The role of governance as asset servicers weigh ESG considerations
Oct 2024
As environmental and social concerns continue to dominate the financial landscape, Rudi Kuntz, head of business, Global Proxy Distribution at ISS STOXX, takes a closer look at the ‘G’ in ESG — governance
Image: ISS STOXX
From Europe to the Americas to capital markets across the Asia Pacific region, ESG, defined herein by the environmental and social factors underlying the acronym, has in recent years become the darling of the institutional investor community, with implications for asset servicers and other intermediaries across the three regions. This article explores how governance (the ‘G’ in ESG, of course) impacts the asset servicer community.
How governance has evolved in the age of ESG
While ESG has in recent years been in sharp focus for many within the investment and broader financial services industry, it is important to understand how services provided by custodians facilitate shareholder participation in the governance of the companies they invest in.
As companies and investors become more aware of the material impact of environmental and social factors on long-term investments, there appears to be a significant shift towards incorporating these considerations into corporate governance practices, primarily through proxy voting.
Many institutional investors are using their voting power to influence corporate behaviour and promote sustainability by, for example, supporting calls for greater transparency and accountability from companies, particularly as it applies to their environmental and social impacts.
While most annual shareholder meetings have standard agenda topics relating to the election of directors and executive remuneration, there are a growing number of instances of shareholders submitting ESG proposals at meetings.
These proposals could relate to issues pertaining to climate change, human rights or otherwise controversial practices relating to a company.
Participating in shareholder meetings and voting upon these types of proposals is important for investors not only from a reputational perspective as it relates to voting disclosure but also to ensure they have a say in how the companies in which they invest conduct business and govern their practices.
Given the importance and growing demand from investors for sophisticated and reliable proxy voting services from their custodian banks, many banks and intermediaries choose to partner with a vendor to ensure proxy voting can be offered in a timely, secure and efficient manner.
Vendors, such as ISS, address this market demand through the provision of a voting platform, allowing investors to view upcoming shareholder meetings and vote upon meeting agendas, coupled with technical connections across sub-custodians and market agents globally to process voting instructions through to the shareholder meeting.
A regional look at heightened voting activity
Shareholder voting activity has indeed increased in many regions, driven by the growing recognition of the importance of corporate governance. Hot spots for shareholder voting activity vary across regions.
The US has been quite active in institutional shareholder voting, and the US Securities and Exchange Commission (SEC) mandates disclosure of mutual fund voting. Institutional investors and activist shareholders are increasingly using their voting power to influence corporate decision-making, particularly on issues related to executive compensation, board composition, and environmental and social policies.
In Europe, shareholder voting activity has also increased, most recently driven by regulatory changes and investor engagement. Historically, many European investors would vote in their home or adjacent markets.
Regulatory initiatives such as the Shareholder Rights Directive (SRD II) have encouraged greater shareholder engagement and voting across an investor’s entire portfolio.
Asian Pacific markets, particularly Japan and South Korea, have also witnessed an increase in shareholder voting driven by corporate governance reforms. What remains a challenge in certain APAC markets is that some custodians do not offer a proxy voting service which impedes their investor clients’ ability to effectively manage their ESG and voting programmes across all holdings.
Australia has witnessed a surge in shareholder voting activity, particularly in relation to climate change and sustainability issues. Shareholders have been pressuring companies to disclose their climate-related risks and take action to mitigate them. This has led to increased resolutions on climate-related issues and greater engagement between companies and their investors.
Historically apathetic to voting, retail investors awaken
While proxy voting has been important to institutional investors for many years, we are also now seeing a growing demand from other types of investors who may not have historically leveraged their voting rights or have been able to directly participate in the proxy voting process.
With growing public demand as well as increasing pressure from directives such as SRD II, there has been an increase in the volume of investors required to be offered a proxy voting service and many custodians have had to rapidly evolve their offering to accommodate the need.
This development, which includes wealth managers and retail banks, to facilitate shareholder meetings and vote processing to investors means two things:
First, more investors than ever can now participate in the proxy voting process.
Second, custodian banks and other intermediaries face even more pressure to ensure they are offering and facilitating a voting service for their clients.
With advancements in technology and increased awareness, the retail investor community is now more actively participating in voting. Providers have emerged that offer investors platforms to access information and tools to make informed voting decisions.
These platforms allow retail investors to more easily access proxy materials, review company proposals, and cast their votes electronically.
Shareholder advocacy groups and organisations have also played a crucial role in educating retail investors to exercise their voting rights.
These groups provide information and resources on voting matters, empowering retail investors to make their voices heard.
It is important to note that while the rate of retail investors voting is increasing, they still face certain challenges, including the need for further simplification of the voting process.
To address this challenge, firms such as BlackRock and State Street Global Advisors have implemented voting programmes which offer participants in pooled funds the ability to directly partake in proxy voting process and have the portion of their shares voted at shareholder meetings according to their own decision.
This growing participation of the retail investor community in voting is a positive development as it promotes transparency, accountability, and shareholder democracy.
What have been the greatest pressures on institutional investors in terms of governance and how has this impacted the custodian community?
Institutional investors, such as pension funds, mutual funds, and insurance companies, have faced significant pressures in terms of governance in recent years. These pressures have resulted from a combination of regulatory changes, investor demands for transparency and accountability, and evolving societal expectations.
Institutional investors are subject to various regulations and guidelines that govern their investment activities and fiduciary responsibilities. Compliance with these regulations requires robust governance frameworks, risk management systems, and disclosure practices. Failure to comply with regulatory requirements can result in legal and reputational consequences.
While not regulatory, there are also initiatives such as the United Nations Principles for Responsible Investing (UNPRI) as well as many countries globally adopting some form of stewardship code for investors which, broadly speaking, call for investors to vote across their holdings and disclose this voting activity or, if they did not vote, to explain why.
Shareholder activism has become more prevalent, with investors increasingly using their voting power and engaging in dialogue with companies to influence their governance practices. Institutional investors are under pressure to actively participate in voting, engage with company management on governance issues, and support or oppose shareholder proposals.
ESG factors have gained significant importance in investment decision-making. Institutional investors are facing pressure from stakeholders, including their clients, to integrate ESG considerations into their investment processes. This requires assessing companies’ ESG performance, engaging with companies on ESG issues, and exercising voting rights in alignment with ESG goals.
The impact of these pressures on the custodian community has been significant. Custodians have had to adapt their services to meet the evolving governance requirements of institutional investors. This includes providing enhanced reporting and transparency on governance-related matters, offering voting services, and supporting clients in complying with regulatory obligations.
Custodians have also had to invest in technology and systems to ensure efficient services supporting investors in meeting their governance obligations.
The evolving regulatory landscape
The European Union has been at the forefront of regulatory reforms related to governance considerations. Several initiatives and regulations have been introduced to strengthen corporate governance practices and promote sustainable and responsible investment within the EU.
SRD II aims to enhance the engagement and transparency of institutional investors and asset managers. It requires them to disclose their engagement policies, including how they integrate ESG factors into their investment strategies. It also promotes long-term shareholder engagement by facilitating the ability for investors to exercise their rights as shareholders, such as voting and participation in general meetings.
While not necessarily regulation, many EU markets maintain local investor stewardship codes requiring their members to have a voting programme and disclose their voting activity.
Beyond regulation and directives aimed at facilitating broader participation in voting, there have been numerous reforms implemented over recent years, such as the Sustainable Finance Disclosure Directive and the EU Action Plan on Sustainable Finance, which demonstrate the EU’s commitment to strengthening the governance aspect of ESG and promoting sustainable finance practices.
The reforms aim to enhance transparency, accountability, and long-term value creation in corporate governance, while also aligning investment practices with sustainability objectives.
As these regulations continue to evolve, they are expected to have a significant impact on how companies and financial market participants integrate ESG factors into their decision-making processes within the EU.
Market trends
From an oversight perspective, custodians and asset servicers can expect to focus their efforts on several key areas in response to evolving market trends and regulatory developments.
Custodians and asset servicers will need to enhance their capabilities to support the integration of ESG factors into investment processes and reporting. This includes providing ESG data and analytics, developing frameworks for ESG risk assessment, and enabling clients to incorporate ESG considerations into their investment strategies.
As regulatory scrutiny on ESG issues intensifies, custodians and asset servicers may need to assist their clients in complying with new and evolving regulations. This may involve implementing robust systems and controls to monitor and report on ESG-related activities, such as proxy voting, engagement, and disclosure requirements. They will also need to stay up-to-date on regulatory developments and adapt their practices accordingly.
Custodians and asset servicers will need to embrace innovation and adopt technology solutions to meet the evolving needs of clients and regulators. This may involve leveraging technologies, such as artificial intelligence or machine learning, to enhance ESG data analysis, reporting, and compliance processes.
Given the broader participation rate of varying types of investors as it relates to proxy voting, custodians will also need to think about using technology to facilitate services to meet the varying needs of different types of investors, whether that be the provision of data and reporting frameworks or providing a simple, easy-to-use service for a retail investor.
Looking ahead for custodians
Simply put, the demand and participation rate in proxy voting will over time only increase. Custodians need to be prepared to facilitate this service and, crucially, understand how it is being used by their clients and why it is important.
The ‘G’ in ESG may not always grab the headlines, but it is a crucial component of many investors’ ESG programmes.
By addressing this imperative, custodians can deepen client relationships, mitigate reputational risks, and gain a competitive edge in the rapidly evolving investment landscape.
How governance has evolved in the age of ESG
While ESG has in recent years been in sharp focus for many within the investment and broader financial services industry, it is important to understand how services provided by custodians facilitate shareholder participation in the governance of the companies they invest in.
As companies and investors become more aware of the material impact of environmental and social factors on long-term investments, there appears to be a significant shift towards incorporating these considerations into corporate governance practices, primarily through proxy voting.
Many institutional investors are using their voting power to influence corporate behaviour and promote sustainability by, for example, supporting calls for greater transparency and accountability from companies, particularly as it applies to their environmental and social impacts.
While most annual shareholder meetings have standard agenda topics relating to the election of directors and executive remuneration, there are a growing number of instances of shareholders submitting ESG proposals at meetings.
These proposals could relate to issues pertaining to climate change, human rights or otherwise controversial practices relating to a company.
Participating in shareholder meetings and voting upon these types of proposals is important for investors not only from a reputational perspective as it relates to voting disclosure but also to ensure they have a say in how the companies in which they invest conduct business and govern their practices.
Given the importance and growing demand from investors for sophisticated and reliable proxy voting services from their custodian banks, many banks and intermediaries choose to partner with a vendor to ensure proxy voting can be offered in a timely, secure and efficient manner.
Vendors, such as ISS, address this market demand through the provision of a voting platform, allowing investors to view upcoming shareholder meetings and vote upon meeting agendas, coupled with technical connections across sub-custodians and market agents globally to process voting instructions through to the shareholder meeting.
A regional look at heightened voting activity
Shareholder voting activity has indeed increased in many regions, driven by the growing recognition of the importance of corporate governance. Hot spots for shareholder voting activity vary across regions.
The US has been quite active in institutional shareholder voting, and the US Securities and Exchange Commission (SEC) mandates disclosure of mutual fund voting. Institutional investors and activist shareholders are increasingly using their voting power to influence corporate decision-making, particularly on issues related to executive compensation, board composition, and environmental and social policies.
In Europe, shareholder voting activity has also increased, most recently driven by regulatory changes and investor engagement. Historically, many European investors would vote in their home or adjacent markets.
Regulatory initiatives such as the Shareholder Rights Directive (SRD II) have encouraged greater shareholder engagement and voting across an investor’s entire portfolio.
Asian Pacific markets, particularly Japan and South Korea, have also witnessed an increase in shareholder voting driven by corporate governance reforms. What remains a challenge in certain APAC markets is that some custodians do not offer a proxy voting service which impedes their investor clients’ ability to effectively manage their ESG and voting programmes across all holdings.
Australia has witnessed a surge in shareholder voting activity, particularly in relation to climate change and sustainability issues. Shareholders have been pressuring companies to disclose their climate-related risks and take action to mitigate them. This has led to increased resolutions on climate-related issues and greater engagement between companies and their investors.
Historically apathetic to voting, retail investors awaken
While proxy voting has been important to institutional investors for many years, we are also now seeing a growing demand from other types of investors who may not have historically leveraged their voting rights or have been able to directly participate in the proxy voting process.
With growing public demand as well as increasing pressure from directives such as SRD II, there has been an increase in the volume of investors required to be offered a proxy voting service and many custodians have had to rapidly evolve their offering to accommodate the need.
This development, which includes wealth managers and retail banks, to facilitate shareholder meetings and vote processing to investors means two things:
First, more investors than ever can now participate in the proxy voting process.
Second, custodian banks and other intermediaries face even more pressure to ensure they are offering and facilitating a voting service for their clients.
With advancements in technology and increased awareness, the retail investor community is now more actively participating in voting. Providers have emerged that offer investors platforms to access information and tools to make informed voting decisions.
These platforms allow retail investors to more easily access proxy materials, review company proposals, and cast their votes electronically.
Shareholder advocacy groups and organisations have also played a crucial role in educating retail investors to exercise their voting rights.
These groups provide information and resources on voting matters, empowering retail investors to make their voices heard.
It is important to note that while the rate of retail investors voting is increasing, they still face certain challenges, including the need for further simplification of the voting process.
To address this challenge, firms such as BlackRock and State Street Global Advisors have implemented voting programmes which offer participants in pooled funds the ability to directly partake in proxy voting process and have the portion of their shares voted at shareholder meetings according to their own decision.
This growing participation of the retail investor community in voting is a positive development as it promotes transparency, accountability, and shareholder democracy.
What have been the greatest pressures on institutional investors in terms of governance and how has this impacted the custodian community?
Institutional investors, such as pension funds, mutual funds, and insurance companies, have faced significant pressures in terms of governance in recent years. These pressures have resulted from a combination of regulatory changes, investor demands for transparency and accountability, and evolving societal expectations.
Institutional investors are subject to various regulations and guidelines that govern their investment activities and fiduciary responsibilities. Compliance with these regulations requires robust governance frameworks, risk management systems, and disclosure practices. Failure to comply with regulatory requirements can result in legal and reputational consequences.
While not regulatory, there are also initiatives such as the United Nations Principles for Responsible Investing (UNPRI) as well as many countries globally adopting some form of stewardship code for investors which, broadly speaking, call for investors to vote across their holdings and disclose this voting activity or, if they did not vote, to explain why.
Shareholder activism has become more prevalent, with investors increasingly using their voting power and engaging in dialogue with companies to influence their governance practices. Institutional investors are under pressure to actively participate in voting, engage with company management on governance issues, and support or oppose shareholder proposals.
ESG factors have gained significant importance in investment decision-making. Institutional investors are facing pressure from stakeholders, including their clients, to integrate ESG considerations into their investment processes. This requires assessing companies’ ESG performance, engaging with companies on ESG issues, and exercising voting rights in alignment with ESG goals.
The impact of these pressures on the custodian community has been significant. Custodians have had to adapt their services to meet the evolving governance requirements of institutional investors. This includes providing enhanced reporting and transparency on governance-related matters, offering voting services, and supporting clients in complying with regulatory obligations.
Custodians have also had to invest in technology and systems to ensure efficient services supporting investors in meeting their governance obligations.
The evolving regulatory landscape
The European Union has been at the forefront of regulatory reforms related to governance considerations. Several initiatives and regulations have been introduced to strengthen corporate governance practices and promote sustainable and responsible investment within the EU.
SRD II aims to enhance the engagement and transparency of institutional investors and asset managers. It requires them to disclose their engagement policies, including how they integrate ESG factors into their investment strategies. It also promotes long-term shareholder engagement by facilitating the ability for investors to exercise their rights as shareholders, such as voting and participation in general meetings.
While not necessarily regulation, many EU markets maintain local investor stewardship codes requiring their members to have a voting programme and disclose their voting activity.
Beyond regulation and directives aimed at facilitating broader participation in voting, there have been numerous reforms implemented over recent years, such as the Sustainable Finance Disclosure Directive and the EU Action Plan on Sustainable Finance, which demonstrate the EU’s commitment to strengthening the governance aspect of ESG and promoting sustainable finance practices.
The reforms aim to enhance transparency, accountability, and long-term value creation in corporate governance, while also aligning investment practices with sustainability objectives.
As these regulations continue to evolve, they are expected to have a significant impact on how companies and financial market participants integrate ESG factors into their decision-making processes within the EU.
Market trends
From an oversight perspective, custodians and asset servicers can expect to focus their efforts on several key areas in response to evolving market trends and regulatory developments.
Custodians and asset servicers will need to enhance their capabilities to support the integration of ESG factors into investment processes and reporting. This includes providing ESG data and analytics, developing frameworks for ESG risk assessment, and enabling clients to incorporate ESG considerations into their investment strategies.
As regulatory scrutiny on ESG issues intensifies, custodians and asset servicers may need to assist their clients in complying with new and evolving regulations. This may involve implementing robust systems and controls to monitor and report on ESG-related activities, such as proxy voting, engagement, and disclosure requirements. They will also need to stay up-to-date on regulatory developments and adapt their practices accordingly.
Custodians and asset servicers will need to embrace innovation and adopt technology solutions to meet the evolving needs of clients and regulators. This may involve leveraging technologies, such as artificial intelligence or machine learning, to enhance ESG data analysis, reporting, and compliance processes.
Given the broader participation rate of varying types of investors as it relates to proxy voting, custodians will also need to think about using technology to facilitate services to meet the varying needs of different types of investors, whether that be the provision of data and reporting frameworks or providing a simple, easy-to-use service for a retail investor.
Looking ahead for custodians
Simply put, the demand and participation rate in proxy voting will over time only increase. Custodians need to be prepared to facilitate this service and, crucially, understand how it is being used by their clients and why it is important.
The ‘G’ in ESG may not always grab the headlines, but it is a crucial component of many investors’ ESG programmes.
By addressing this imperative, custodians can deepen client relationships, mitigate reputational risks, and gain a competitive edge in the rapidly evolving investment landscape.
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