Reading the transparency reports submitted by signatories to the UN Principles for Responsible Investment (PRI), it becomes clear that asset managers take widely different approaches in the integration of environmental, social and governance (ESG) factors.
Unfortunately, little seems to have materialised. Some research implies that asset managers are probably not integrating ESG the way that they should.
Stating this with certainty is tricky, since we really do not know enough about the way asset managers make their investment decisions.
In a previous article for Board Agenda, I pointed out that these investors tend to rely (to some extent) on the ESG rating and ranking industry. I also stressed that the sheer number of ESG questionnaires sent out by this industry can cause ESG reporting fatigue among companies.
In this article I will talk about the 45 interviews I have conducted with asset owners, asset managers and companies. These anonymous respondents are located in the UK, the Netherlands and Germany.
ESG and investment decisions
I find that many investors buy their ESG data from third-party providers. Their motivation for this is often efficiency or to challenge their own viewpoint.
It must be stressed that many of them are aware of the pitfalls of the ESG rating and ranking industry, but they consider this industry to be their best option. They claim that there is much to be improved when it comes to ESG data supplied by companies.
According to the investor respondents, this limitation impedes their effort to incorporate ESG in their investment decisions.
I also find that they tend to favour ESG ratings by MSCI or Sustainalytics, because of their substantial coverage. In particular, MSCI is well known for its high-quality governance data, and Sustainalytics is well known for its expertise on social and environmental data.
Based on the interviews, it appears that there are differences between the asset managers in the way they rely on these ESG research providers. There are three types on the reliance continuum:
1. Investors who blindly rely on the ESG rating and ranking industry to construct their portfolios.
2. Investors who use it with caution. For example, some investors have a small, internal ESG team to double-check the scores in case of discrepancies. These discrepancies can be found by subscribing to more than one rating agency and by comparing the scores. Others may only double-check scores for their largest holdings to avoid large mistakes.
3. Investors who use the narrative in the ESG reports and form their own assessment. This type of integrated approach is relatively rare, since it is a time-consuming task when your portfolio consists of hundreds or thousands of companies.
If they blindly rely on ratings and rankings, they can hardly claim that they have a unique ESG product. After all, they rely on someone else’s opinion on the ESG performance of companies.
They may also end up with a very similar best-in-class portfolio as their competitor. It then becomes clear that those investors who interpret their own investment implications from the narrative (and other information) demonstrate the more thorough case of ESG integration.
An example of this type of investor is Generation Investment Management, founded by Al Gore. Its successful track record shows that this approach can pay off when it is done right.
As I pointed out in my previous article, this is not often a feasible option for investors. Portfolios tend to comprise hundreds of companies (or more), which makes it difficult to research and assess both the ESG and financial performance of those companies.
Finance and ESG silos
The description of the first and second type of approach implies that there are silos between finance and ESG. Indeed, I find that in about half of the cases, ESG and finance are still too separated to be referred to as “integrated’’.
Some of the asset manager respondents even mention these silos explicitly as one of the barriers to mainstreaming responsible investment.
Using the interviews with asset owners, I partially solve the puzzle of why integrated thinking is not as widespread as it seems.
Of course, part of this answer is the difficulty with large portfolios, but I also find that asset owners often drop the ball. Specifically, their selection, monitoring and review efforts are often insufficient.
Some asset owners, for example, merely ask if the asset manager is a signatory to the UN PRI. They then check the “ESG” box and leave it at that. It then becomes clear that the asset managers they hire can quite easily get away with the superficial adoption of ESG. This appears to be related to the finding that they are, overall, sceptical of the business case for ESG.
They also mention that it is a difficult topic to grasp, as there are so many facets to it. If asset owners were to dig a little deeper and challenge their asset managers a little more, the latter would be more inclined to move towards integrated thinking.
Barriers to ESG integration
There are several barriers that impede the thorough integration of ESG. I will only touch upon those that are most frequently mentioned.
First, the data supplied by companies often fails to demonstrate the business case of ESG. How material was the reduction in water usage for the company? How many more savings can we expect from this?
Of course, not everything can be quantified, but the least companies can do is to explain how ESG efforts benefit them. Fortunately, company respondents do acknowledge that they should do a better job of reporting the business case for ESG.
If they do, this will help investors move towards integrated thinking (and therefore break down the silos between ESG and finance). Moreover, it will help convince asset owners who are still sceptical when it comes to the business case of ESG.
It will also significantly improve the quality of the ESG rating and ranking industry. Of course, investors are constrained by the large portfolios they manage. There is, nevertheless, room for improvement in the way most asset managers incorporate ESG.
Asset manager respondents also mention that incentive schemes are simply not aligned with long-term, responsible investment. This is especially pronounced, because ESG takes a while to unfold.
In addition, clients can be a barrier as their demand tends to be inconsistent and not as long-term as it should be. This is especially the case when looking at the smaller asset owners, who are not always as educated (as compared with the larger ones) when it comes to responsible investment.
This brings us to the last point: education. Unfortunately, responsible investment is not yet widely integrated in business school curricula. I find that Germany is especially lagging behind in educating its students about the importance of ESG.
This obviously limits the availability of talent to asset managers or owners.
Stephanie Mooij is a researcher at the Smith School of Enterprise and the Environment, University of Oxford. For further information, see Mooij, Stephanie, Asset Managers’ ESG Strategy: Lifting the Veil (25 November, 2017.)