ESG Environmental, social and governance Outlook for Asset Managers

Published: Dec 10, 2020
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Environmental, social and governance (ESG) is increasingly becoming a focus for asset managers, and some are faced with the challenge of having an ESG framework or policy at the firm level and in some cases a policy for their ESG investment strategy. Public and private firms continue to concern themselves with ESG matters such as corporate board diversity, environmental issues and the treatment and empowerment of employees. Investors are seeking opportunities that make themselves appear more accountable. Recent world events, such as extreme weather and natural disasters, potential government regulation and societal pressures regarding diversity all contribute to an increased focus on ESG considerations and investment opportunities.

Asset managers who previously wouldn’t consider ESG concerns in their investment strategies or business dealings are now realizing that there is a level of interdependence between social responsibility and profitability. Many investors expect managers to invest in companies that are focused on making a difference in society, such as responding to COVID-19 or reducing carbon emissions, and many managers are learning how to make investment decisions in an environmentally and socially responsible manner to attract capital from these conscious investors.

There are, however, managers that continue to resist socially responsible or impact strategies because they simply don’t have the expertise, don’t understand where to begin, or feel that there may be potential fiduciary issues. Some asset managers may not be open to launching such strategies as it just may not fit their business profile.

Implementing an ESG approach has many challenges. Some managers may be reluctant to adopt ESG investment strategies because of the inconsistency in data. Other managers are open to implementing ESG frameworks but may be reluctant due to differing standards and confusion regarding ESG terminology across the industry. Managers that are looking to incorporate ESG frameworks and strategies may also incur additional costs as they may need to purchase data or hire staff to oversee the compliance aspects of the new strategy. Lastly, there is also the concern of providing sufficient data and reporting so as not to appear as though the firm is misrepresenting their investment strategy or greenwashing.

Public company ESG oversight is heavily driven by specialized data and there are several service providers that compile ESG ratings of specific companies as well as a wealth of reporting. Some of the best-known providers are MSCI, ISS, Morningstar Inc. and S&P Global. Interestingly, during the COVID-19 pandemic, there has been quite a bit of consolidation in this space, as the larger players have been acquiring niche service providers such as Sustainalytics and Trucost. Many large companies have sought to build out their ESG data offerings as the need for ESG data and research increases among managers. Today, the ESG ratings of an underlying investment company may be considered as highly as the performance or other financial ratings.

Alternatively, in the private fund space, there is not an abundance of ESG research or data, making it especially challenging for fund managers who are looking to implement ESG frameworks or measure the effectiveness of their ESG investment products. Many of these groups tend to rely upon ESG checklists or guidance that is generally more applicable for public companies. There is increasing investor pressure to incorporate ESG strategies in private investment vehicles or portfolio companies, yet little industry guidance. Although private funds are openly embracing ESG, it’s most commonly the larger managers who have the financial resources to more easily incorporate ESG and/or impact investment strategies. Other managers who require ESG implementation guidance and oversight may be better served by consulting with experienced service providers who will help them develop ESG policies and guidelines for their investment strategies or products.

Challenges

As many managers consider embracing ESG, whether due to their own social standards or pressure from investors, one of the biggest challenges they face is the many different definitions of ESG. Reporting on ESG/impact investments can be burdensome. Additionally, managers may be challenged by investors that require different ESG specific reports, and the need to collect ESG portfolio data points for analysis or compliance purposes. The private fund space is further challenged by insufficient or not-very-robust ESG data in addition to the minimal guidance. The lack of private company ESG data has caused some private fund managers to delay ESG implementation, measurement and reporting.There are many considerations when launching a fund that may address a social need but could potentially compromise the manager’s fiduciary responsibilities or prove to be cost-prohibitive. Even though investors are focused on ESG, smaller asset managers may worry that mediocre investment performance in their ESG or impact fund may make asset raising more difficult. They are concerned that satisfying a social demand may result in compromised performance. Larger firms with multiple product lines may be in better positions to offer ESG investment strategies that may not have stellar returns because they have other offerings to attract investor assets. Some firms may shy away from ESG investment strategies because they have concerns about the upfront costs of implementing strategies that ultimately may not be able to attract enough capital. Unless there is specific investor demand that is sizable enough to launch an ESG investment product, some managers may not be willing to do so.

Regulation

The E.U. currently has the most in-depth ESG regulatory oversight with the Disclosure Regulation that came into effect in December 2019 and will apply in early 2021. The regulation will require asset and fund managers and advisors to provide investors with certain ESG-related information so that investors are able to make informed decisions. Additionally, financial market participants would need to publish certain disclosures on their websites, periodic reports, marketing material and contracts. Internal policies at these firms would also need to be updated to reflect the firm’s focus on sustainability.

In the U.S., there is no one regulatory body that is putting their hand up to set uniform ESG standards. ESG disclosures and standards adopted by U.S. companies are all currently voluntary and predominantly based upon standards communicated by various groups such as the Global Reporting Initiative, the Sustainable Accounting Standards Board (SASB) and Task Force on Climate-Related Financial Disclosures. Although the adoption of standards and disclosure reporting is a reasonable starting point, companies that are serious about ESG must be diligent and carefully monitor developments in order to respond to investor concerns and provide meaningful and consistent reporting. Larger institutional investors and managers have proactively adopted certain ESG frameworks that they feel support their investment goals and, in doing so, will put pressure on portfolio companies to comply with the chosen standards if they hope to earn the investor’s trust. Interestingly, other investors have elected to have multiple, differing frameworks or disclosures to give them the flexibility to adapt to a particular business.

Consistent ESG disclosures would provide better clarity to investors and allow them to understand the risks to the balance sheets or investment program performance while at the same time understand the positive impact to the environment and/or society. In addition to the organizations promulgating various ESG standards mentioned earlier, there are a number of other non-governmental and intergovernmental ESG frameworks such as the UN Sustainable Development Goals. In September of this year, SASB and four other frameworks, committed to collaborate, with a goal of providing effective market guidance on applying ESG frameworks and standards and disclosure requirements.

Meanwhile, the Department of Labor (DOL) is proposing to prevent 401(k)/ERISA plans from offering ESG funds. Although the DOL has not provided a justification as to why they may ban such investment strategies, there is sentiment that these types of plans are not instruments for furthering social goals and policies and should be managed in the best financial interest of the workers whose retirement savings are at risk and therefore should be invested in the most prudent manner. The Securities and Exchange Commission (SEC) is not currently attempting to prevent advisors from participating in ESG investment strategies but is focused on the accuracy of the disclosures and reporting that advisors provide on these strategies. Meaningful and more accurate ESG reporting and disclosures may be instrumental in addressing regulatory concerns around ESG type investments.

Compliance

Along with the challenges associated with ESG reporting disclosures, managers must confront the overall compliance challenges of ESG reporting disclosure and ESG framework adoption. Financial firms that adopt ESG frameworks and provide reporting on their investment products should have the appropriate internal controls and the appropriate staff for producing such disclosures or should engage a consultant or service provider that is experienced in the space. The type of ESG framework adopted and the ESG disclosure language provided must carefully address the concerns of investors or clients and should explain the firm’s ESG or impact investing capabilities. Firms that do not have ESG investment products but incorporate certain aspects of ESG in their businesses should also be able to articulate in their disclosures their views on ESG and how they plan to incorporate certain aspects of ESG in the business activities. A firm’s overall ESG policy or framework need not be far reaching, and, in the case of investment products, the firm should not over commit to reporting requirements and investment oversight goals that it may not be able to accomplish. Firms with operations in several jurisdictions must also consider the different reporting requirements of the countries in which they operate as disclosures and data points may differ.

Where do we go from here?

Companies should not jump onto the ESG bandwagon simply to keep up with social demands/pressures unless they have the means or resources to do so effectively. Firms that act imprudently may find themselves in a situation where they do not produce positive returns or provide adequate ESG reporting. Importantly, no firm wants to be investigated by regulators because they are advertising as investing consistently with ESG standards when in fact they are not. Although there is currently no comprehensive regulatory guidance or standard, there are industry best practices that may be considered and followed to create an offering that is social or impactful in a thoughtful approach. ESG may one day become business as usual, but until then, firms should implement the best ESG solutions that work for their businesses, or engage knowledgeable, experienced consultants to help them develop the most suitable frameworks.