ESG: the new normal?
04 Mar 2020
Investment in ESG products exploded in 2019, supported by new ESG product launch and strong investor interest. Is this a fancy trend or a significant shift in the market?
Image: Shutterstock
Over the past years, asset managers have massively invested in environment, social and governance (ESG) capabilities, recognising that embedding ESG consideration within investment decisions adds the qualitative aspect to the investment process, allowing one to identify investment risks – such as controversies that could affect a company’s performance – or opportunities, for example, companies well-positioned to address sustainability challenges.
The integration of ESG factors into the investment-management process started with blue-chip equity investment but is now a dimension that is increasingly embedded within all asset classes – including private investment and real assets.
At the same time, interest from investors has significantly increased, starting with institutional investors but expanding to all categories.
In our latest publication, Asset and Wealth Management Revolution: Investor perspectives - Rethinking purpose and performance, we surveyed 750 institutional investors and 10,000 retail investors and found that ESG is the third priority of investors (across all categories and continents), more important than fees.
In response to increased market demands, asset managers have introduced more ESG products on the market.
By ESG products, we mean products that are sold as such to investors, with an explicit ESG objective – this is in contrast to portfolios where ESG factors are integrated amongst other data considered in the investment process.
Furthermore, the upcoming EU regulations are likely to accelerate this transformational change, making it a requirement rather than an option. The EU Commission pursued three main objectives when implementing its ambitious Action Plan on Sustainable Finance, as released early 2018:
To manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues
To foster transparency and long-termism in financial and economic activity
To reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth
Managing financial risks
Indeed, the EU Commission shall soon impose all asset managers to consider sustainability risks, such as ESG risks, among their processes, addressing the concern that the next stability crisis affecting the financial sector could stem from underestimated sustainability risks, such as climate change for instance. As a result, even the ESG or climate sceptics will have no option but to adapt their investment approach.
Foster transparency and long-termism
The soon-to-come new rules will also transform the interaction with investors, requesting the formalisation of investors’ ESG preferences, to be linked with products’ target-market definition. Those products with no environmental or social explicit characteristics will only be eligible for investors with no ESG preferences.
Considering that more than 90 percent of EU citizens see climate change as a serious issue, betting on the high proportion of them claiming that they have no ESG preferences at all, may reveal a risky strategy. Asset managers have only one year to redefine their product approaches—distinguishing between those that exhibit environmental or social characteristics, those that will be considered as Sustainable (based on the new definitions introduced by the EU commission) and other products—and engage with distributors about their products’ re-classification and adjust product prospectuses in line with the newly imposed disclosure requirements.
Indeed, the new regulation on sustainability-related disclosures, as published in the OJEU on 9 December 2019, introduces comprehensive disclosure requirements, at asset manager and at the product level.
All asset managers will be required to disclose how they manage sustainability risks, such as the risks that environmental or social issues could negatively impact the value of the assets, hence the performance of the portfolio, and large asset managers will also have to disclose the impact of their investment decisions on environmental social or employee matters. Alignment of the remuneration policy will be required.
The regulation also requires extensive disclosure at the product level. All products will have to assess and disclose the likely impact of sustainability risks in their return—and if not relevant, justify why. Products promoting environmental or social characteristics will disclose in the prospectus or website how these characteristics will be met and in the annual report how they have been achieved. Products qualifying as sustainable investments will also be asked to report on the sustainability-related impact of financial products.
Reorient capital flows towards sustainable investment
Unlike the approach currently taken by various labelling initiatives, the regulations do not define what is to be considered as an ESG product as a reference to certain investment processes, such as the exclusion of specific sectors, best-in-class or positive ESG screening.
The approach chosen by the EU commission under the “to-be finalised soon” taxonomy regulation is rather to focus on the activities of the underlying investments, proposing a screening mechanism to determine if these activities are in line with the EU environmental (and in a later stage social) objectives. The six environmental objectives identified by the commission are:
Climate change mitigation
Climate change adaption
Sustainable use and protection of water and marine resources
Transition to a circular economy
Pollution prevention and control
Protection and restoration of biodiversity and ecosystems
For the sector of activities that could contribute the most to the achievement of these objectives, the commission will define technical screening criteria in order to determine when an underlying activity can be considered as sustainable. As an example, the technical expert group on sustainable finance has proposed some metrics and thresholds for sectors as diverse as transportation, manufacturing and real estate.
The specialists will focus their work on climate change-related objectives in 2021 and will address the other four environmental objectives in 2022.
The taxonomy regulation will also amend the just-adopted disclosure regulation mentioned above, requiring funds to disclose the percentage of the investments in taxonomy-aligned activities (products promoting environmental characteristics and environmentally sustainable investment) or a statement indicating that the financial product does not take into consideration the EU criteria for environmentally sustainable investments. These changes will occur between 2021 to 2022, leading to successive adjustments of pre-contractual information. The taxonomy will also impose new requirements for large listed companies, which will be required to complement their non-financial reporting with information on the proportion of their activities that are aligned with the taxonomy. These changes are transformational by nature, as they will affect product and distribution strategy.
The product review and related disclosure requirements could be seen as a costly compliance exercise – significant developments of the data acquisition and quality review processes, risks assessment and monitoring activities, as well as investors reporting, will indeed be necessary, over a very short time frame. But at the same time, it is a fantastic opportunity for front-runner European asset managers to deploy a successful product and distribution strategy.
Given the very tight time frame, some could be tempted to play the clock, betting on a delayed implementation. Such a strategy would be very risky: the new commission has indeed announced clearly, through the Green Deal plan, for instance, that financing transition to a greener economy is a top priority – expanding the sustainable finance agenda.
Transition to a greener economy is not only a key European priority but also a societal challenge. And most of the EU citizens now recognise that we all have a role to play in this critical and urgent battle to secure decent environmental conditions for our next generation – we can only win if citizens, investors, financial market players, public and private sectors join forces on a common ambitious agenda.
The integration of ESG factors into the investment-management process started with blue-chip equity investment but is now a dimension that is increasingly embedded within all asset classes – including private investment and real assets.
At the same time, interest from investors has significantly increased, starting with institutional investors but expanding to all categories.
In our latest publication, Asset and Wealth Management Revolution: Investor perspectives - Rethinking purpose and performance, we surveyed 750 institutional investors and 10,000 retail investors and found that ESG is the third priority of investors (across all categories and continents), more important than fees.
In response to increased market demands, asset managers have introduced more ESG products on the market.
By ESG products, we mean products that are sold as such to investors, with an explicit ESG objective – this is in contrast to portfolios where ESG factors are integrated amongst other data considered in the investment process.
Furthermore, the upcoming EU regulations are likely to accelerate this transformational change, making it a requirement rather than an option. The EU Commission pursued three main objectives when implementing its ambitious Action Plan on Sustainable Finance, as released early 2018:
To manage financial risks stemming from climate change, resource depletion, environmental degradation and social issues
To foster transparency and long-termism in financial and economic activity
To reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth
Managing financial risks
Indeed, the EU Commission shall soon impose all asset managers to consider sustainability risks, such as ESG risks, among their processes, addressing the concern that the next stability crisis affecting the financial sector could stem from underestimated sustainability risks, such as climate change for instance. As a result, even the ESG or climate sceptics will have no option but to adapt their investment approach.
Foster transparency and long-termism
The soon-to-come new rules will also transform the interaction with investors, requesting the formalisation of investors’ ESG preferences, to be linked with products’ target-market definition. Those products with no environmental or social explicit characteristics will only be eligible for investors with no ESG preferences.
Considering that more than 90 percent of EU citizens see climate change as a serious issue, betting on the high proportion of them claiming that they have no ESG preferences at all, may reveal a risky strategy. Asset managers have only one year to redefine their product approaches—distinguishing between those that exhibit environmental or social characteristics, those that will be considered as Sustainable (based on the new definitions introduced by the EU commission) and other products—and engage with distributors about their products’ re-classification and adjust product prospectuses in line with the newly imposed disclosure requirements.
Indeed, the new regulation on sustainability-related disclosures, as published in the OJEU on 9 December 2019, introduces comprehensive disclosure requirements, at asset manager and at the product level.
All asset managers will be required to disclose how they manage sustainability risks, such as the risks that environmental or social issues could negatively impact the value of the assets, hence the performance of the portfolio, and large asset managers will also have to disclose the impact of their investment decisions on environmental social or employee matters. Alignment of the remuneration policy will be required.
The regulation also requires extensive disclosure at the product level. All products will have to assess and disclose the likely impact of sustainability risks in their return—and if not relevant, justify why. Products promoting environmental or social characteristics will disclose in the prospectus or website how these characteristics will be met and in the annual report how they have been achieved. Products qualifying as sustainable investments will also be asked to report on the sustainability-related impact of financial products.
Reorient capital flows towards sustainable investment
Unlike the approach currently taken by various labelling initiatives, the regulations do not define what is to be considered as an ESG product as a reference to certain investment processes, such as the exclusion of specific sectors, best-in-class or positive ESG screening.
The approach chosen by the EU commission under the “to-be finalised soon” taxonomy regulation is rather to focus on the activities of the underlying investments, proposing a screening mechanism to determine if these activities are in line with the EU environmental (and in a later stage social) objectives. The six environmental objectives identified by the commission are:
Climate change mitigation
Climate change adaption
Sustainable use and protection of water and marine resources
Transition to a circular economy
Pollution prevention and control
Protection and restoration of biodiversity and ecosystems
For the sector of activities that could contribute the most to the achievement of these objectives, the commission will define technical screening criteria in order to determine when an underlying activity can be considered as sustainable. As an example, the technical expert group on sustainable finance has proposed some metrics and thresholds for sectors as diverse as transportation, manufacturing and real estate.
The specialists will focus their work on climate change-related objectives in 2021 and will address the other four environmental objectives in 2022.
The taxonomy regulation will also amend the just-adopted disclosure regulation mentioned above, requiring funds to disclose the percentage of the investments in taxonomy-aligned activities (products promoting environmental characteristics and environmentally sustainable investment) or a statement indicating that the financial product does not take into consideration the EU criteria for environmentally sustainable investments. These changes will occur between 2021 to 2022, leading to successive adjustments of pre-contractual information. The taxonomy will also impose new requirements for large listed companies, which will be required to complement their non-financial reporting with information on the proportion of their activities that are aligned with the taxonomy. These changes are transformational by nature, as they will affect product and distribution strategy.
The product review and related disclosure requirements could be seen as a costly compliance exercise – significant developments of the data acquisition and quality review processes, risks assessment and monitoring activities, as well as investors reporting, will indeed be necessary, over a very short time frame. But at the same time, it is a fantastic opportunity for front-runner European asset managers to deploy a successful product and distribution strategy.
Given the very tight time frame, some could be tempted to play the clock, betting on a delayed implementation. Such a strategy would be very risky: the new commission has indeed announced clearly, through the Green Deal plan, for instance, that financing transition to a greener economy is a top priority – expanding the sustainable finance agenda.
Transition to a greener economy is not only a key European priority but also a societal challenge. And most of the EU citizens now recognise that we all have a role to play in this critical and urgent battle to secure decent environmental conditions for our next generation – we can only win if citizens, investors, financial market players, public and private sectors join forces on a common ambitious agenda.
NO FEE, NO RISK
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