned above.
PI: What is one development you are excited about in 2022?
Corrigan:
On climate change, the US Security and Exchange Commission’s proposed rule requiring publicly traded companies to disclose material climate related risks will likely pave the way to greater transparency and accountability by providing investors with the information required to push companies to take real action.
Biodiversity and social inclusion are rising rapidly up the agenda and are two exciting developments we are currently watching. During COP26, we saw a greater focus on nature, particularly the issue of deforestation and the ocean, in recognition of the interlinked nature of these two environmental crises. Healthy ecosystem services and nature based solutions are an important part of climate change mitigation, for example through carbon sequestration.
Rose:
One interesting development in 2022 might be that investors continue to focus on Article 8 and Article 9 funds. This demand could help drive increased demand for the consideration of measuring / understanding the exposures of key risks and opportunities that companies (investments) are facing and looking at these in context. The more information investors have at their disposal, perhaps the less investors will focus on an ESG score which looks only at a few aspects of a group’s business, rather than the context of an investment’s overall material risks and opportunities.
Udall:
We are most focussed on those high-carbon, hard-to-abate sectors of the economy that we see as the real key to achieving a net zero future. Across our most innovative high carbon companies- what we call transition leaders, I would highlight that the common thread that runs through their strategies is finding use cases for hydrogen as a replacement for fossil fuels in their operations and products. We are very excited by the rapid development we are witnessing in the hydrogen economy across a multitude of sectors. For example, engine manufacturer Cummins, a name we invest in, is using hydrogen fuel cells to power trains on hydrogen rather than their historic diesel powertrains or SSAB a steel producer is establishing itself as a leader on the drive for zero carbon steel again with a process they are developing which will be fuelled by hydrogen. We see hydrogen rapidly emerging as a key solution to enable the decarbonisation of these hard to abate sectors and look forward to finding more opportunities for investment in the hydrogen economy.
Solomon:
The International Organization of Securities Commissions (IOSCO) is the international body that brings together the world's securities regulators and is recognised as the global standard setter for the securities sector. In collaboration with IOSCO, the IFRS Foundation announced that it would be establishing a new International Sustainability Standards Board (ISSB) to develop globally adopted sustainability disclosure standards, incorporating the Value Reporting Foundation and the Climate Disclosure Standards Board within its structure. This new body will have a multi-location structure to ensure that the differing needs of the various regions are reflected as the standards are developed. Just as IFRS Accounting Standards was a positive gamechanger for the investment industry, setting out how a company prepares its financial statements, IFRS Sustainability Disclosure Standards will set out how a company discloses information about sustainability-related factors that may help or hinder a company in creating value.
We are pleased about the establishment of ISSB as we believe the development of a comprehensive global baseline of high-quality sustainability disclosure standards will help meet investor needs and should enable easier assessment of our investee companies. Once in place, there is potential for unprecedented uniformity based on a common standard of sustainability assessment and analysis.
PI: There has been a great deal of focus on the ‘E’ of ESG. What about the ‘S’ and ‘G’?
Solomon:
The social dimension in the ‘Just Transition’ is behind the big changes in the way our economy works in order to achieve climate neutrality. We believe the most resilient and successful companies are ones in which good leadership considers the creation of broader prosperity for all stakeholders – employees, suppliers, customers, and society at large – with a constructive attitude towards shareholders and financiers.
In the long-run, no company can prosper without high-quality governance and a healthy, inclusive corporate culture. It must treat all its employees fairly without discrimination, it must conduct its business legally, and it must compensate its management and staff appropriately, thereby fostering an alignment of interests with shareholders. Companies where management endanger both the capital of their shareholders and the jobs of their employees by using risky financial manoeuvres or opaque decision-making processes are simply unsustainable.
‘E’ doesn’t occur in a vacuum, as stranded assets demonstrate; the range of environment-related risks interwoven with ‘S’ and ‘G’ need to be properly understood and priced. Effective boards are likely to find it easier to maximise opportunities in a changing world and respond appropriately to implement climate-linked initiatives. We encourage our investees to promote sustained change through good governance and social improvements.
Udall:
I have always found the segmentation of E, S and G a complete misnomer. You can’t have good environmental policies and practices without good governance. Strong social policies are highly interconnected with strong governance and environmental issues. As an example, climate change is as much a social issue as it is an environmental one. Climate change will displace millions of people who have a much higher reliance on stable food prices and availability of affordable heating and power. Climate policies require strong government policy and corporate governance to enable the transition to a sustainable economy. The E, S and G are all joined at the hip.
Corrigan:
In the run up to COP26, ‘E’ received lots of attention be it climate change, fast fashion and the circular economy. There has also been a much needed increase in focus on biodiversity and the ‘S’
For four decades, Federated Hermes has been actively engaging on Governance—holding boards to account on their composition, executive remuneration and minority interest protection. ‘G’ is critical to ensure that all actors in the economy are working in the long term interests of investors and society.
Social has also always formed part of our engagements be that addressing human rights issues in companies operating in specific regions, labour rights from a health & safety or living wage point of view or the social housing, public spaces and schools in a number of the place making projects we are invested in.
From a social point of view, wellbeing as a result of Covid and Diversity and Inclusion in the aftermath of George Floyd’s murder and continuing gender and wealth inequalities are also getting more attention. In the current economic climate and in the face of climate and technological disruption, Social will need far more attention due to the cost of living crisis and widening inequality as a result of the pandemic.
Rose:
It’s critical to understand all the exposures that investments have, no matter how the exposures are sub-classified. The exposures that are most likely and most impactful are considered to be a company’s key exposures. While the market swings in cycles about which areas it is interested in, this change doesn’t impact the fact that a company has exposures or change the level of exposure for a group.
Ultimately, we need companies to report more thoroughly on their key exposures and how they are managing these (many of these exposures are E, S or G related), and investors to take greater interest in what their investments are facing (both near and longer term) and engage their companies on how they are managing these issues. We also need asset managers to integrate consideration of these exposures (and how they are being managed) into their investment decisions, and for them to report on how the consideration of these exposures impacts their investment decisions.
Gemma Corrigan, Head of Policy and Advocacy, Federated Hermes
Cindy Rose, Head of Responsible Capitalism at Liontrust Asset Management
Paul Udall, Portfolio Manager, Climate Transition Strategy, Lombard Odier Investment Managers
Sylvia Solomon, ASIP, Board Member, CFA UK, and Director of ESG and Business Development at Equitile Investments
