The new ESG normal
Even if regulators were not pushing the issue of sustainability so hard, the asset managers’ fiduciary duties require them to take into account the physical and market impacts of climate change. To continue to generate sustainable returns, they must integrate ESG risk in finance and investment decisions at the most granular level, taking into account evolving regulations, the new geopolitics of energy and climate change and the growing risks of carbon transition to traditionally robust stocks as the cost curves of renewables continue to decrease and brands respond to consumer and regulatory pressure to go green.
In the next five years, ESG will be a major disruptor in the commodities markets. Already, we can see car manufacturers seeking out green supply chains, with low-carbon steel and aluminum produced with renewable energy, to prepare for the possibility of a European Union carbon border tax.
In this environment, rather than using a traditional investment assessment approach, where financials were front and center of the investment decision, asset managers must integrate ESG factors within their investment due diligence process and risk management process. According to an EY report (pdf) into key ESG priorities for Singapore’s asset managers, this will both better protect against climate risks and better price the assets they are investing in.
ESG integration starts with identifying all the elements in the new risk universe and overlaying them across investment strategies to understand their implications for portfolios. Next, asset managers can link key risks back to the available data out of the market, uncovering any information gaps and pressing companies for transparent reporting.
ESG strategy is a spectrum
This is not to suggest that asset managers need to adopt extreme ESG strategies. When it comes to developing the right ESG strategy, there is no one size fits all. The spectrum of responsible investment approaches starts with the regulator’s requirements to identify, manage and report environmental risks.
The next step up is actively pursuing ESG opportunities. At the simplest level, asset managers are using positive screening. More sophisticated institutions are using quantitative and qualitative information in their investment processes to take ESG factors into account at the portfolio or even at the stock level.
Some asset managers are taking ESG further still, offering their clients sustainability-themed funds, with a selection of assets where impact is central to the underlying investment. For example, some asset managers will offer funds specifically designed to help address challenges such as climate change. And some of these instruments may even prioritize impact ahead of financial returns. Eventually, we expect such offerings to crystalize into personalized ESG themes for retail investors, powered by AI and machine learning.
Wherever asset managers are on this spectrum, they need to understand where the market momentum is going. The increased capital flows to ESG and impact products will spur innovation, accelerating positive real-world ESG outcomes that will only serve to increase awareness of and demand for investment impact – until ESG investment becomes entry level.
Trust will be the big differentiator
To differentiate their ESG investment strategies in what will soon be a crowded market, asset managers should focus on building trust through internal audit, independent assurance and other confidence building measures. The United Nations has already released guidelines on confidence-building measures for PRI signatories, with recommendations ranging from ESG internal controls assessment to external assurance on ESG.
Asset owners need to understand what controls are in place over the investment management processes, including any that are outsourced, and have confidence that these controls are functioning properly to ensure responsible investment policies are implemented and operating effectively. An independent assurance report over investment management processes will help asset owners to make informed choices, so they can appoint, and monitor wealth and asset managers aligned with their individual responsible investment objectives.
Asset managers also need to look beyond current ESG trends and understand what’s coming. Climate change is today’s ‘hot button’, but biodiversity is about to emerge as the next major environmental theme. Water scarcity is also bubbling along just under the horizon. Water links many environmental issues, including pollution, biodiversity, food, energy and climate regulation – and is critical to urban systems.
