16 August 2024
ESG Exposures for Investment Managers and Asset Management Executives
Incorporating environmental, social, and governance (ESG) criteria into the investment decision-making process is not a new concept. However, scrutiny is increasing alongside established frameworks for assessing ESG credentials.
As the investment approach has become more mainstream, both investors and government regulators have called for greater standardisation about what does and does not constitute ESG investing, and which funds are worthy of this label.
As the Financial Conduct Authority (FCA) works to reshape the UK’s financial regulation, ESG stands high on its agenda, particularly regarding retail investors. There are also implications for the wider asset management community.
As the Financial Conduct Authority (FCA) works to reshape the UK’s financial regulation, ESG stands high on its agenda, particularly regarding retail investors.
Investing roots
ESG is an outgrowth of the socially responsible investing (SRI) movement that began to gain traction in the 1970s. SRI relied heavily on exclusionary screening, avoiding companies that produced products that could cause harm, such as tobacco, pesticides, and weapons. Asset management firms were free to define their own SRI process.
As investment managers and investors became more sophisticated about this approach, they began to factor in societal and workplace issues.
According to Jonathan Drinkwater, a Divisional Director with Gallagher Specialty, “SRI and now ESG factors mirror changes in acceptable behaviours and standards in our broader society. ESG portfolio management has moved beyond avoiding sin stocks. Especially in the UK, it now may involve proactive corporate engagement around these key issues.”
Growth spurt
The significant increase in ESG assets that asset managers have seen over the past five years is attributable to several factors. Among the most prominent are:
· Increased corporate transparency and the growth of big data.
· The rise of climate activism and the growing inclusion of environmental concerns on corporate and government agendas.
· The impact of the COVID-19 pandemic on investor attitudes.
Today, nearly all public companies provide sustainability reporting as well as social and governance risk reporting. This reporting makes it easier for investment managers to monitor these considerations.
Numerous surveys from consultancies and asset management firms have shown that most investment managers place greater importance on ESG performance in their decision-making than before the COVID-19 pandemic. With the pandemic in the rearview mirror, many retail ESG funds have experienced outflows since 2022.
Alex Burton Brown, Executive Director at Gallagher Specialty, noted, “The COVID-19 pandemic not only spurred fund inflows, but it shifted greater emphasis onto the ‘S’. Workplace issues and issues around contingent workers gained prominence in the investment process. Now that the pandemic has ended, those concerns among stakeholders have lessened.”
Greenwashing scrutiny
As ESG stakeholder and regulatory pressures on public companies have increased — particularly around the “E” — so have instances of greenwashing. Greenwashing involves misleading the public into believing that a company or entity is doing more to protect the environment than it is.
“It often occurs because companies set overly ambitious goals for themselves, they’ll make promises and set targets without considering what it takes to achieve them.” Burton Brown said, pointing to research showed that nearly two-thirds (62%) of senior leaders at large UK businesses are concerned that their ESG targets put them at risk of litigation. Of those surveyed, close to three-quarters (72%) admitted feeling pressured into setting targets without regard for how they would be reached.
For a specific greenwashing example, a recent ruling against a major airline highlighted concerns where an activist group argued that the company’s “Fly Responsibly” campaign was misleading. Holding a greenwashed company in its portfolio creates contingent risks for asset managers.
“An analyst’s or investment manager’s inability to identify greenwashing may cause investors to lose confidence in the portfolio holdings and might motivate them to move their money elsewhere,” Drinkwater explained. “It may also create compliance issues and even cause them to veer from their investment mandate and stated risk profile.”
As demand for ESG investing opportunities has outpaced supply, asset management firms may be tempted to greenwash themselves due to the pressure to launch new ESG products and portfolios to meet the surge in retail and institutional demand.
Of senior leaders at large UK businesses are concerned that their ESG targets put them at risk of litigation
A market matures
Creating more consistent standards and eliminating greenwashing have become priorities for regulators worldwide. Following the rapid growth in ESG assets, the FCA addressed the topic of ESG in its 2021/2022 business plan.
The regulator stated, “We will increase our supervisory focus on whether asset managers present the environmental, social, and governance (ESG) properties of funds in terms that are fair, clear, and not misleading.”
The FCA took these concerns a step forward in November 2023 when it released its policy statement on Sustainable Disclosure Requirements (SDR) and investment labels. This included an anti-greenwashing rule for FCA-authorized firms that sustainability claims be “…fair, clear, and not misleading.” These went into effect in May 2023.
The FCA also introduced four investment labels for retail investors that fund holding at least 70% of their assets in sustainable companies. While the labels are not mandatory, if the asset management firm declines to use them, they can no longer use ESG, climate, green, and other terms associated with sustainable investing in a fund’s name or marketing materials.
From an ESG perspective, asset managers must continue to follow the rules of the regulatory road.
ESG - Insurer selection
Asset managers have increasingly begun to consider the ESG credentials of their service providers, including choice of insurer; Drinkwater commented, “we have seen a growing number of clients request ESG information and certification concerning their insurers, this is now one of many assessment criteria clients are taking into account when deliberating which insurer is the right fit for their business”. Gallagher expect this growing trend will continue to emerge in coming renewal cycles with ESG being a selection tool at the clients’ disposal.
Looking ahead
Insurance companies that underwrite Directors and Officers (D&O) insurance for asset management firms have noted the FCA’s evolving focus. As ESG regulations become more stringent, carriers are taking a closer look at how asset managers integrate ESG considerations into their investment process.
These new rules will make it easier to sue asset management firms for ESG-related improprieties. Yet just as the FCA is unlikely to follow the US Securities and Exchange Commission’s lead — and level multi-million-pound fines against asset management firms for greenwashing — the UK is unlikely to experience the level of anti-ESG lawsuits that are currently making their way through the US courts. Regardless, D&O insurers are monitoring for an upswing in ESG-related claims and litigation activities.
Asset managers now need to be more diligent in screening for ESG and positioning themselves with investors. Some firms may elect to drop the ESG label altogether to have greater investment flexibility and improve returns.
Asset management firms that commit to this market should develop an investment policy that outlines how ESG criteria will guide their investment decisions. Any existing policy should be reviewed in light of the new greenwashing and labelling regulations.
Analysts and investment managers will need to be more diligent in their research and more cautious about relying on third-party data. In addition to the data, they may want to consider using forward-looking analysis to guide their decisions. This can help avoid a situation where a key portfolio holding suddenly backpedals on a sustainability goal because it is unlikely to achieve it.
From an ESG perspective, asset managers must continue to follow the rules of the regulatory road.
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