Appetite for environmental, social, and governance (ESG) funds has never been higher. Inflows exceeded $180 billion in the first quarter of 2021 – equal to the whole of 2019 – and, according to some estimates, ESG funds are set to outnumber conventional ones by 2025. A forum of industry leaders looks at how the market for ESG investing is evolving, discusses the current challenges and evaluates the latest tools and methodologies for managing ESG risk
- Jaspreet Duhra, Managing Director, Global Head of ESG Indices, S&P Dow Jones Indices
- Peter Plochan, Principal Business Solutions Manager, Risk Presales, SAS
- Mike Chen, Head of Sustainable Investments, PanAgora Asset Management
- Dimitri Senik, Investment Committee Member, PwC Switzerland Pension Fund
- Dr Steffen Hörter, Head of ESG, Munich Re Investment Partners
- Bruno Bertocci, Managing Director, UBS Asset Management
Does there need to be more corporate disclosure on firms’ ESG goals and criteria and, if so, what form should this take?
Peter Plochan, SAS: Over the past couple of years, we have seen some positive development in the uptake of disclosures by companies globally – the Task Force on Climate-related Financial Disclosures (TCFD) being one of the emerging standards within an accelerating trend. This is supported by some jurisdictions that are making this mandatory. So, first, I would like to see everyone joining a standard. At this time, it is difficult to obtain even such relatively simple information as the carbon footprint of a company. For example, in SAS’s recent climate risk webinar, a chief risk officer (CRO) from a global systemically important bank said they were able to collect carbon footprint data for only 17% of their corporate portfolio. For the rest, they had to use proxies. The second question this CRO raised was, even if we can collect the data, can we trust and understand what is behind it? The TCFD has also done a good job of providing the first hints on standardisation of the measures that companies put into their reports. I am confident that, in the next year or two, we will see more initiatives like this that will improve transparency and comparability.
Jaspreet Duhra, S&P Dow Jones Indices (S&P DJI): In the 20 years we have been using ESG data in our indices, we have seen a notable uptick in disclosure from companies. In part, it’s due to regulation; for instance, the European Union’s Non-Financial Reporting Directive requires companies to disclose on a number of ESG topics. This is just one of many global initiatives that recommend disclosure of non-financial metrics from companies. In part, it is due to investors and data providers such as S&P Global asking companies questions pertaining to ESG metrics.
Despite this, there are still notable data gaps and, yes, we would like to see more corporate disclosure. The more data we have, the better the ESG analysis we can use in our indices. However, ideally, this data should be consistent, comparable, verified, and so on.
S&P Global ESG Scores form the foundation for the ESG scores we use in our indices. As part of the data collection process, S&P Global is looking at information in the public domain, but also considers information submitted from companies in response to questionnaires, enabling S&P Global to form a richer understanding of the companies’ ESG profiles. In turn, this can potentially lead to better public disclosures as companies may begin to report on ESG issues if they see these issues attracting investor interest.
We also have ways to tackle data gap challenges. For instance, we use S&P Global Trucost data for climate metrics. Trucost has developed modelling techniques to fill in the gaps where data from companies may be lacking in metrics such as carbon footprints.
Mike Chen, PanAgora Asset Management: ESG disclosure and ESG data are huge challenges. They have improved over the years, but there is still so much confusion right now. The lack of common standards is a serious impediment to the development of the field.
PanAgora and Google Research recently completed a study that found that the more ESG data a firm discloses, the better ESG commercial rating they tend to get, even if the underlying data does not state the case. A lot of ESG ratings are tick-box exercises on whether a firm has a given policy – and these are categorical rather than numerical. So there is a cognitive bias here. But it is to a firm’s advantage to publish as much ESG data as it can. Hopefully there will be a centralised data repository or standardisation in the future, where ESG data could be disclosed in the same way as accounting standard data.
Steffen Hörter, Munich Re Investment Partners: Despite numerous voluntary and regulatory ESG efforts, corporate ESG disclosure still needs to be advanced globally. As an investor, what I need are the right ESG key performance indicators (KPIs), not more quantity. But materiality of ESG KPIs is industry-contingent. So qualitative context is required to understand quantitative ESG KPIs. For example, I am keen to understand the forward development of a corporate’s ESG programme and how it has integrated sustainability into its business growth strategy. I’d also like to understand which ESG KPIs are considered relevant and what capital expenditure and research and development they invest into those. I also want to know what ESG risk management practices they apply and how they mitigate adverse sustainability footprints, as well as other business controversies.
Preferably, quantitative ESG KPIs would be standardised, electronically accessible, machine-readable and clearly mapped to a corporate issuer identifier. They would be structured to reflect business activities, using internationally accepted industry classification codes. I would expect them to be linked to financial metrics and integrated into International Financial Reporting Standards (IFRS). And, ideally, ESG KPIs would be submitted directly from the corporate source.
Bruno Bertocci, UBS Asset Management: Everybody is calling for more disclosure. As asset managers we need consistent, standardised disclosure. There is currently a huge amount of less structured disclosure, with information we cannot use. But I think the formation of a new value reporting initiative from IFRS, the International Sustainability Standards Board (ISSB), will lead to a global framework of standardised ESG disclosure. This is something regulators are looking for as well. The Norwalk agreement between the Financial Accounting Standards Board and the London-based International Accounting Standards Board in 2002 eventually led to a standardised global framework for accounting data, which is a good model for the effort to standardise sustainability data.
How can the industry move towards greater standardisation of ESG criteria when it is such a subjective topic?
Jaspreet Duhra: There are plenty of grey areas when it comes to ESG and sustainability. There are some topics that are less subjective – such as governance, and health and safety. Counting women on the board or the number of accidents should be straightforward but, even in these areas, there is subjectivity. For example, what percentage of the board should be women? Should this percentage be reflective of the workforce or the broader population? What is a poor accident rate? Are sick days due to work-related stress accounted for? Once you start looking at the details, it is easy to understand why ESG scoring providers end up with different assessments. However, there may be some straightforward metrics that all companies should be able to disclose, and there are initiatives in progress to encourage consistent disclosure. For instance, the IFRS Foundation is working to develop a unified framework of consistent comparable company sustainability disclosure requirements.
More broadly, users of ESG data may want to consider what their goal is when it comes to ESG assessments. Is it to understand how companies will be impacted by ESG issues? Or how a company is impacting the world and society? Are users satisfied with a rating that assesses a company’s direct operations only or do they also want to understand the impacts of the products produced? There are numerous angles to think about, which can make it a challenge to create a standardised approach.
In addition, there is the simple fact that people have different opinions when it comes to ESG values. For instance, is involvement in military contracting a controversial business activity that needs to be screened out of an ESG fund or are these companies providing an essential service to allow national defences to function?
Ultimately, ESG is difficult to outsource and standardise. Engaged, responsible investors will need to take time to understand methodologies and philosophies when deciding how to incorporate ESG.
Peter Plochan: Taking the carbon footprint calculation example, there is a lot of latitude for subjective and expert-based assumptions, particularly in scope 3 emissions, which capture indirect emissions within a company’s value chain. This is very industry- and company-product-specific, and requires a very granular approach and methodology. And, as we see more and more jurisdictions and investors requiring companies to produce mandatory ESG disclosures, the need for standardisation and comparability increases. The TCFD has worked well in starting this but, as it is industry-generic, it has limitations. Therefore, each industry has an important role to play in this.
For example, a year ago, we saw the Partnership for Carbon Accounting Financials publish the Global Greenhouse Gas Protocol Corporate Accounting and Reporting Standard for the financial industry, which provides a standardised methodology for carbon footprint calculation focusing on scope 3 financial portfolios. What started as the initiative of a small number of Dutch financial institutions has now turned into a standard that has been adopted by more than 250 institutions worldwide. The point is that key industry players should not be waiting until somebody defines this for them; they should be actively involved and driving this standardisation.
Mike Chen: Studies have shown vast disparities among ESG ratings because people have different approaches to what constitutes ESG, what data you can use to verify it and how you should measure it.
ESG is values-based investing, and different companies care about different things. Some companies care about the same things, such as climate change, where there are some commonly agreed-upon main ESG criteria. And the main quantitative data can be standardised for cut-and-dried elements, such as carbon and water. Things like gender, ethnic/racial and age composition of companies, independent boards and incentive alignment can also be standardised.
But, some companies want to disclose relatively esoteric items. These might be relevant to their own operations or things their investor-base cares about. And there are many questions around corporate culture, for example, that are more qualitative and not easily quantifiable. For that kind of information, utilising our natural language processing capabilities we seek to assess these aspects so they may be disclosed in both tabular and textual formats.
Steffen Hörter: When it comes to corporate disclosure, the recent creation of the ISSB by the IFRS is a promising step. This consolidates important groundwork from such organisations as the Sustainability Accounting Standards Board (SASB) and will focus on financially material ESG KPIs. Moreover, from an EU perspective, the new Corporate Sustainable Reporting Directive will help to shape sustainability reporting standards.
In tandem with financially relevant ESG KPIs, the EU’s dual sustainability risk approach requires metrics on the adverse environmental and social footprint. This new requirement aims for corporate transparency in this area. And then there is the holy grail of ESG standardisation, the EU Sustainability Taxonomy – a powerful, impact-driven approach to sustainability that evaluates business activities and investment funds. This is relatively complex and rigid, but corporates should expect it to gain traction.
I don’t think harmonisation of corporate issuer ESG ratings is necessary. As much as sell-side stock recommendations vary, there is value in having different ESG rating approaches. However, we do need qualitatively reliable ESG ratings and transparent methodologies for investment decision-making. To this end, granular ESG KPIs are more relevant than aggregated ESG ratings.
Dimitri Senik, PwC Switzerland Pension Fund: There is a perception that ESG is something very customised and unique for every investor. But the topic is not subjective per se. It’s just that some investors have preferences for some specific ESG factors or elements. And it is a very broad topic because you need to look at the E, the S and the G. And, within each of those, you have a variety of criteria that need to be established.
When investors select specific stocks or issuers for their ESG portfolios, they will probably be applying the same criteria, such as exposure to controversial industry sectors, norm violations and climate impact, on the environmental side. But it’s like any investment strategy: you might have some common definitions, but the implementation will be different. So, the set of criteria can be standardised, but the way individual managers or ratings providers will be weighting those criteria will probably be different.
Bruno Bertocci: The focus on materiality is key. There is a core set of indicators initially identified and delineated by the SASB. These use a materiality framework that carries over to the current ISSB effort. The TCFD provides a very good global approach that is being taken up by regulators. The ESG Technical Committee for the Chartered Financial Analyst (CFA) Institute has created an ESG product disclosure framework, which is a very good start for a global standard.
If a standard is focused on material indicators, I think disclosure will be highly encouraged, if not mandated, by regulators. And, with a framework that is aligned with what we’re used to seeing in the field of financial disclosure, investors will be well on their way towards standardisation.
How can asset managers know that a particular ESG portfolio meets the variety of expectations ESG investors may have?
Mike Chen: First, investment managers must be transparent with asset owners about how they derive the ESG portfolio. And they must disclose how the portfolio measures the ESG metrics that their portfolios target.
But every manager builds their portfolio to different benchmarks and ESG criteria, and each of them discloses different types of ESG reports. So, in addition to our report showing the portfolio versus our own ‘secret sauce’, we produce another report to demonstrate how the portfolio measures against a standard commercial ratings benchmark, such as MSCI. And we suggest asset owners ask each of their managers to generate this type of report so they can compare them.
Steffen Hörter: Getting a full understanding of the institutional investor’s ESG and financial investment objectives, policies, constraints and portfolio legacy is paramount. To align the portfolio to these, investment managers should seek to identify the investor’s exclusion criteria and whether they aspire to specific sustainability outcomes or favour optimising specific portfolio ESG KPIs. ESG goals need to be clearly documented and regularly reviewed in meetings with investors and supported by focused ESG fund reports.
For ESG mutual funds, it’s a bit trickier. Investor preferences differ and these funds cannot be customised to meet all of these. So these funds aim to meet the ‘average’ ESG preferences of investors. One way to approach this challenge is to make a fund comply with a specific, independent ESG label or provide better ESG transparency. The EU Sustainable Finance Disclosure Regulation (SFDR) sets minimum product disclosure for ESG characteristics and impact funds.
Dimitri Senik: Asset managers need to talk to prospective investors before launching an ESG product, such as a pooled mutual fund. Otherwise, it won’t necessarily be aligned with the expectations of the potential target group. For example, Switzerland has regulatory fiduciary duties that pension funds must comply with. Often when asset managers offer an ESG investment product, they only highlight the ESG parameters and features. But they fail to demonstrate that this product does not impair our fiduciary duties, for example, in terms of the expected impact of the ESG investment decisions on returns, risk, liquidity, and so forth. They need to understand the regulatory environment, and the duties and requirements investors need to fulfil in their target markets. And then they need to align their message with those local requirements.
Bruno Bertocci: There will not be consistent agreement across the entire market about the sustainability of portfolios. For example, some investors will consider a portfolio green enough if it includes the traditional energy companies that are transitioning to a clean profile. Some will not. The marketplace accepts a certain amount of cognitive dissonance in other areas, and there will always be some here too. However, transparency and a common understanding of the criteria that drive the portfolio construction decision-making are key. Right now, that’s very challenging because we don’t have the uniform, comparative set of disclosures we have in other areas. The CFA product-labelling standards encourage this, and I think other efforts such as SFDR will similarly help investors enable better comparability.
Peter Plochan: ESG investors are much more sensitive to qualitative information than traditional performance-driven investors. The standardisation previously discussed, in combination with transparency, will be the key here. Simply put, the more ESG information disclosed, the better picture investors can get. For example, once the EU’s Green Taxonomy and Green Asset Ratio reporting frameworks go live next year, it will be easier to compare different financial portfolios and assess how green they are. In the current setup, where one way of doing this has not yet been established, it might be worthwhile for asset managers to disclose information according to the variety of ESG reporting frameworks. Disclosing a little too much will definitely be better than disclosing too little.
Jaspreet Duhra: It is important to note that S&P DJI is not an asset manager or investment adviser. In general, the asset manager will need to take the time to understand the ESG expectations of the investor. It would also be best practice for regular reporting to be provided to clients on how the portfolio is performing against ESG metrics alongside any stewardship activities that may be undertaken by the asset manager. We understand investors have different appetites and objectives when it comes to ESG. Some are looking for core benchmarks with an ESG overlay that seek to maintain a low tracking error versus the parent index. Other investors may be willing to accept potentially higher tracking errors, but want to see heightened attention to ESG considerations.
As a benchmark provider, we are transparent about the way we construct indices; all methodologies are published on our website and a range of supporting content is produced discussing the methodologies of key ESG data inputs.
When allocating assets to an ESG portfolio, how can a portfolio manager measure the full environmental and societal impact of those assets given that they are part of a complex supply chain?
Jaspreet Duhra: Constructing an ESG rating for a company is an incredibly complex process. In some cases, up to 1,000 data points may be collected per company and then analysed by industry ESG experts. This detailed research and analysis needs to be replicated for thousands of companies globally – an arduous and time-consuming task.
Although some pragmatism is necessary when it comes to how deep a rating can go into second- or third-tier supply chains, ESG ratings can look beyond the direct operations of companies. They can take into account supply chain policies and, increasingly, the impacts of the end use of the company’s products.
Mike Chen: When it comes to supply chains, investors are really constrained by data. For example, we know there are a lot of human rights violations by cotton suppliers in certain parts of the world, but there is no real data to substantiate this. Although it is inadequate as a solution, it is now best practice to monitor news sources and flag companies that source from unethical suppliers. The onus should be on companies to do more and be more aware, but we are doing what we can.
From an environmental perspective, scope 1 and 2 emissions are relatively easy to measure but, when it comes to supply chain – in effect, scope 3 emissions – people are forced to make hundreds of assumptions and get wildly different figures, so we don’t include those.
There are very significant data gaps for investment managers and anyone in the industry in terms of disclosure involving supply chains. And this is something governments should probably provide guidelines on.
Peter Plochan: Looking back at the recent 2021 UN Climate Change Conference (COP26) held in Glasgow and the recently formed Glasgow Financial Alliance for Net Zero, more than 450 financial institutions committed to full decarbonisation of their portfolios (net zero) by 2050. With aggressive targets for 2030, and with new institutions joining almost every day, there is going to be a tremendous push on assets in their portfolios to become greener. There are many roads that lead to ‘net-zero Rome’, and each will have a different risk/return profile. The challenge lies in finding the optimal one that will enable you to achieve net zero by 2050, with the lowest risks and highest returns along the way.
To identify this optimal pathway, portfolio managers will need to collect more data and do more forward-looking portfolio analytics – get smarter and better at simulating the impact of their portfolio choices on portfolio KPIs and key risk indicators that, from now on, need to also include carbon footprint indicators. This includes running more simulations with multiple alternative asset allocation mixes over longer time periods (until 2050), under multiple scenarios and with alternative business and modelling assumptions. Having done their maths, portfolio managers can then make smarter portfolio allocation decisions backed by analytical evidence, and maximise their returns while meeting their carbon reduction targets and minimising the risks.
Dimitri Senik: Right now, it is not possible to measure the full environmental and societal impact. A lot of progress has been made measuring impact in the climate area. However, although we can reliably measure scope 1 and 2 carbon dioxide emissions, scope 3 is a model-based calculation for emissions from the whole supply chain, and you can’t reliably measure that, let alone other environmental and societal impacts. We don’t really have reliable measurement processes for such metrics because of the lack of or poor reliability of the underlying data. When the depth and transparency of corporate disclosures improves and issuers start publishing detailed statistics about how their businesses impact climate, pollution, water, diversity and other societal matters, then that information can be transferred into the investment management process.
Bruno Bertocci: Impact investing has come through to equities and fixed income from the private equity side, where it is much easier to measure. This is a very complicated area that is under development, with no standards really set yet for measurement. But, according to the CFA Institute product labelling framework, managers must disclose how they will achieve their stated objectives, as well as measure and evaluate them. For example, it is incumbent on the manager to do this for funds designated as article 9 under SFDR, where objectives have been set. According to the Global Impact Investing Network, an impact strategy must have the key attributes of intentionality, measurability, verifiability and additionality. Additionality comes primarily through engagement with the issuer, as it does in the private equity space. This is certainly the bleeding, cutting edge of the field but, with so much focus on it, I do think this will come together.
The simplest methodologies – for example, those that screen out certain stocks – are the easiest to communicate and understand, but not necessarily the most effective in making true ESG progress. However, the more complex methodologies risk curbing liquidity. How can asset allocators navigate this dilemma and which direction do you see things moving in?
Steffen Hörter: Sustainable investing is moving from negative screening to ESG integration and, ultimately, to delivering positive environmental and social impact outcomes. I see impact investing as the final and decisive approach aiming to shift the ESG needle towards measurable progress for people and the planet.
Often, impact investments are project-driven. And, while these investments focus on better, measurable sustainability outcomes, they usually come with a period of financial lock-in and illiquidity. The upside of such impact investments is that – depending on risk profile – they can provide stable cashflows and serve as liability matching assets. So, they can be a substitute for low- and negative-yield bonds.
The challenge is in scaling impact investments, especially in emerging markets. Green bonds offer a middle ground, where corporates commit to allocating bond proceeds for a ring-fenced project to achieve positive improvement of defined environmental KPIs.
Dimitri Senik: Divesting decreases the demand for the specific security. So, in the long run, there will be less capital allocation, which leads to increased cost of capital for issuers. However, the real impact of this strategy is very limited.
Impact investments are an example of more complex ESG investment methodologies that risk curbing liquidity. They are less liquid because they tend to be in the private markets. But there are also liquid products that have much better impact than simple exclusions. For example, there are ESG integration or best-in-class ESG strategies that involve overweighting good-performing ESG stocks and underweighting lower-performing ones. And investors can achieve much more through engagement with issuers than through exclusions.
Peter Plochan: At the time of writing, the leading financial institutions are setting up products and frameworks that will help their counterparties transition towards net zero. Green loans and green bonds are just examples of where ‘exclusion’ can be turned into a new products and opportunities. In the end, it will be up to each institution’s net-zero strategy as to how they want to get there with how much exclusion and how much assistance with transition they want to do.
Bruno Bertocci: Exclusion criteria are usually something that clients mandate. Or managers might adopt them as part of client requirements for a pooled vehicle. It is often up to the asset owner to specify any exclusions. At this point, people are much more concerned about what investors own rather than what they exclude. For example, nowadays, who wants to invest in controversial weapons?
And there are many regional and individual differences. For example, French portfolios often include nuclear utilities and German ones exclude them. And faith-based investors have their own set of exclusions. If clients expand the list of exclusions significantly, they can eventually make the portfolio difficult to construct. But, in general, the exclusions that investors want are quite limited and can easily be built into diversified portfolios.
Mike Chen: Exclusions make sense for certain investors. For example, there are certain things that an Islamic or Catholic investor just cannot have in their portfolio. However, from an alpha perspective, exclusion is a very crude approach. It focuses on risk management, whereas so much of ESG is really a glimpse into how well a company is run. The world of ESG investing has become more sophisticated, and I think inclusion or integration approaches will be the predominant approaches going forward.
In an integration approach, the aim is to invest in companies that are responsible and can also add alpha. Here, investors consider ESG another criteria by which to judge how well a company is run. And liquidity is one of those criteria that we consider, along with other risks, when building an ESG portfolio.
How do you see the use of ESG derivatives for managing ESG risk growing?
Bruno Bertocci: If you include ESG exchange-traded funds in the discussion, I think they serve a real purpose in terms of getting exposure to factors or themes such as diversity or clean energy.
There are a variety of methodologies to offset carbon exposures and portfolios, and some debate as to whether all of those achieve real-world objectives. That said, there are various offsets within carbon-related structures that will prove useful to portfolio constructors in managing the carbon footprint. If they have a bona fide engagement strategy with the issuers, then they can credibly talk about the carbon footprint of the total portfolio from a holistic viewpoint.
Mike Chen: We’re not in the best position to opine on that as we don’t use derivatives in our ESG portfolios.
Steffen Hörter: At Munich Re Investment Partners, we think ESG derivatives offer various opportunities for ESG investing, which has been defined thus far by long, cash equity and fixed income strategies. For example, ESG derivatives can be used for price discovery. More specifically, ESG index derivatives can provide efficient access and exposure to ESG-related asset classes for investors. Furthermore, asset owners and investment managers can use ESG derivatives as ESG policy-consistent hedging instruments. Overall, ESG derivatives can contribute to flexible, cost-efficient portfolios and ESG-compliant investment management.
Dimitri Senik: My understanding is that there are essentially two types of ESG derivatives. The first kind are just pure ESG-related structured products, with a basket of exposures to issuers or stocks based on specific ESG criteria. These are easier to bring to market than pooled funds, which often have specific regulatory or diversification requirements. Instead, investors can design the product’s structure, investing in a few specific stocks that give them the desired ESG performance.
The second kind of ESG derivatives are linked to the credit risk of specific issuers. These are typically linked to fixed income instruments with specific ESG parameters, where, for instance, the interest rate is variable depending on the issuer fulfilling some ESG KPIs. The issuer can hedge that ESG-related interest rate risk by issuing a derivative, such as a credit default swap. Essentially, this is transferring the ESG-related risk to other investors. Issuers that hedge ESG risks must evaluate this area very carefully, and there needs to be a lot of transparency to understand the impact. Otherwise, investors in their bonds could potentially be contributing much less in terms of ESG than they think. Also, the reported volume of ESG investments may become inflated.
The panellists’ responses to our questionnaire are made in a personal capacity, and the views expressed herein do not necessarily reflect or represent the views of their employing institutions
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