Having talked up environmental, social and governance (ESG) factors for some time, the asset management industry has really started to incorporate them in what they do over the past few years. Product launches and innovation have been considerable, and flows into these funds have been impressive (see View from Morningstar opposite).
“ESG was a gradual movement until five years ago, when it started exploding,” says Henrik Pontzen, head of ESG at Union Investment.
Hotter summers and the refugee crisis have led investors to believe they need to take a longer term perspective, he explains. “And there is the fundamental conviction that adding ecological, decision and corporate governance analysis is adding value and quality to your investment decisions.”
The firm took a strategic decision to reorganise portfolio management, make ESG integration a key consideration across all asset classes, and set up a research and investment strategy department. There were five people in his department when Mr Pontzen joined Union three years ago; now there are 18.
“I would say one common misunderstanding is to see ESG as thematic investing,” he says. “It’s not. It’s more a kind of investing philosophy. It’s more a style.”
Nothing new
Bottom-up, long-only investors who are trying to buy into and own a business for the long term should always have cared about its sustainability practice, says Luke Barrs, head of fundamental equity client portfolio management for Emea and Asia ex-Japan at Goldman Sachs Asset Management.
“If you went back 15 or 20 years, the emphasis you were putting on assessing sustainability of practice was around governance,” he explains. “That was the bit that you could vet most clearly and could then make a determination that with very strong and sound governance, there’s a higher likelihood of sound, environmental and social practice.”
Back then, investors lacked access to data that would have helped pinpoint specific material, environmental and social issues. While data science has since improved, this is a “very low” bar to clear.
Mr Barrs does not see ESG as a distinct investment discipline, rather a way of enhancing core investment research. “How we vet the sustainability of a business needs to be subjective, it needs to be informed by research and it needs to sit in the hands of analysts. What we really don’t want to do — and what we’ve adamantly avoided doing — is try to quantify ESG practice into a rating based off the available data, which is sometimes lacking in quality and quantity.
“It’s not academically obvious how you can bring all of that together into a statement,” he continues. “‘Good ESG’ versus ‘bad ESG’ means we want to keep this as a subjective discipline.”
When a credit rating agency such as Fitch or Moody’s provides a rating, you tend to see high correlations between them, says Mr Barr, typically around 0.98 or 0.99. “We can have a discussion around whether there’s a herding mentality within that industry — I think probably a little bit in the margin there is. But the reason you get such high correlation is because there’s an academic basis for how you assess credit worthiness,” he claims.
Yet the situation is very different when it comes to rating ESG, where the major providers have correlations around 0.4 or 0.5. “Our conclusion is that is not that one of those has solved it perfectly, and the others just haven’t yet, but it’s to say that there’s too much ambiguity in terms of what is material. How do you find that in a world where data and information are limited?”
He gives the example of carbon emissions, where it is now possible to find out the carbon emissions for “pretty much every single company on earth”, yet only “25 to 30 per cent of companies are actually reporting on this data”. A huge amount is therefore estimated, while much of what is reported is potentially out of date. “It is useful as a starting point, but you shouldn’t just be dependent on what this data is telling you.”
Data analysis
Although there is a plethora of third parties offering ESG ratings, many asset managers prefer to do this work in-house. “We don’t think you can do the fundamental analysis and the ESG analysis separately,” says Louis Florentin-Lee, portfolio manager of the Lazard Global Sustainable Equity Fund. “To understand both, you have to have the same person doing them. And when you plot an ESG score from one third-party provider against a second, the scatter plot is almost random.”
The Lazard fund is looking for companies offering products and services that are helping to solve the world’s sustainability problems, and which must also support or improve the company’s financial productivity. The companies must also run their own resources in a responsible way.
This means that large parts of the market are a no-go. “There are hard restrictions, like oil, tobacco or mining; but, for example, we don’t own renewable energy companies, because the returns on capital for those businesses are effectively regulated,” he explains. “So, they’re never going to meet our criteria of being very high return on capital business, or dramatically improving the capital business, because they won’t meet the standards we look for.”
Valuations are something to consider, says Mr Florentin-Lee, explaining how in 2020 and 2021, as the ESG story gained momentum, many “in vogue” stock prices reached “extraordinary valuations”. However, he reports that many of these equities have now pulled back and are starting to look attractive again.
Although investor pressure has undoubtedly prompted the asset management industry to demonstrate its sustainability credentials, the arrival of new regulations has accelerated and formalised the movement, especially in Europe. The Sustainable Finance Disclosure Regulation (SFDR) entered into force in December 2019 and started to apply across the EU from March 2021, while the new taxonomy regulation has been brought in to define ‘sustainable’ investment and to avoid greenwashing.
These new directives have led to growth, says My-Linh Ngo, head of ESG investment at BlueBay Asset Management. “The industry was left to self-regulate, but the pace had been too slow; now that we have the scale and urgency of systemic risks, like climate change, the regulators are saying ‘actually, it’s not enough. It’s not going in the right way.’”
But despite the good intentions, she warns that regulation is a “very blunt instrument” and that in some cases, authorities could “actually undermine” what they are trying to achieve.
“There’s an underlying assumption that what is ESG and what is not is ‘black and white’. But, fundamentally, what they are trying to regulate and define is actually a spectrum of very valid, legitimate, ways to incorporate non-financial factors and considerations into the investment process. It’s not one way or the other, there’s no right or wrong.”
This is why disclosure and transparency are so important, she believes, as this allows investors, who may have very different ideas about what kind of sustainability approach they wish to take, can make an informed decision. SFDR has been trying to address this, reports Ms Ngo, but “it’s been subverted into people thinking it’s a label”.
Another issue, she claims, is that by its very nature, regulation is always “backwards looking” and this is a very fast-moving sector.
“You need to get the balance and not be too prescriptive, and allow for innovation,” says Ms Ngo.
“But then if you’re not prescriptive enough, people can circumvent the rules. So where do you find that balance?”
Away from equities
Although much of the early ESG running took place in the world of equities, fixed income has been making progress as well. Yoshie Phillips, director of ESG investment research at Russell Investments first got involved in ESG back in 2014 because of specific client demand for green bonds, but has since seen it expand far further into the fixed-income universe.
“The corporate credit bond market was the first to integrate ESG, which is understandable because corporate bonds are closest to equity. And so, the information available on the equity side can be translated into fixed income,” she explains, though cautions that other parts of the universe face more challenges than others. Sovereign bonds, for example, tend to have a much bigger time lag for reporting data, while you must also consider factors such as politics and regime changes.
Regulators are trying to bring in standardisation and improve disclosure, reports Ms Phillips, which is a positive step. Although she stresses there is still a long way to go, she is optimistic this will lead to a better world.
“A few years ago, some people were sceptical about ESG integration because they saw it as restrictive. Investors wanted flexibility and the freedom to deliver performance, and anything that limited that was unpopular. But now there is a new appreciation of what ESG integration is all about.”
The search for yield has been pushing investors into private markets, yet ESG disclosure and data have not been as advanced in this part of the market as they are in public ones. “Public equities and credit have received a great deal of investor focus and media attention when it comes to incorporating ESG considerations,” says Steve McGoohan, managing director of private markets at Federated Hermes.
“But less is said about private markets and the vital work they can do in the name of sustainable wealth creation. Private market investing creates many opportunities to influence positive change.”
When compared to traditional engagement with listed companies, private equity affords investors a greater amount of direct influence and control over a given company’s operations, he claims, meaning they can drive real change. Investors also tend to get access to companies at an earlier stage of development, allowing them pure play access and a more targeted approach.
But one issue for investors in private markets is the lack of shared and standardised ESG data. Third-party providers are not active in this space, says Mr McGoohan, meaning fundamental, bottom-up research is required.
There is no doubt that the financial services industry has at last got serious about ESG, but is all of this actually having an impact and helping to provide answers to the myriad challenges facing the world today?
Mr Pontzen at Union Investment believes it is and will continue to do so. “I would say the financial industry can only play a very indirect role, because we can do nothing else but provide capital. Even though this route is very indirect, it’s very powerful. Because we allocate more money where we see a better and more sustainable future and we allocate less where we see an unsustainable future comes along with more risks.”
High-tech data solutions
Investor interest and regulatory demand for sustainability data have led to several providers offering this information on a third-party basis.
One such firm is Clarity AI — while it points out it is a technology company, not a rating agency, it is one that provides clients the capability to measure the sustainability dimensions of their investment portfolios. The firm uses machine learning algorithms and big data to deliver these insights.
“Data is a challenge for different reasons,” says Patricia Pina, head of product research and innovation at Clarity AI. “In terms of quantity, not all companies report the data we would like in order to make these assessments, and even if they do, they might not be reporting all the relevant metrics.”
The firm leverages machine learning techniques to build estimation models by combining the available data on a company with information taken from comparable companies. It is important that clients know they are dealing with estimates though, and are aware of the potential drawbacks.
Quality is also an issue, with errors and a lack of complete data being commonplace. “We have built reliability algorithms that do different checks on whether the data is reliable and of good quality. We also gather the data from different sources, so we have multiple providers for the same data points.”
The next challenge is then to be able to integrate these tools into clients’ existing systems in order for it to be of use in their decision-making process.
VIEW FROM MORNINGSTAR: Passive funds proliferate
The past 18 months have seen a proliferation of passive funds tracking the newly created EU Climate Benchmarks. As of April 1, 2022, Morningstar has identified 57 index funds or ETFs domiciled in Europe that track either the Paris-Aligned Benchmark (PAB) or the Climate-Transition Benchmark (CTB). Roughly 90 per cent of these products are classified as article 9 funds under SFDR and all but three are equity-focused strategies.
Thirty of these funds were launched in 2021 alone, while others are the result of conversions. For instance, Blackrock switched six of its enhanced ETFs (totalling a whopping $9bn) into CTB products in December 2021. Amundi made a similar move as recently as last month, repurposing €13bn ($14bn) of ex-fossil fuel ETFs into nine PAB and four CTB offerings.
The Paris-Aligned and Climate Transition benchmarks were introduced by the European regulator for three reasons. First, to improve transparency and comparability among indexes with explicit climate-transition goals; second, for the creation of investment products; and finally, to help fight greenwashing by substantiating the claims of carbon reduction and transition towards a climate-resilient economy made by funds tracking climate indexes.
The two benchmarks were designed to consider both climate risk mitigation and investment opportunity-seeking while ensuring a yearly decarbonisation target of at least 7 per cent, in line with the decarbonisation trajectory of the IPCC 1.5˚C scenario. Paris-Aligned benchmarks, however, take a stricter approach than Climate-Transition benchmarks. Most notably, PABs have a higher threshold for scope 1, 2 and 3 carbon intensity reduction versus the standard investable universe (50 per cent, compared with 30 per cent for CTBs). They also employ additional activity exclusions on high-emitting fossil fuels and electricity producers.
PABs and CTBs provide broad and diversified exposure to the market. They are therefore suitable as part of a portfolio core allocation holdings for climate-conscious investors.
The proliferation of CBT and PAB passive offerings has however spurred a debate on whether these products efficiently help with the climate transition given their broad market exposure and limited involvement in transitioning industries. This is particularly the case for PABs which exclude companies involved in the most carbon-intensive sectors that are also the most in need to transition.
While the debate is still raging within the investment community, there is no question that CTB and PAB funds are useful investment tools that can help orient financing towards low-carbon emitters and providers of climate-resilient products and services.
In addition, passive CTB and PAB products accommodate the investment needs of climate-conscious investors at a very affordable price. While PAB funds are more suited for investors who want to benefit from the opportunities offered by the climate transition, CBT funds are a better choice for investors who simply want to protect their portfolios against climate change risks while tracking the pace of transition towards a low carbon economy.
Samiya Jmili, lead sustainability and ESG analyst at Morningstar
