The asset-owner community has realised the power of their capital beyond the typical risk/reward copula, and overwhelmingly wishes to wield that power to make a positive and measurable impact for the benefit of society as a whole.
In other words, capital owners are increasingly including within their thinking the non-financial impact and benefits of their investments – and wish to measure this to report such value to their stakeholders across the various economic, social and governance criteria used to assess these objectives.
Investment managers – as facilitators as well as capital investors – are uniquely positioned to assist the asset-owner community in achieving their wider non-financial objectives. However, as this is a nascent movement, many are still unsure of the options available, or wary of the costs and the implications of this change. Further, they are concerned the directional path is uncertain and, as such, leads to confusion in management’s strategic thinking on the topic and hence actual implementation variations in practice.
In this article, we ask three key questions and in doing so hope to provide directional signposts for investment managers to follow:
- What are the various ESG strategies available?
- How can an investment manager improve a real-asset business by implementing ESG?
- How do we, as an industry, move beyond the ESG screen into a situation of systematic integration at all levels of operation
The four stages of ESG development
Looking back at the evolution of ESG, we recognise four major steps in the development, subsequent refinement and impact of ESG investment. The concepts outlined below provide stepping stones, i.e. a pathway to develop impact-investment programmes.
Stage one: exclusion screening
Investors initially seek to screen out from their portfolios certain controversial industries or companies that they did not wish to be associated with. Historical examples include tobacco, alcohol and arms. More recent examples focus on those entities having perceived negative energy and environmental impact, such as logging, nuclear energy and coal. The clear objective is to align the allocation of the investors’ money with their broader beliefs, while at the same time mitigating certain ESG risks associated with the identified ESG-screening factors.
Stage two: positive screening
Developing from a relative passive position, active investors seek to invest in companies with a good or improving ESG track record, which triggered the prerequisite of the company in question to disclose its ESG commitment and progress with their financial reporting. The objective of the LP here is to improve long-term, risk-adjusted returns through the mitigation of ESG-related risks and identification of investment opportunities in companies and assets demonstrating appropriate ESG behaviour and potential.
A typical set of ESG factors included in this screening process is featured in the table on p.22. These criteria are also applicable in the further concepts below.
Stage three: ESG integration
Investors want a relevant set of ESG criteria – a subset of the table on p.22 – fully integrated into the investment-decision process. The major step here compared with the two previous stages is that the full integration of the ESG criteria allows investors to move from a binomial/Manichean decision-making matrix (‘exclude/support’ or ‘good/evil’ framework) into a more subtle and holistic investment decision-making matrix. One that includes a more nuanced appreciation of the ESG returns into the investment-decision matrix and allows for a gradual approach instead of the binary ESG approaches described above. The traditional two-dimensional efficiency margin becomes a three-dimensional efficiency surface. The key challenge here is the change in the decision-making process into a three-dimensional process, which GPs in general haven’t been used to before.
The main benefit of the new ESG-integrated framework is that investment opportunities can now be assessed in terms of blended value creation across both financial and impact returns and hence act as an enabler for investors to allocate capital in accordance with their specific objectives.
Stage four: Impact investment
Impact investment is the next step in the evolution and pathway detailed previously. It builds on the ESG integration described above by adding specific as well as quantifiable impact metrics, including auditable regular reporting of the metrics. The latter allows the investor and the GP to communicate and report on the effectiveness of their capital allocation to their stakeholders.
Metrics could be as simple as jobs created, water saved, CO2 saved or as complex as contribution of the invested capital to global warming.
While ESG is seemingly well integrated into the mainstream investment management and corporate world, with well over the equivalent of $80 billion in assets now signatories of UNPRI, only a small percentage of these assets are actually taking into account ESG data in a systematic and quantifiable way, embedding it into the company’s processes. This is where the current challenge lies for GPs to help investors move from integration to a quantifiable element which is auditable.
A call to action
From our discussions with our investors, the most relevant concepts are ESG integration and impact investment, when it comes to the implementation of their non-financial objectives in the context of real asset investment strategies. How can these be implemented by the manager to improve his real-asset business?
The first expected step by asset owners is ESG integration at the firm level, ensuring its culture, but also its strategic and operational management, are well aligned with the overall ESG intent. That is, ensuring management understands, lives and acts with a strong ESG intent. Typically, this will include participation in regular reporting and benchmarking exercises, allowing the industry to improve.
The second step is at the product level – integrating ESG information into the investment decision-making process, with a view to improving the risk-return characteristics of a portfolio. Often, investor clients advise that when it comes to ESG integration, the objective is not necessarily to make the world better, as their fiduciary responsibility is first and foremost the ability to pay a pension/premiums to their current and future pensioners/stakeholders.
Investment managers have a constructive role to play in talking with asset owners to define which ESG factors are material to their capital allocation to a specific real asset strategy. Referring to Table 1 on p. 22, we believe that, depending on which real asset class, around 50 percent or more of the topics listed are relevant in an ESG integration context.
When it comes to impact investment, whereby, as described earlier, investment opportunities are assessed quantitatively using three dimensions instead of the traditional risk/reward copula, our role as the investment manager also includes the choice of material ESG factors to the strategy, what determination of the target impact return of the strategy and a commitment to a practical reporting framework.
Doing this empowers asset owners to allocate their capital with well-defined objectives that are measurable, and reported, while being cognisant that impact measurement is a new domain that is currently being developed by the industry, with many challenges to build a cohesive and transparent system that accurately translates impact into tangible and comparable data.
This is where the current fundamental challenge of ESG integration lies: how do we as an industry move beyond the ESG screen into a situation of systematic integration at all levels of operation?
Based on the above, investment managers have a role to act in loco parentis by ensuring we extend the asset owner’s strategies by implementing the relevant ESG steps in our specific subset of industry. The implementation starts with ensuring the investment manager has the appropriate ESG alignment and that typically starts with the appropriate culture and mindset along the right corporate set-up. It can be investor-focused only but will also, when deeply embedded within the culture of the company, include initiatives focused on corporate employees, the community and the local environment.
In our role as investment manager, we also need to moderate various asset-owner groups – aware that these pools of capital may be at various stages in the integration of ESG within their own investment and indeed overall strategies. We must recognise that asset owners are at different stages of implementing ESG and certain pools of capital are well ahead of others. As investment managers, we need to act as moderators and constantly deal with asset owners’ varying wishes.
One of our key roles is to offer products that achieve the ESG objectives of asset owners. As such, and with those capital owners not as advanced in their transition to sustainability, we also have the role of ensuring these asset owners understand the benefits of implementing these objectives within their capital investment framework, bringing additional asset owners on board to such strategies, acting as advocates for sustainability.
A final consideration that must be addressed in the context of the fiduciary duty to LPs is the impact of ESG integration – and impact investment – on the financial performance of such strategies. Here, the overwhelming result of recently updated meta-research, carried out by the University of Oxford and Arabesque Partners, points out that in 80 percent of reviewed studies, prudent sustainability practices have a positive impact on investment performance.
One of the greatest challenges for our industry is to accompany our asset-owner clients on their journey, expanding their fiduciary duty to include ESG factors – not at the expense, but to the benefit of returns. This is achieved by entering into a constructive dialogue with our clients, but also
our peers, and recognising we are embarking on a long journey – one where the benefits to all stakeholders are clearly outlined, but where the road is only partially identified at best.