It’s been widely covered, but concerns about climate change and sustainability have permeated all areas of modern culture.
Financial services is no different and the rise of ESG investing (and all the various terms associated with this) has, at least on the surface, become extremely popular with over £100m flowing into ESG funds every week throughout most of 2019. There are a number of debates arising around ESG investing, not only as a concept but in how it is implemented. How effective can ESG investing be? Should ethics be involved in something as black and white as investment? Have topics such as ESG been hijacked as a marketing ploy for active asset managers, desperate to warrant under-fire charging structures? The list goes on.
This blog isn’t about any of that. Instead, here we’re looking at the very real prospect of ESG investing (and even though there are numerous topics and themes at play here, we’ll stick to ‘ESG’ for sheer simplicity).
Bowing to greater pressure from investors concerned about the environment, policymakers have become increasingly involved in this space. Even though actual regulation on what can/can’t/shouldn’t be invested in is not on the table, ESG reporting is a hot topic.
With greater awareness of the issues facing our environment, consumers want to know how ‘green’ their goods and services are. Investments are now under the same pressure and there is a growing demand for greater knowledge of how ‘green’ a fund is (i.e. to what extent is a fund invested in fossil fuels, what is the carbon footprint of the fund’s underlying holdings etc).
In light of this, last year the London Stock Exchange introduced guidelines on recommendations on ESG reporting best practices to the 2,700 UK companies it has listed. In Europe, ESMA has called for a clampdown on ‘greenwashing’ (the practice of misleading investors to how green a fund is) and is working on more stringent reporting guidelines. And, not to be outdone, the FCA has announced it will be doing more on this area by consulting on new rules to improve climate-related disclosures from funds and potentially introducing frameworks for independent governance committees on how they oversee and report on firms’ ESG activities.
A watershed moment, however, could be when the upcoming Pensions Schemes Bill is introduced. Currently in the drafting stage, an amendment has just been added by the Department of Work and Pensions to make ESG reporting from UK pension schemes mandatory.
Under the newly added ‘Climate Change Risk’ clause, the bill will include some of the following requirements for pension scheme trustees:
• Reviewing exposure to climate risks
• Determining, reviewing and (if necessary) revising a strategy for managing the scheme’s exposure to climate change risk
• Determining, reviewing and (if necessary) revising targets relating to the scheme’s exposure to climate change risk
• Measuring performance against such targets
In addition, trustees will be required to regularly publish updates on their progress in line with the above and these reports have to be made available free of charge. And if trustees don’t comply? Individuals can be fined up to £5,000 and fines of up to £50,000 can be issued in other cases.
These steps, to compel instead of nudge, come after research showed little is being done to meet non-mandatory ESG reporting requirements. Since October 2019, pension schemes have already been obliged to report on how ESG measures are incorporated but research has proven that only 2% of trustees have made material changes to underlying companies as a result with 38% regarding these requirements as a ‘box ticking’ exercise.
However, even though the demand for ESG transparency is mounting (and soon due to be mandatory, at least in the pension scheme sector) creating such reports will be a challenge. Reporting on financial metrics and performance measures such as alpha, beta etc is second nature to the funds industry, but ESG data is very much the new frontier for these firms. Standardisation of ESG reporting will go some way in easing the challenge, but according to a recent research note by the CFA Institute the real difficulties lie in gathering and dissecting ESG data.
In particular, the expanse of data available is a challenge:
“For example, governance factors can run more than 150 variables. How can all that data be distilled down to something useful? Applying statistics in a unique way, we reduce the 17 most important variables to a single index.
“Not only is that index consistently predictive within a 12-month time frame, but it has very strong R-squared explanatory power across multiple financial variables and impact measures. An investment manager, client, or investment board looking at a report may only be interested in a single index measure. That measure needs to be well-researched and robust to be effective.”
Knowing what data to include and what not to include will take a great deal of analytical resource. Some companies might be able to readily deliver information on their carbon footprint, but SMEs may struggle – could this limit fund managers’ ability to invest in them? And who is relied upon to gather this data, the fund management firm or the underlying holding? Could a third party be used?
In response, an entire subsector of fintech firms aimed at ESG data provision has emerged. The BNP Paribas ESG Global Survey 2019 highlighted that ESG data remains the biggest obstacle to ESG integration for investors, well ahead of costs, a lack of advanced analytical skills and the risk of greenwashing. At 66% across all respondents, the evidence of this ESG data challenge in 2019 is even greater than reported in the BNP Paribas survey from 2017. This all suggests that investors have become more sophisticated in their ESG integration, demanding a solution to the current data challenges they face.
The overall challenge is the intangible nature of ESG investing. How do you quantify the governance strength of a company? How do you measure the environmental benefits of a company? Is it possible to compare the ESG characteristics of one company against another? Research from AXA Investment Managers has raised the notion that intangible qualities now outstrip tangible measures when it comes to assessing a company’s value.
Some progress is being made though, with the Sustainability Accounting Standards Board (SASB) that had some success with an industry-specific materiality map it created for the pharmaceutical and biotech sector. AXA’s head of ESG research and active ownership Yo Takatsuki said: “SASB is increasingly establishing itself as an ESG reporting benchmark for corporates and is backed by many leading investors. We support SASB’s approach and believe that we can further the adoption of SASB’s reporting framework through our participation in the Committee, research activities and engagement with companies.”
Hopefully regulations around ESG reporting will include advice and guidance on how regulated firms could be expected to create such reports. And, in time with technological developments, there will be improvements in the ability to effectively gather and assess ESG data. When mandatory ESG requirements do land however, it will be incumbent of regulated firms to ensure they have the correct information accurately published on their websites in a timely manner.
Having evidence of this compliance, ensuring the right information is published online and that a firm's digital presence is being properly and responsibly managed, is an increasing burden on compliance teams. This is why website archiving is proving so popular with firms. Website archives are living, breathing snapshots of a website at a certain point in time and an ISO-compliant, time-stamped and tamperproof archive can be invaluable in dispute resolution and satisfying queries from the regulator.
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