FIRSTavenue on how to put the S in ESG

This article is sponsored by FIRSTavenue

The pandemic, along with growing awareness of racial and gender inequality, has encouraged investors to place a stronger focus on social issues. This presents a challenge for many infrastructure managers, who may be experienced in assessing environmental risks in their portfolio but will find that their social impacts are harder to quantify.

Francesca Lloyd, managing director at FIRSTavenue, notes that LPs are getting more sophisticated in scrutinising the ESG claims made by fund managers. The result, she says, is that managers must adopt a robust reporting framework and insist that portfolio companies provide data to measure their performance.

Why should investors pay more attention to social issues, alongside environmental considerations?

Environmental considerations have been part of the infrastructure investment process for quite some time now. Environmental impact assessments are often a gating feature of the initial tender or planning process for an infrastructure project. Environmental factors are arguably easier to analyse in a quantitative manner than social factors, so by virtue of that are more digestible and comparable.

But we have to recognise that ESG is, first and foremost, a risk mitigation assessment, and the ESG factors are complex and do not exist in a vacuum. They cannot be fully understood, and the risks cannot be fully understood, without a comprehensive review of all three of the factors. We see companies, including some renewable energy companies, that have a really firm grasp of environmental issues, but they might have serious social issues within their supply chain.

While ESG is primarily a risk mitigation exercise, people are starting to realise that ESG – all three components – are a business opportunity. Improved social indicators can help the long-term sustainability of your business. Conversely, recent ethical scandals have shown that social issues can also erode significant shareholder value, despite this perception that environmental issues tend to be financially more material than social issues.

Also, shareholders, LPs and regulatory bodies are forcing GPs to consider social factors. There has been an unrelenting growth in ESG requirements. Certain industries and jurisdictions have now increased their barriers to entry, based partly on social requirements. In the UK, for example, failing to adhere to social requirements, such as those in the UK Stewardship Code, the Modern Slavery Act, and certain pension scheme regulations, results in harsh penalties.

What are the key social issues that the infrastructure investing industry should be thinking about?

Some social factors have long been featured in infrastructure portfolio assessments – human rights, modern slavery, health and safety, and human capital management are in most GP templates for assessing an investment. Recently, there has been a new wave of social issues – socio-economic equality, diversity, equality and inclusion, digital rights, land issues. The materiality of these new topics is coming to light, so they need to be considered by managers.

Also, historically, infrastructure investors have been guilty of outsourcing these issues down the supply chain. Ignorance has been bliss, to a certain extent. Going forward, however, managers need to make sure they have the ability to get the data on all these social elements – and also decipher it and disclose it.

Transparency is going to be key going forward on social issues. Investors will have to work out whether these policies that the underlying portfolio companies say they have are truly applied in practice.

Is it always feasible to measure outcomes on social issues?

Historically, within social, a lot of infrastructure investors have had a tick box process – “does the portfolio company have X, Y, Z policies in place?” We need to move away from the tick-box culture.

Admittedly, it is a little bit harder within social to find quantitative data. I think a lot of managers right now are simply identifying the UN Sustainable Development Goals that they think relate to their portfolio.

The SDGs are a good starting point, but they leave a lot of room for interpretation. We do need to get to a more granular level of measurement.

Managers need to step beyond the SDGs and learn to identify the most useful indicators. There is an abundance of third-party standard providers that provide a framework for assessing social indicators. You’ve got the Sustainability Accounting Standards Board, the UN Guiding Principles, the OECD guidance, the UN Global Compact. And once managers have identified the right set of indicators, they need to demand more data from the portfolio companies.

How will the drive to standardise ESG reporting affect infrastructure fund managers?

Almost all managers are now UN PRI signatories. It is a pre-requisite for most LPs when they’re assessing a fund manager. And completing that annual assessment is now routine for most managers. Did we think we would get there five years ago? Maybe not. But they have all moved up onto one standard.

The launch of the EU Sustainable Finance Disclosure Regulation is the next step for everybody in terms of standardised ESG reporting. We’re already hearing a lot of LPs say that their stated preference is for Article 8 or 9 funds under the SFDR taxonomy. Over the next 18-24 months, SFDR disclosures are going to be the biggest reporting challenge for fund managers. But I think it will quickly become the norm.

Will we eventually get to a standardised suite of reporting, like there is for, say, measuring financial performance? ILPA has recently laid out a framework for manager due diligence and that acts as a good foundation for review. It will take time to standardise reporting – ESG factors can be so industry specific, there’s no one-size-fits-all.

That’s going to be a difficulty, but we’re definitely moving towards standardisation. This won’t be a burden – in fact, a lot of managers would probably welcome additional guidance.

What are LPs demanding from managers on ESG due diligence?

There are very many infra funds coming into the market that are branded as providing impact or sustainable investing. LPs have to demand data from the GP to assess how genuine their intentions really are and how impactful that strategy really is.

Investors have to make sure that GPs are not just tapping into the LP appetite for impact and sustainability. That is why the due diligence is becoming more sophisticated and intrusive.

Fund managers, when they go to market, spend a lot of time making sure they can stand by their ESG claims and avoid any accusations of greenwashing or impact washing, which can be more prevalent with social issues, given the level of subjectivity that’s often present there.

Managers must now have, depending on size, a dedicated ESG resource – and that ESG resource should have representation on the investment committee. ESG accountability has to start at that leadership level and then extend down through the organisation. Managers must be really prepared for increasingly sophisticated LP questions. They must ensure their responses are objective and that they’re evidenced.

Managers also need to start demonstrating that they walk the walk themselves. They need to own their own social impact. They could introduce KPIs linked to things like community involvement, inclusive recruitment, intern schemes, equal pay and gender equality.

Generally, I don’t think a GP’s social performance is a deal breaker right now for most allocations, but LPs are starting to focus on making sure there isn’t a contradiction between the manager’s promises at the portfolio level and their own practices.

How will ESG considerations change the industry over the next few years?

Financial returns are always going to be the primary focus within this industry, but the growing importance of strong ESG performance means that ESG-linked incentive structures will become common practice. Alongside this, expectations on ESG reporting are going to increase.

Even minority shareholders and lenders need to assess ESG risks and opportunities in their investments. For so long, people have been able to say “that’s the main shareholder’s issue” and minority shareholders and debt investors have been able to step away from the subject. But they are going to increasingly come under pressure to show that they are assessing ESG risks as well.

How has the pandemic affected investor interest in social issues?

Covid-19 has certainly put a spotlight on global social issues, whether it be unequal access to healthcare, bottlenecks in the supply chain, human capital management, or flexible working. When we couple the pandemic with other recent civil movements, we see that the public conscience appears to be more engaged and receptive than ever to social inequality and the need for change. So, the two together are acting as a catalyst.

Prior to the pandemic, there was a mounting collective concern around climate change. That has facilitated the focus on the environmental factors. Now, we’re starting to realise that to have a just transition to a lower carbon economy, we need to include social factors in our thinking. Infrastructure managers must focus on the social elements if they want to participate in this just transition and make truly sustainable infrastructure investments.