ESG – Progress and Pitfalls

By Seymour Banks, INDOS Financial Limited

Published: 14 June 2019

Environmental, Social and Governance (ESG), three words with wide ranging definitions, interpretations and impact in the eyes of investors, regulators, governments and investment managers, have been thrust into the spotlight during the past 18 months, having previously existed in the shadows of bespoke funds and niche investments.

The increased visibility of ESG within the financial sector is due to many reasons. In part, it is the result of influential supporters acting as disruptors in otherwise tried and tested fields of asset management. In a recent speech by the Bank of England Governor, Mark Carney, titled “A transition in Thinking and Action”, the Governor set out the wider systemic risk that can occur to the financial system due to the events of uncontrolled and unmitigated climate change. At the same time the prominent investment group, BlackRock, is now championing the integration of ESG investing into the mainstream market with the launch of six, highly publicized, ESG exchange traded funds. The Bank of England Governor and Blackrock have both set a trajectory of how they envision ESG will impact the financial world and the need to be proactive in its adoption to ensure success and survival.

Regulatory drivers

Jurisdictions such as the European Union continue to encourage institutional support for sustainable investment via the European Commission’s Action Plan on Sustainable Finance. Political agreement has been reached on a proposal that will introduce sustainability disclosure requirements for asset managers. Changes to regulations such as AIFMD and UCITS are expected to be introduced that will require investment firms to consider sustainability factors in investment due diligence and to develop engagement strategies that are consistent with the ESG needs of their investors.  

In the UK, the Government has introduced legislation, with effect from October 2019, that will require pension scheme trustees to consider, as part of their fiduciary obligations, ESG during their investment decision making and capital allocation processes. Furthermore, the Financial Conduct Authority is currently consulting on proposals that will require financial services firms to publicly disclose how they manage climate financial risk.

Changing demographics

Beyond governmental policy and regulation, there is a continuing shift in attitudes towards investing as the transfer of wealth from the Baby boomer generation to Generation X and Millennials accelerates. Many of these younger investors are more conscious about the source of investment returns, which in turn is prompting a shift towards ESG mandates. Pension funds also need to adapt to meet the investment needs of more “sustainability conscious” beneficiaries.

Data deficit

Whilst there is an increased awareness of responsible investing and wider ESG factors, there are still issues hampering its widespread adoption. At the heart of these issues is the availability of consistent, quality data across market sectors, strategies and asset classes. This stems from a lack of breadth and quality of ESG data reported by listed companies themselves, that in turn acts as the foundation for ESG data analysis used to determine ESG scores and ratings. Difficulties in obtaining relevant disclosures from companies, the “cherry picking” of ESG data to report and the ability to not report, creates a skew in the quality and reliability of the market data available. Whilst listed equities are highly represented by the largest ESG data providers, inconsistencies and differences are common as no market wide taxonomy exists, evidenced by a lack of correlation between ESG scores. In addition, many asset classes such as private equity, unlisted debt / credit and distressed assets are not represented within existing ESG data sets.

Industry research has shown that the current quality of ESG data may also increase the tracking error within a portfolio, due to a reduced universe of stocks rated as best in class based on ESG scoring methodologies. This in turn may unintentionally skew the geographic allocation of a portfolio’s investments, as more developed markets, where ESG screening and scoring is more prominent, achieved greater visibility and higher scores.

Greenwashing

Besides the data challenges, the investment industry has yet to fully address the ESG implications of certain trading practices such as shorting stocks or active ownership of poor scoring ESG investments (as opposed to negative screening) and develop clear processes to follow in order to deem a fund, strategy or asset class as having sufficiently incorporated ESG factors into its responsible and sustainable investing practice. In order to help breakdown these barriers and to achieve its Action Plan on Sustainable Finance, the EU Commission has enlisted a high-level steering group to devise a taxonomy to help classify a sustainable investment. However, a taxonomy, whilst potentially solving some issues for industry stakeholders, also presents its own challenges. At a recent industry conference, experts warned that a taxonomy may result in (or exacerbate) “greenwashing”, the act of falsely promoting a product / service as environmentally friendly, by asset managers and / or issuers if “green” definitions are classified too vaguely.

ESG momentum to continue

In spite of these challenges ESG is not a fad and the integration of ESG within the asset management industry is here to stay. As its relevance to decision making for asset owners and asset managers continues to grow, so will the industry need to adapt accordingly.