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).
Sources: Global Sustainable Investment Alliance, Moody’s Investors Service
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.