As investor and regulator focus on environmental, social, and governance (ESG) issues has gathered pace globally in recent years, attention is turning to how investment managers, hedge funds and private equity firms can build effective ESG programmes that stand up to regulatory scrutiny and help them stay competitive in a rapidly evolving marketplace.
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As investor and regulator focus on environmental, social, and governance (ESG) issues has gathered pace globally in recent years, attention is turning to how investment managers, hedge funds and private equity firms can build effective ESG programmes that stand up to regulatory scrutiny and help them stay competitive in a rapidly evolving marketplace.
The European Union and, to a lesser extent, the UK have been setting the pace of change through the EU’s Action Plan on Financing Sustainable Growth – which includes the far-reaching Sustainable Finance Disclosure Regulation (SFDR) framework. Meanwhile the UK, through its own Taskforce on Climate-related Financial Disclosures (TCFD) initiative, looks to make TCFD-Aligned Disclosures mandatory.
Against that backdrop, ESG and sustainable investing is set to be a key area of focus for a broad spectrum of asset managers and investment firms in the coming years while they look to implement ESG programmes that meet the evolving needs of investors and regulators alike, says Dani Williams, senior principal consultant, ESG Governance Lead at ACA Group in London.
A shift in focus
“We’re now entering an interesting period for ESG,” Williams observes of the prevailing landscape. “Previously, there was an ad-hoc approach amongst most firms; we saw a few cases of managers developing great ESG programmes, while others seemed to take the approach that simply having a short policy or simple responsible investing statement was enough to pass for an ESG programme.”
Over the last few years, however, there has been a steady build-up towards what Williams sees as a formal implementation phase, as firms have moved from that initial tentative process of policy-building towards acknowledging that ESG needs to be more ingrained and ubiquitous within their business models, and move beyond elements of just the governance, or ‘G’ factors, of ESG integration.
And while regulatory steps such as the EU’s SFDR may have proved a catalyst, Williams believes the increased focus of firms on implementing more robust ESG programmes is largely due to investor-driven demand, with client appetite for ESG further accelerating this defining shift in investment management.
“ESG has become more commercial and normalised and is moving beyond just good governance to focus on the impact that ‘E’ and ‘S’ factors have in today’s global economy and the role in the longer-term impact on their investments,” she observes.
Williams also touches on some of the previous misconceptions surrounding ESG, in particular, how perspectives are changing when it comes to the dynamic between investors and alternative investment managers.
“Previously, there was a somewhat of a negative perception that ESG products are costly to manage with limited potential for growth and alpha generation. But now the evidence is clear that ESG funds can perform as well as the traditional funds, which means they are increasingly appealing to investors who don’t want to sacrifice positive growth for a ‘good cause’ and that assessing ESG factors can be an effective risk management tool for longer term growth.”
Underlining this point, she highlights research by Morningstar that indicated global investor inflows into sustainability funds were up 14 per cent in the third quarter of 2020, as the number of sustainable funds climbed almost 20 per cent. At the same time, she notes, there were more global sustainable-focused funds launched in Q3 last year than in any previous quarter.
Sustainable open-end and ETFs offered to European investors drew net inflows of EUR233 billion (USD278.7 billion) annually in 2020, according to Morningstar data – almost double 2019’s total. In Q4, sustainable funds attracted almost EUR100 billion (USD120 billion) of new investor capital, some 45 per cent of overall European fund flows.
“However, with this increased focus from both investors and regulators, firms are under increasing pressure to ‘do more’ in terms of integrating ESG considerations into their investment strategies and into their firms. This is a difficult process for some, since firms have for too long been able to take their own interpretation of what ‘ESG’ is and what it means in terms of their investment process. This has led to a lack of clarity in the market as to what it means to incorporate ESG, and in some cases this has amounted to intentional, or even unintentional, ‘greenwashing’ and misinformation on products marketed as ‘ESG friendly.’”
Still a ways to go
With the SFDR coming into effect, the regulation aims to hold firms accountable by formalising definitions of ‘sustainability’ and providing a harmonised framework from which to report against sustainability risk factors. In-scope firms have the ability to choose to either ‘comply’ or ‘explain’ while they will, or will not, be integrating ESG considerations into their investment process and/or at their firms.
“Although we saw a lot of firms who initially sought to ‘explain’ and classify funds under Article 6 to avoid reporting under the requirements, we have seen a shift and an increasing amount of investment managers asking, ‘What do we need to do to move our products from an Article 6 to an ESG-friendly Article 8 or 9 because we are getting investor pressure to do so’,” Williams says.
Although firms are striving to do more and regulatory framework is catching up, there is still a way to go.
“It’s not a perfect system; SFDR has been criticised as some basic questions remain unanswered or are vague in nature. But it is an important first step in pushing a large section of the financial world towards a cohesive understanding and reporting framework for ESG,” she continues.
With such momentum and increased regulatory focus, ultimately comes a degree of harmonisation and cohesion into reporting metrics, which helps asset managers to more effectively monitor their programmes and shape the way the industry rates, classifies and monitors investments.
One recurring challenge within the alternatives space – and the reason why some hedge funds, credit firms, and others are apprehensive around integrating ESG firmly into their investment process – stems from a lack of quality and/or availability of ESG data on investments. This, in turn, has added an additional concern for those firms looking to be more ESG compliant.
“Although there are a number of available platforms that monitor sustainability characteristics and risk, there remains some inconsistency and gaps in data,” Williams says.
“Although this can mitigated, it can be a more manual process that needs to be performed by someone who knows and understands the sustainability characteristics of the product, and this may put an additional drain on a firm’s resources.
“That said, with the rise in focus of ESG factors within financial space, we are seeing more and more firms come out with alternative solutions to some of the data quality challenges; and the information available is increasingly getting better.”
But it doesn’t stop there – a global push
On the increasing global focus on ESG, Williams believes that as countries work towards hitting the targets set under the Paris Agreement, the global financial industry will be increasingly pushed by governments and their regulators to be more ESG friendly, especially when it comes to assisting in meeting the ambitious targets set for reduction of carbon emissions.
“Either through regulation, or making certain industries less attractive from an investment standpoint, what we see is a global push towards more ESG friendly investment strategies and investments,” she explains.
“Europe is setting the benchmark with SFDR – I don’t think anyone would disagree. But other nations that have large financial sectors are pushing forward with objectives of their own to both encourage ESG investing, harmonise reporting and prevent greenwashing to investors.”
She suggests that while the UK may be behind Europe at the moment, it has been vocal about its intent on introducing a framework that will’ match the ambition’ of the EU Sustainable Finance Action Plan, including SFDR, and mandatory TCFD reporting is already set to come into effect for certain investment firms over the next few years.
“TCFD is one of the major reporting structures and globally there seems to be an appetite in using that as a key criteria in firms’ disclosures.”
She also points to the US rejoining the Paris agreement this year and other actions taken by the Biden administration on climate change, as well as the SEC’s establishment of a dedicated Climate and ESG Task Force in the Division of Enforcement. There has also been a “significant shift and increased focus” on climate and environmental, social, and governance (ESG) related risks and strategies in this year’s SEC exam priorities as further evidence of ESG becoming an increasing focus for regulators globally.
“We also should not discount the role that voluntary membership groups play in helping firms to demonstrate ESG criteria and transparency. In the past few years there has been an exponential uptick in financial services signatories to the UNPRI reporting framework, despite that framework continuing to require more onerous reporting from signatories, as seen particularly in the last year.”
Ultimately, though, time will tell who is behind the curve and who is meeting the grade, she observes.
Uniquely placed
ACA Group assembled its ESG advisory team as a response to what it was seeing in the market. One of its core objectives is to provide a 360-degree view in order to address the assortment of challenges faced by investment managers of all stripes and sizes. In practical terms, this has meant the firm pooling expertise from its performance, valuation, cyber and regulatory consulting teams, along with recruiting specific technical experts for the ESG unit.
“If managers are wondering how their peers are doing, or what to benchmark themselves against, or what is best practice in terms of programme development, we provide firms a holistic view on what is going on in the market, how to build a programme that will stand up to regulatory scrutiny, as well as what it means to step up and get ahead of the curve,” Williams says of ACA Group’s services.
She says ACA Group is uniquely placed, thanks to its background and pedigree in the regulatory and compliance space, to offer such a holistic service.
“Because ESG is still developing, and we’ve seen momentum gather pace so rapidly within the last few years – be it driven by investors, or driven by regulation, or even just growing interest on an ad-hoc basis – wherever firms are coming from on this, we at ACA can help because we have a broad view of what the market is doing.”
