An Asset Owner's Guide to ESG

July 20, 2020

Asset owners’ decisions affect people over the world, so they want to know if investment managers’ ESG efforts are serious. Here are eight things to check.

ESG flows and marketing ramp up

Over the past few years, there has been steady growth in the number of firms and funds that seek to integrate ESG into their investment strategies.  According to the UNPRI’s 2019 Annual Report, the organization saw a 20% year-on-year growth in its signatory base; in North America, 456 new signatories joined UN PRI in 2018, and 628 did in 2019.  Morningstar’s first Global Sustainable Fund Flows Report, published in May 2020, demonstrates continued appetite for ESG funds in the wake of the COVID selloff. In Q1, sustainable funds globally saw $45.7bn in net inflows, while the overall fund universe saw outflows of $384.7bn.

As ESG-related flows – and marketing –  ramp up, asset owners must determine which managers are truly integrating ESG into their thinking, and which managers are addressing ESG at the margins.  A question we often hear is “how can we tell if a manager is really integrating ESG, or just doing the minimum to check a box?” Here are eight things to look at. The first four are “inputs”, and the second four are “outputs” — or an overview of areas asset owners must understand.

Things to check

  1. Check the profile of the ESG person/team.  Not all firms have an ESG department, but most have a dedicated ESG professional. (If they only have someone who “looks after” ESG on a part-time basis, note that too.) Ideally, the head of ESG will have a mix of investment and operating company experience and be a senior professional with a track record of influencing the C-Suite.  From an organizational perspective, the closer this person sits to the deal teams and CIO, the greater the likelihood that the firm is integrating ESG into its investment process.  Meaningful integration is less likely if the role is housed in marketing, for example.
  2. Interview the head of ESG together with the investment team during the diligence process. Explore how they work together throughout the investment process. Ask to see the tools the team uses to assess material ESG risks and opportunities. Are they plugging in a score from an ESG data provider, or conducting deep analysis of company disclosures and third-party sources?
  3. Conduct a document review.  Does the manager include ESG risks and opportunities as part of their screening process? Is ESG factored into investment committee memos including risk assessments and position sizing? Where in investment committee decks does the section on ESG lie? Is it one page, at the end? Is there evidence that the investment team engages management teams on material ESG issues?  Is ESG incorporated into investment stewardship?
  4. Examine the firm’s ESG/sustainability policy. How ambitious, detailed and clear is it? Does the firm describe things it actually did, or things it seeks to do? Does it talk mostly about its charitable giving, or focus on its core activities? To illustrate, compare these two European firms on their own carbon practices. The first firm says “the net CO2e emissions from electricity consumption, scope 2, totaled 0 in 2019.” The second firm, similar in size and strategy, says instead “we aim to reduce [our] carbon footprint by identifying more efficient resource use, and where necessary by paying to offset our carbon emissions.”

Things to form a view on

  1. Understand how ESG risks are assessed across the current portfolio.  Has the firm assessed the physical risks of climate change, such as supply chain interruptions, and weather-related damage? Does it understand the costs of mitigating those risks? Would portfolio companies be able to pass through to customers a carbon price of $100 or $150 per metric ton? If not, what would the effect be on EBITDA? These carbon tax figures aren’t imaginary: they lie at the heart of the Energy Innovation and Carbon Dividend Act of 2019 (currently a bill in the House of Representatives). Columbia University researchers in turn found the plan – which would cut American carbon pollution by almost 40% by 2030 – also had the most support in Congress.
  2. Understand the firm’s approach to ESG as a value lever, and as an investment theme. Recent work by PWC report noted “A majority of GPs and LPs do not currently estimate the value created by the ESG activities of their portfolio companies, but many intend to do so. While 41% of GP respondents say they do this, there is still a way to go in terms of moving this forward.” On the investment theme front, is there evidence that the manager is actively considering  societal shifts to sustainability and diversity in its deal-sourcing? A long-term ESG outlook can mitigate risk, and unlock investment opportunities.
  3. Evaluate the firm’s approach to training. Do all investment and investor relations professionals receive ESG training? If so, is it a one-off? Or is it reinforced and updated? The same 2019 PWC report found that nearly half of firms do not train their investment teams on ESG.
  4. Evaluate the firm’s approach to ESG in its own management. Does the firm measure and report on its own carbon footprint? How is that footprint managed? As an example, EQT began measuring this in 2015. It has kept emissions per employee at 29 metric tons of carbon dioxide equivalents, and offsets all greenhouse gas emissions that cannot be avoided. Examine the firm’s approach to its suppliers and advisors, as well to its recruiting and promotion. How proactive is it about improving the diversity of its own workforce, and of those businesses and advisors it interacts with?

Asset owners, as well as GPs, are themselves becoming more fluent in ESG concepts. As a group, they are becoming more convinced that ESG themes are not just about values, but about value too; and the shift has been dramatic enough to be called an “investor revolution.” As fiduciaries, it behooves them to be much more detailed and rigorous in their review of asset managers’ ESG practices.

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