The increasing prominence of Environmental, Social, and Governance (ESG) in societal, business, and regulatory spheres poses unique challenges for asset managers. These professionals stand at a unique juncture, grappling with the intricacies of data risks, pro and anti-ESG investor sentiments, and facing the contrast of detailed regulations versus the absence of global standardization. This article delves into how asset managers can effectively steer through these evolving landscapes.
Asset managers with international operations, especially those targeting global investors, must remain compliant with all relevant regulations. Given the fluid nature of these regulations, continuous monitoring and adaptation are essential.
Within the European Union, the Sustainable Finance Disclosure Regulation (SFDR) came into effect in March 2021, followed by the Taxonomy Regulation which started its phased introduction from January 2022. These regulations target a broad spectrum of “financial market participants” that includes but is not limited to EU MiFID investment entities, UCITS1, and both EU and non-EU Alternative Investment Fund Managers (AIFMs). In essence, these regulations mandate firms to:
- Classify investment funds based on their environmental or sustainability goals, i.e., “dark green” for those with clear objectives, “light green” for those promoting environmental or social features, and “grey” for others.
- Ensure transparency in promotional and offering materials.
- Adhere to specific criteria and reporting standards for qualifying investments.
Meanwhile, in the UK, the Financial Conduct Authority (FCA) is wrapping up its consultation regarding a distinctive ESG disclosure framework, with the final guidelines anticipated by the third quarter of 2023. Although these regulations primarily address UK-authorized asset managers, it’s uncertain if foreign products marketed in the UK will fall under this umbrella. Notably, the FCA has shown intent to synchronize with international protocols, suggesting a likely alignment with the EU approach.
Contrastingly, the US lacks a uniform federal ESG framework. The US Securities and Exchange Commission (SEC) is projected to establish rules for ESG-related disclosures and to enhance the monitoring of ESG claims. The SEC’s stance, particularly concerning energy transition and climate change components, remains unpredictable, especially given the resistance from some US states.
The SEC continues to spotlight “greenwashing” prevention, ensuring that advisors accurately represent their ESG strategies. The SEC’s actions in 2022 underscored this, with significant enforcement against entities making misleading statements about their ESG incorporation, as observed in cases like that of BNY Mellon.
Despite regulatory dynamics, investors independently solicit ESG-related data from asset managers for various purposes, including fulfilling their own reporting obligations and gauging ESG investment outcomes.
In regions lacking definitive regulations, asset managers often negotiate data terms individually. Given the digital era’s data abundance, discerning valuable, cost-effective data becomes challenging, especially as each Limited Partner (LP) might have distinct performance benchmarks and KPIs.
To standardize this, the private equity sector is pivoting to a uniform metrics set, as seen in the ESG data convergence initiative, which zeroes in on 15 core metrics such as greenhouse gas emissions, leadership diversity, and staff engagement. It remains uncertain if global regulators will adopt a similar standard.
In terms of applying the above, we recommend four key principles:
- Stay updated with the regulations pertinent to your product or investment.
- Maintain transparency and consistency in actions and promises.
- Exercise caution when committing to ESG data provision.
- Recognize LPs’ data requirements, ensuring efficient delivery without jeopardizing future contractual agreements.
Asset Managers and the Need for Integrated ESG Advisory
Institutional investors are increasingly feeling the pressure to make the right decisions. The clear stance of regulators on the issue of greenwashing is evident, as some asset managers, including Goldman Sachs Asset Management, have faced hefty fines, such as a recent $4 million penalty from the US Securities and Exchange Commission. Such events can tarnish the reputation of asset managers’ clientele.
Efforts by regulators and decision-makers to introduce clear categorisation and oversight, while generally positive, have stirred debates and led to misunderstandings. A case in point is the changes in the European SFDR (Sustainable Finance Disclosure Regulation) guidelines and the subsequent reclassification of funds by asset managers, like the shifts from SFDR Article 9 to 8 or from Article 8 to 6.
Shifting the focus away from these pressures and regulatory actions, we firmly believe that conducting ESG assessments and adopting sustainable investment strategies are crucial for informed investment choices. Numerous pension plans, endowments, insurance companies, and other investors have, independent of regulatory guidance, expressed robust and overarching pledges towards ESG integration, including areas like carbon reduction and impactful contributions. It’s now imperative that these commitments are met for all stakeholders, backed by the expertise of asset management partners.
For effective oversight and evaluation of investment managers, investors should examine ESG practices both at the product/strategy tier and at the organisational level. In this piece, we spotlight four primary hurdles investors encounter in their ESG evaluations. While the realm of ESG and impactful vetting is multifaceted, concentrating on these four areas can offer investors insight into the trustworthiness of potential and existing collaborators.
Gauging managers’ dedication to sustainability amidst compelling marketing.
Nearly two decades ago, the management guru Peter Drucker famously said, “culture eats strategy for breakfast”. Evaluating the ESG credibility of asset managers, one of the most crucial yet challenging attributes to gauge is the solid sustainable investment principles and convictions permeating the entire firm, from the top brass down.
As ESG considerations have increasingly become a business necessity for asset managers, ascertaining real dedication is more challenging. Companies are eager to project an ESG-conscious persona to their clientele and stakeholders. In our day-to-day dealings, they stand to lose substantial assets if they falter in this. However, while recognising the progress made by investment professionals in this arena, the overpowering drive for profit can inadvertently lead to a bit of greenwashing.
Delving deeper than the glossy promotional materials, company ethos, sustainability audits, and articulate sales representatives is often necessary. It’s beneficial to scrutinise three areas more intimately: organisational pledges, answerability, and ESG personnel. Analysis should be detailed and considerate, going beyond merely checking if managers have established policies and sufficient ESG staff. Simplistic metrics should be sidestepped, and the evaluation must be attuned to factors like the company’s size and the nature of the assets they manage.
In the context of the above, we see eight key risks which emphasise the challenges and considerations associated with assessing asset managers’ commitment to sustainability, particularly in the context of Environmental, Social, and Governance (ESG) integration.
Beyond Superficial Indicators: It’s important to look deeper than mere labels and checkboxes when evaluating ESG integration. This involves understanding the nuances of specific asset classes and the importance of considering both investment and operational aspects.
Genuine Commitment: While many firms project an image of being ESG-conscious, genuine commitment to sustainable practices can be challenging to discern. The strong commercial motivations can lead to “greenwashing,” where firms give a misleading impression of their environmental responsibility.
Policy Depth: Not all ESG policies are created equal. Detailed and asset class-specific guidelines are crucial. There are disparities between firms regarding the internal accountability of these policies.
Research Findings: Research shows variations in how asset managers address different ESG topics in their policies. For instance, 70% address climate change, while only 34% address biodiversity.
Accountability and Oversight: How ESG policies are overseen and who is accountable for them speaks volumes about a firm’s genuine commitment to sustainability. Effective risk management and internal audits regarding ESG integration are crucial.
ESG Resourcing: The structure and size of ESG teams can vary widely among asset management firms. However, it’s crucial to understand the roles and interactions of these ESG teams with the investment team.
Climate Change Approach: Climate change is a paramount concern, with many managers establishing climate-related targets. However, firm-level commitments may not necessarily reflect the goals of individual investment funds. Participation in initiatives like the Net Zero Asset Manager Initiative and the Taskforce for Climate Related Financial Disclosures can indicate a firm’s dedication to climate action, but the actual implementation and commitment at the strategy level can vary.
Net Zero Targets: A significant gap exists between firm-level Net Zero commitments and those at the strategy level. Even for strategies that are explicitly sustainable or impact-focused, there is often a mismatch between company-wide goals and the specific objectives of the strategy.
In summary, while the ESG landscape has evolved significantly with many asset managers showcasing their commitment, it’s essential for investors to delve deep and assess the genuine commitment, policy depth, accountability mechanisms, and specific strategies in place to ensure sustainable investment practices.
The depth of a policy indicates a company’s genuine commitment to sustainability.
Though a significant number of firms now boast an ESG or responsible investment policy (or multiple such policies), they vary widely in their thoroughness. It’s still frequent for such policies to miss guidelines tailored to specific asset classes, which can be instrumental in assuring uniformity and pinpointing crucial distinctions. Additionally, there’s a distinct variance among firms regarding internal responsibility for these policies.
Most (74%) of asset managers tackle climate change within their policies — either embedded within the ESG/RI policy or as a distinct policy, while only 34% of managers incorporate biodiversity within their policy framework.
When thinking about policies, it is also worth looking at companies’ corporate social responsibility (CSR) programmes, in part to understand whether a manager ‘walks the walk’ as a company, as well as ‘talking the talk’. How many managers have company-wide CSR policies, and how many Diversity, Equity and Inclusion (DEI) policies are supported by measured data points?
Company-level pledges or objectives can also take the form of participation in external bodies and initiatives. ESG and sustainability are subjects that inherently need industry collaboration if meaningful progress is to be made. Many asset managers can provide long lists of initiatives to which they subscribe, but the bar for involvement can be low.
Ensuring strong accountability and audit of the ESG approach is not only important in ‘investment due diligence’ but is also increasingly relevant in ‘operational due diligence’, given the potential consequences of inadequate controls in today’s market.
We prefer to see policies approved by the Board and accountability lying with senior leadership alongside a dedicated ESG individual. Going a step further, we would argue that best practice entails running risk management, compliance and internal audit processes at the product level to assess how an investment team has applied the firm’s policy to ESG within a specific fund: this practice is growing among asset managers today.
ESG resourcing is not a clear-cut issue either. As an asset management firm develops a stronger focus on ESG, this will typically be accompanied by a rising headcount dedicated to this subject and the provision of other relevant resources. On the staffing side, most asset managers have dedicated ESG personnel, with varying team sizes. The structure of the ESG teams also varies: centralised functions, dedicated specialists within asset classes or a combination of both are all common. This is supplemented in some cases with external expertise, be it consultancy/advisory or academic. Scientific involvement can be particularly helpful in certain subjects, such as climate change and biodiversity, given the complexities surrounding these topics.
There is no right or wrong answer when it comes to the size or structure of an ESG team, though larger managers without obvious resource constraints are expected to demonstrate a strong headcount. As ever, the devil is in the detail. While ESG headcount can be a useful indicator of genuine firm-level commitment, ESG teams and specialists can often be siloed and may lack clout with underlying investment teams. It is therefore very important to understand the roles and responsibilities of ESG individuals and their interactions with the investment team: do they offer support and guidance or conduct the full ESG analysis?
The rapidly evolving nature of ESG issues calls for dedicated expertise. Yet we consider genuine ESG integration to be visible where there is no longer a stark separation between ESG and financial analysis and when sector analysts and portfolio managers can all enthusiastically describe ESG risks and opportunities inherent in their investments without the ESG team’s presence.
Differentiate between robust and less-effective approaches to climate concerns.
The threats that climate change presents to both our society and economy are now clearly detailed and measured. There’s ample information and data backing the perspective that financial implications of climate risks are significant, and thus, they should be integrated into the investment strategy.
Due to regulatory obligations, investor expectations, and even potential risks to reputation, investment managers are now forming a position on climate change, which includes setting climate-centric goals.
Even when funds set Net Zero targets, these goals don’t always align with managing climate risks during the investment process. The strategies and success rates for achieving these targets can vary widely among managers. It’s essential to evaluate these targets from both ‘investment due diligence’ and ‘operational due diligence’ perspectives, with each perspective emphasizing different aspects. Investors should also reflect on whether they’re merely meeting these targets on the surface in their portfolios or genuinely affecting tangible change, such as reducing the carbon footprints of companies they invest in or promoting less harmful technologies and processes.
Presently, many asset managers, across both public and private sectors, have crafted methods to weave climate change considerations into their investment and risk assessment procedures. According to PRI data, half of its members integrate climate-associated risks while evaluating conventional investment risks like credit and market risks. While there’s a growing emphasis on fostering positive climate outcomes in active ownership programs, our latest research shows that just about half of asset management oversight policies specifically address climate-related risks and opportunities.
An intriguing trend we’ve observed is how managers evaluate the financial implications of reducing carbon emissions in companies they invest in. Commonly, they check if a company has set a net-zero goal, its ambition level, and its alignment with Science Based Targets. However, setting targets can be superficial or even counterproductive if they’re not financially feasible. We’re beginning to see strategies that factor in the capital and operational costs needed to genuinely lower a company’s carbon emissions, with an emphasis on accounting for ‘Scope 3’ emissions. Yet, this approach hasn’t gained universal adoption.
The Imperative for Asset Managers to Prioritise Comprehensive ESG Criteria
In today’s investment landscape, asset managers are under increasing pressure to ensure their portfolios reflect responsible and sustainable practices. Central to this is the integration of detailed and expansive Environmental, Social, and Governance (ESG) criteria, with a specific emphasis on embodied carbon calculations and Scope 3 emissions.
Embodied carbon refers to the total carbon emissions generated during the full lifecycle of a product, from raw material extraction to disposal. Scope 3 emissions, on the other hand, encompass all indirect emissions that occur outside of an organisation’s direct control, including those in the supply chain. By assessing these elements, asset managers can gain a more holistic understanding of the environmental impact of their investments.
The risks of neglecting these criteria are manifold. Investing in so-called ‘dirty assets’—those which do not meet stringent ESG standards—poses a threat of both financial and reputational damage. As regulatory environments evolve, such assets are increasingly likely to face sanctions, devaluation, or become stranded. Moreover, there is a growing public and institutional demand for ethical investment, with shareholders and stakeholders becoming more discerning about the sustainability of their investments.
In essence, prioritising a detailed ESG framework, including considerations for embodied carbon and Scope 3 emissions, is no longer a choice but a necessity. For asset managers, it’s crucial not only for the sake of ethical responsibility but also to ensure the longevity, resilience, and credibility of their portfolios in a rapidly changing global market.
Summary of findings
The importance of Environmental, Social, and Governance (ESG) in asset management has grown significantly, and asset managers now navigate through complex data risks, diverse investor sentiments, and varying global regulations. Asset managers operating internationally must continuously adapt to changing regulations. The European Union introduced the Sustainable Finance Disclosure Regulation (SFDR) in March 2021, followed by the Taxonomy Regulation from January 2022. These require firms to classify investment funds based on environmental goals, ensure promotional transparency, and adhere to specific criteria and reporting standards.
Institutional investors face pressures from regulators on greenwashing, with companies like Goldman Sachs Asset Management recently penalised. Regulators’ efforts to introduce clear categorisation have caused debates and led to reclassifications of funds. Nevertheless, independent ESG assessments are vital for informed investment decisions. Many investors have committed to ESG integration, such as carbon reduction. It is essential these commitments are met, with asset management partners’ expertise.
Companies’ depth of ESG policy indicates their sustainability commitment. Many firms have ESG policies, but these differ in thoroughness. While 74% of asset managers address climate change in their policies, only 34% consider biodiversity. Examining firms’ corporate social responsibility (CSR) programmes and Diversity, Equity and Inclusion (DEI) policies provides insights into their ESG commitments. Participation in external sustainability initiatives also indicates firms’ genuine commitment to ESG.
Addressing climate concerns is vital. The financial implications of climate risks are significant and should be integrated into investment strategies. Many investment managers are setting climate-centric goals. However, the success in achieving these varies. It’s crucial to assess whether these goals are superficial or result in real change, such as reducing company carbon footprints. Many asset managers now integrate climate change into their investment strategies, with half considering climate-associated risks alongside traditional investment risks.