Integrating ESG
What does ESG Integration look like in capital markets?
This decade, Environmental, Social and Governance (ESG) has arguably evolved into one of the most important themes in capital markets, with the associated principles of fairness, sustainability and ethicality increasingly driving the decision making of investors.
As such, capital markets firms have explored ways to become more ESG-centric and stay relevant to the demands of their client bases.
According to Morgan Stanley, ESG Integration – the infusion of existing processes and products with ESG characteristics – has already been adopted by more than 60% of global asset managers and asset owners. A further cohort of more than 30% of both groups are either actively planning to integrate within their investment strategy, or desire to do so but do not currently have the resources to do so. There are numerous different ways in which financial institutions pursue ESG Integration Strategies:
Product Origination
This is the practice of creating products, such as funds, securities or indices with a particular ESG focus. ESG can be integrated into the origination process with a higher degree of confidence and uniformity than was previously the case due to the recent wave of regulation. Products are originated as ESG products through the intentional design of their investment strategy or policy, or through their structuring as such.
Manufacturers of financial products (funds, ETFs, structured products, debt) are bound to carry out the initial origination– and if relevant ongoing management – of their products as committed to within investment strategies or investment policies. Within these investment policies a firm would typically undertake ESG integration through one of the following methods:
● Targeting a specific regulatory classification, such as SFDR Articles 6, 8 and 9.
● Targeting headline figures that fall under regulatory reporting regimes, for instance a minimum percentage of investments in areas considered sustainable under the EU taxonomy.
● Pursuing an exclusion policy: a manager will apply a test for investee firms to see if their percentage of revenue derived from an activity exceeds a threshold. For example, a fund may not be permitted to invest in a firm deriving >0% of its revenue from oil and gas extraction, or a firm deriving more than 10% of its revenue from the distribution of tobacco products.
● Pursuing an inclusion policy: a manager will target its investments towards a particular economic sub-sector of issuing firms (i.e., green energy providers or battery producers) or towards issuers which the manager considers to be advancing the progress of specific themes (i.e., the circular economy or global nutrition).
Once these ESG products have been created, they will in most cases require ongoing management to ensure that the investment policy is being kept to. This happens through decisions executed around a portfolio’s allocation, as well as direct interaction with stakeholders from the investee issuer. This is less the case when talking about sustainable securities.
Portfolio allocation
A fund manager may pursue an overweight or underweight of an underlying asset in their portfolio for ESG reasons. This may be done to ensure adherence to a pre-set investment policy or the SFDR-defined minimum percentage of sustainable investments. It may also be done to reduce ESG-related risk, through reducing the physical risk of Climate Change or legal risk within the supply chain. Those risk factors exemplify how an ESG integration strategy may be pursued without any explicit ESG focus or SFDR label, for the primary purpose of reducing financial risk.
ESG Performance Analysis & Management
Typically including carbon accounting, this entails measuring and track an asset’s ESG performance. This typically begins with the estimation of the ESG credentials of an issuer and their operations. This operational data can then be rolled up, weighted by the size of an equity or debt stake, such that an entire portfolio or fund can be assessed. These ESG performance metrics can then be disaggregated and analysed through the contribution of individual issuers or sectors to the portfolios overall performance.
Using this data, changes can be suggested to be made the issuer’s operations, to improve ESG performance. Alternative asset managers – private equity and venture capital funds, for instance – may directly engage with the management of a majority owned asset, to improve their ESG performance through changing suppliers or cutting back on certain bad ESG practices. Stewardship typically refers to the process undertaken by investors of putting pressure on, or speaking with issuers they hold stakes in, to encourage an improvement in their ESG performance.
ESG Regulatory & Client Reporting
This includes the creation of reports on an owned or managed portfolio or asset for submission to either clients or regulators. ESG regulatory reporting typically entails the calculation of product and entity level ESG metrics, followed by the input of these metrics into standardised regulatory templates.
These regulatory reports will typically also require a limited amount of qualitative input for contextualisation of the data and / or an explanation of the calculation methodology used. In some cases, they will require a significant qualitative aspect, such as in the Taskforce on Climate-related Financial Disclosures (TCFD) entity level report. This requires that a firm describe their strategy, governance and risk management approaches to the climate, as well as their Metrics & Targets, one of the four pillars of TCFD.
Accurate ESG client reporting allows firms to satisfy the 88% of asset owners who consider ESG reporting and disclosure as ‘extremely important’ or ‘somewhat important’ when they evaluate third-party investment managers. Client reporting in of itself fulfils regulatory requirements when delivered to retail clients, under the MiFID II Sustainability Preferences regime.
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