Why think about ESG?
Corporate treasurers mandated with investing their firm’s money to preserve capital, maintain liquidity and deliver some yield have tended to think of ESG as a secondary concern, if at all. Those who did consider it – including asset managers – largely believed it would restrict the investment universe and the flexibility of money market funds.
In fact, ESG is a key determinant of value creation and protection, and therefore highly relevant to treasurers’ aims. ESG factors are the non-financial aspects of a company’s performance that are key contributors to its bottom line – so taking them into account is highly pertinent. It is not the same as ethical investing, which avoids specific investments for ethical reasons without taking into account the impact of these choices on financial performance.
For instance, the money market funds using ESG criteria today are prime funds, invested in commercial paper and other private instruments, so their primary exposure is to the financial sector. As such, governance has always been an implicit – but essential – consideration. In recent history, examples of material governance failings readily come to mind, from Wells Fargo to Danske Bank, and of course the subprime crisis. This also highlights how some ESG risks can materialise quickly, impacting short-term investors perhaps even more than longer-term ones who can afford to ride out a crisis.
As illustrated by the number of ESG money market funds launched recently in the US, but also flows into these funds, interest is growing rapidly. According to Fitch Ratings, assets rose 15% to US$52bn over the first half of 2019, after growing 1% through all of 20181. The momentum is building as regulators and authorities call for greater ESG disclosure from asset owners and managers, and investors understand this. They are increasingly asking probing questions about how ESG is integrated into their portfolios.
Asking the hard questions
Because ESG is complex, investors need to choose managers that understand a wide set of metrics and carry out their analyses within the context of dynamic global events – such as the shift to sustainable consumption, the climate change agenda and the movement for equality, all of which will create winners and losers.
When conducting due diligence, investors should look beyond managers’ claims, to avoid those content with greenwashing, and they should ask challenging questions such as:
Does the investment process go beyond simple exclusion criteria?
Does the manager have a framework to categorise strategies by type of ESG approach (eg integration, active ownership, exclusion, positive screening, etc)?
Do they have a proprietary, forward-looking scoring methodology focused on the material factors most likely to impact performance? For instance, although MSCI ratings are a good start, they present significant limits on these points.
What is the manager’s track record in terms of ESG integration, voting at AGMs, industry lobbying and active engagement to encourage companies to improve their ESG practices? Meaningful engagement of this kind can reveal a manager’s true level of commitment.
Having fully integrated ESG factors into their credit research, asset managers should act on the data. They can exclude some investments where companies present a high level of near-term risk. To take a non-financial example, explicit governance failures led us to shun BP shares in 2010. When the Deepwater horizon spill occurred, this decision benefitted our investors. Where short-term risks are low but long-term risks more meaningful, the best approach is usually to engage with companies to encourage them to adopt best practice, both through voting – where asset managers hold shares – and via meetings and correspondence with company boards, to raise concerns and follow progress.
While ESG is one of the hottest corporate topics today, it has been a key part of our investment philosophy for decades – our record of engaging and voting at company AGMs dates back to the 1970s. We see it as a demonstration of our responsible stewardship of our clients’ money, putting that money into projects, companies and assets that will deliver long-term value.
That said, we recognise that ESG is a complex space. To make further progress, the market needs to come together to make ESG more readily understandable. Among many other initiatives, we have long been advocating for ESG standardisation, and we are pleased to see it emerging. In the UK, the British Standards Institute (BSI) is working towards a standard for sustainable investment. It is also in conversation with its global counterpart, ISO, demonstrating the growing momentum towards a global taxonomy.
Few investors ever used to ask their asset managers what ESG factors they incorporated. Today, this question is becoming increasingly routine. The asset management industry needs to be ready, and as the industry continues to align capital with the ever-more relevant risk metrics of ESG, we urge investors to keep asking those hard questions.
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