The progress of industrial revolutions rarely follows a
neat, linear path. Instead, we typically see periodic spikes of innovation,
prompted by some external factor, followed by the introduction of standardized
manufacturing processes yielding greater productivity and efficiency, and
leading to a step change in industry norms. While images of smoking chimneys
may not immediately resonate with the concept of ESG investment, there are many
parallels. We find ourselves on the cusp of a period of transformation in this
area—specifically in how ESG investment is managed and supported.
The last few years have seen a groundswell of interest in
ESG investment. According to the most recent public report, as of 2018, there was
more than $30.7 trillion in global sustainable assets under management across
five major markets (see figure).
Firms Incorporating ESG Principles; Greater Accountability
Sought
Enthusiasm from investors, buoyed by ESG investment
performance, underscores that it is more than simply “a good thing” from an
ethical perspective, and has drawn increasing focus from the asset management
community on the financial implications. Unsurprisingly, technology firms and
data providers have rushed to meet demand, releasing many new tools and
solutions to the market.
Many financial institutions have made a concerted effort to
incorporate ESG principles into their investment decisions: assessing their
activity, reviewing standards, and increasing their level of reporting in this
area. Many asset management firms have appointed a head of ESG to their
executive management team to lead these efforts.
Beyond the focus on financially material ESG risks and
opportunities, the socially responsible investment movement1 has joined
employee and consumer activism in looking to hold companies accountable for
their impact on the society and the environment, and to reward sustainable
business practices.
Regulations Vary Significantly by Region
Naturally, all of this has brought with it a greater focus
from regulatory bodies, although the response has varied considerably between
the US, UK, and EU. The UK government has put forward proposals to require
occupational pension schemes with £5 billion or more in assets and all
authorized master trusts (there are currently more than 100 such schemes in the
UK) to publish climate risk disclosures by the end of 2022. In the EU, the
European Commission has been working to establish a framework to facilitate
sustainable investment, bringing the Taxonomy Regulation into force in July of
this year.
The most recent publicly available study on the
Non-Financial Reporting Directive from the European Commission uncovered, among
other things, very strong support for common standards (82% of respondents),
strong support for digitalization of non-financial data (64%), and
near-universal concerns about the interaction between different pieces of
sustainability-reporting legislation—only 3% of respondents believe that these
interactions currently work well. This push for standardization is reflected in
the current work on the EU Green Bond Standard, which aims to establish
uniformity in this important area across the EU.
By contrast, in the US, the SEC has yet to mandate ESG
disclosures. In addition, the US Department of Labor’s recently published
proposal around ESG disclosures indicates that the Employee Retirement Income
Security Act (ERISA) plan fiduciaries’ main responsibility should be to employ
an investment strategy that is designed to achieve the best financial outcome
for plan members. If an ESG-driven strategy is being employed, plan fiduciaries
may have to justify that it is expected to be a higher-returning strategy, or a
lower-risk one, such that the plan members’ financial position is not being
compromised for the purpose of non-financial objectives.
Oversight Is Essential
This picture of the ‘industrialization’ of ESG investing is
complex and evolving rapidly. What is clear, and seems to be the consensus
among affected firms, is that they can no longer act in this space and
attribute their efforts to generalized ESG principles, without oversight: the
formerly “wild west” nature of the ESG landscape is becoming regulated, and
asset managers need to be prepared to act accordingly.
We hear and see that asset owners are increasingly
scrutinizing their ESG investments, wanting more in the way of reporting,
meaningful impact, and alignment with existing ESG standards and market best
practices.
However, the divergence in regulations globally is
challenging. There are differing standards for voluntary ESG disclosures—from
the Sustainability Accounting Standards Board to the Global Reporting
Initiative, the Carbon Disclosure Project in the UK, and the U.N. Global
Compact—all with different requirements and principles around application and
understanding of what the standards should be. Unsurprisingly, this leads to
challenges for asset managers who are looking to manage their funds and client
portfolios to these disparate standards.
Recently, the International Organization of Securities
Commissions announced a task force that will look for “commonalities” among the
various global standards to create a “more cohesive, more transparent …
standardized” form of ESG disclosures.
Inconsistent ESG Ratings Present Another Challenge
Layered on top of this is the diverse landscape of ESG
ratings and assessments. There are many ESG rating providers, measuring
different things, so ESG ratings do not always correlate well with each other.
This makes it difficult for asset managers to know which ESG factors to look
for and, consequently, which ESG ratings to use. In a recent survey of asset
managers, we conducted in conjunction with Pensions & Investments, 71% of
respondents said they were currently unable to view the performance attribution
of ESG investment factors—despite wide industry desire for this type of
information.
The market is calling for the creation of one global language
for ESG. But this is by no means straightforward or quick to achieve. What’s
required to manage this complex and evolving landscape are agile and flexible
tools, which can adapt easily to changing data sources, standards, and
reporting mechanisms. Those solutions that are able to draw in many and varied
forms of data and present a single view, and those that accurately piece
together a previously fragmented picture in a consistent way to deliver
actionable insights, will be the ones that move the industry forward as ESG
moves towards its more standardized future.
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