Chapter 2: The consideration of E-related matters can contribute to the proper functioning of the financial markets.

Question 1

World Commission on Environment and Development (WCED)

Answer 1

United Nations (UN) General Assembly convened in 1983.

International group of environmental experts, politicians and civil servants.

The WCED (also called ‘the Brundtland Commission’) was charged with proposing long-term solutions for bringing about sustainable development. In 1987, the Commission issued the Brundtland Report, also called Our Common Future, which introduced the concept of sustainable development and described how it could be achieved.

Question 2

Brundtland Report, also called “Our Common Future”

RIO EARTH SUMMIT

Answer 2

The report laid the foundations for the Rio de Janeiro Earth Summit (also known as the Rio Summit or the UN Conference on Environment and Development (UNCED)), held in 1992, which then ultimately led to
the creation of the UN Commission on Sustainable Development that same year.

The Summit spelled out the role of business and industry in the sustainable development agenda.

Its Rio Declaration states that businesses have a responsibility to ensure that activities within their own operations do not cause harm to the environment as businesses gain their legitimacy through meeting the needs of society.

Question 3

Early phase of ESG investing??

Answer 3

Quakers and Methodists already laid out guidelines to their followers over the types of activities in which they should or should not invest.

Negative screening (in other words, deliberately opting not to invest in companies or industries that do not align with values) was the most popular form of socially responsible investment (SRI) in the early days.

Modern institutionalisation of ethical exclusions arguably began at the height of the Vietnam War in 1971 with the establishment of the Pax World Fund,1 the first ethical mutual fund. At the time, the fund offered an alternative investment option for those opposed to the production of nuclear and military arms.

Question 4

Apartheid (Sullivan Principles late 70s)

Answer 4

In the late 1970s, the divestment movement became increasingly globalised through the divestment campaign in protest at South Africa’s system of apartheid. The Sullivan Principles, used by investors to engage and divest, required that a condition for investment for the investee company was to ensure that all employees, regardless of race, are treated equally and in an integrated environment as a condition for investment. The disinvestment campaign, which was implemented not only by investors but by governments and corporates as well, was credited by some as pressuring the South African government to embark on the negotiations ultimately leading to the dismantling of the apartheid system, resulting in real-world change. This form of SRI, referred to as values-based or exclusionary, primarily considered ethical behaviour.

Mainstream popular and political support for sustainable development gained further momentum following the 1992 Rio Summit.

Question 5

Modern responsible investment

Answer 5

The key development between early and modern SRI has been the growth in shareholder activism and the introduction of positive-screening investing, which seeks to maximise financial return within a socially aligned investment strategy.

This paved the way for responsible investment, which considers financial and ESG factors when valuing companies.

Question 6

early 2000s

Answer 6

Enron, 2002 Sarbanes-Oxley Act.

Question 7

Who Cares Wins

Answer 7

The modern form of ESG investing began with a letter and call to action.

In January 2004, the UN Secretary- General, Kofi Annan, wrote to the CEOs of significant financial institutions to take part in an initiative, under the authority of the UN Global Compact and with the support of the International Finance Corporation (IFC), to integrate ESG into capital markets.

The initiative produced a report entitled Who Cares Wins, which effectively coined the term ‘ESG’.

The report made the case that embedding ESG factors in capital markets makes good business sense and leads to more sustainable markets and better outcomes for societies.

Question 8

Freshfields Report

Answer 8

At the same time (2004)
UNEP FI produced the so- called Freshfields Report,

which showed that ESG issues are relevant for financial valuation and thus, fiduciary duty.

These two reports formed the backbone for the launch of the Principles for Responsible Investment (PRI) at the New York Stock Exchange in 2006 and the launch of the Sustainable Stock Exchange Initiative (SSEI) the following year.

Question 9

Stern Report

Answer 9

The Stern Report was a particular influence on the investment industry.

At the request of the British government, economist Sir Nicholas Stern led a major review of the economics of climate change to understand the nature of the economic challenges and how they can be met.

The review, published in 2006, concluded that climate change is the greatest and widest-ranging market failure ever seen, presenting a unique challenge for economics and that early action far outweighs the costs of not acting.

According to the report, without action, the overall costs of climate change would be equivalent to losing at least 5% of global gross domestic product (GDP) each year, now and forever. Including a wider range of risks and impacts could increase this to 20% of GDP or more.

Although not the first economic report on climate change, it had an important influence on how investors understand climate change, in the UK and globally.

Question 10

2008 Financial Crisis

Answer 10

The global financial crisis of 2008 provided another stark reminder of the interdependence between societies, economies and financial markets. It also provided clear evidence that market pressures do not always result in ideal outcomes for the wider good.

This reignited institutional investors’ interest in the risks and opportunities presented by the extra-financial performance of a company, enhanced by the growing perception of large asset owners as ‘universal owners’, tied to the performance of markets and economics as a whole.

Question 11

ESG INVESTING IN NUMBERS
2.1.1
Explain the size and scope of ESG investing: in relation to the economy; within financial markets; by asset class, investor type, geography and approach; in relation to stakeholders

Answer 11

There is a range of data regarding the ““responsible investment market””.

One of the most comprehensive market reviews is conducted by the Global Sustainable Investment Alliance (GSIA), which conducts research in the five major markets for responsible investment (Europe, USA, Japan, Canada and Australia/New Zealand) every two years.

Its most recent report2 shows sustainable investing assets in the five major markets stood at US$30.7 trillion (£23.7tn) at the start of 2018, a 34% increase in two years.

In all the regions except Europe, the market share of sustainable investing has grown.

In terms of where sustainable and responsible investing assets are domiciled globally, Europe (46%) and the USA (39%) continue to manage the highest proportions.

Question 12

Europe? US? Percentages?

Answer 12

The exception to the trend of increased responsible investing (34% in 2 years overall, , is Europe, where sustainable investing assets have declined relative to total managed assets since 2014.

BUUUT….

At least part of the market share decline in Europe stems from a shift to stricter standards and definitions for sustainable investing in that market.

Europe 46% and US 39% of global sustainable and responsible investing assets.

Question 13

Investments managed by professional asset managers are often classified as either:

Answer 13

1. Retail (investment by individuals); or

2. Institutional (investment firms).

Question 14

Investments managed by professional asset managers are often classified as either:

Answer 14

1. Retail (investment by individuals); or

2. Institutional (investment firms).

Question 15

Although institutional investors tend to dominate the financial market, interest by retail investors in responsible investing has been steadily growing:

Answer 15

In 2012, institutional investors held 89% of assets compared with 11% held by retail investors. In 2018, the retail portion had grown to one quarter.

Question 16

Responsible Investment Allocation

Answer 16

Responsible investments now extend across the range of asset classes commonly found in diversified investment portfolios, as shown in Figure 2.4, which shows the asset class allocation reported in Europe, the USA, Japan and Canada in 2018.

Collectively in these regions:

Most assets were allocated to public equities: 51% at the start of 2018; whereas the next largest asset allocation is in fixed income, with 36%.
This is a reversal from 2016 when, with only Europe and Canada reporting on asset class allocation:
64% of sustainable investing assets were in fixed income; and 33% were in public equities.

**In 2018, real estate/property and private equity/venture capital each held 3% of global sustainable investing assets.

Sustainable investments can also be found in hedge funds, cash or depository vehicles, commodities and infrastructure. These assets are reflected in the ‘other’ assets category.

Question 17

MARKET DRIVERS OF ESG

A. Asset owners.

B. Asset managers.

C. Fund promoters.

D. Financial services

E. Policymakers and regulators.

F. Investees.

G. Government.

F. Civil society and academia.

Answer 17

A. Asset owners.

1. Pension funds.
2. Insurance.
3. Individual (retail) investors and wealth management.

C. Fund promoters.

1. Investment consultants and retail investment advisers.
2. Investment platforms.
3. Fund labellers.

D. Financial services

1. Investment banks
2. Investment research and advisory firms.
3. Stock exchanges.
4. Financial and ESG rating agencies.

Question 18

A. Asset owners

Answer 18

Asset owners include pensions, insurance companies, sovereign wealth funds, family offices and endowments.

They generally invest their assets into some investment vehicle with the goal of getting returns from the invested capital.

They seek to minimise the risks or maximise the returns, and some derive utility from non-financial impacts as well.

In practice, asset owners have legal ownership of their assets and make asset allocation decisions.

Many asset owners manage their money directly, while others outsource the management of all or a portion of their assets to external managers.

Institutional asset owners account for US$54tn (£42tn), of which 35%4 (around US$19tn (£14.7tn)), are concentrated in the 100 largest asset owners.

Question 19

Asset owners (II)

Answer 19

• Legal ownership of assets.

• Make asset allocation decisions based
on investment objectives, capital markets
outlook, regulatory and accounting rules.

• Can manage assets directly and/or outsource
asset management.

• Examples: pension funds, insurers, banks,
sovereign wealth funds, foundations, endowments, family
offices, individuals.

***** Asset owners set the tone for the investment value chain.

Their understanding of how ESG factors influence financial returns and how their capital impacts the real economy can significantly drive the amount and quality of ESG investing from the investment value chain.

Question 20

Asset Managers

Answer 20

Asset managers
• Act as agent on behalf of clients (asset owners).

• Not legal owner of assets under management.
• Not the counterparty to transactions or to derivatives.

• Can manage assets via separate accounts and/or
funds.

• Make investment decisions pursuant to guidelines
stated in Investment Management Agreement (IMA)
or fund constituent documents.

• Required to act as a fiduciary to clients.

Question 21

Intermediaries

Answer 21

Intermediaries

• Provide investment advice to asset owners including asset allocation and manager selection.
• Conduct due diligence of managers and products.
• Examples: institutional investment consultants, registered investment advisers, financial advisers.

Question 22

ESG Influenced by the type of investor the owner is…

Answer 22

A) Directly, or via external asset managers;
or
B) Out of their own account, or acting on behalf of (or in trust for) beneficiaries.

Question 23

The effectiveness of asset owners in steering the investment value chain towards an increased integration of ESG depends on:

Answer 23

A) The number of asset owners implementing responsible investment;

B) The total AUM of these assets; and

C) The quality of implementation across the different asset classes.

Question 24

Multiplier Effect

Answer 24

ESG INVESTMENT CREATES A MULTIPLIER EFFECT

Throughout the investment market.

Effective implementation of responsible investment by individual asset owners signifies to the market that responsible investment is a priority for asset owners.

In turn, this influences the willingness of investment consultants and investment managers to focus on responsible investment and ESG issues in their products and advice.

By implementing their commitments to responsible investment with enough scale and depth, asset owners can accelerate the development of responsible investment through the investment chain.

Question 25

Investment Mandates

Answer 25

Institutional asset owners establish contracts, known as Investment Mandates, with asset managers.

These are important as they define the expectations around the investment product, and at times even aspects around the manager’s processes and resources more broadly.

Question 26

RESPONSIBLE INVESTMENT CLAUSES IN ASSET OWNER CONTRACTS WITH THEIR INVESTMENT MANAGERS

A) Acting in accordance with responsible investment beliefs of policy

B) Reporting on agreed responsible investment activities

C) Voting requirements

D) Specific requirements for ESG incorporation into decision-making

E) Reporting on the ESG characteristics of the portfolio

F) Reporting on the impact of ESG issues on financial performance

G) Engagement Requirements

Answer 26

RESPONSIBLE INVESTMENT CLAUSES IN ASSET OWNER CONTRACTS WITH THEIR INVESTMENT MANAGERS

A) 91% Acting in accordance with responsible investment beliefs of policy

B) 65% Reporting on agreed responsible investment activities

C) 45% Voting requirements

D) 44% Specific requirements for ESG incorporation into decision-making

E) 33% Reporting on the ESG characteristics of the portfolio

F) 24% Reporting on the impact of ESG issues on financial performance

G) 22% Engagement Requirements

Question 27

Pension funds

Answer 27

Of the largest 100 asset owners, 59% are pension funds.

For their size, as well as the long-term nature of their investment, pension funds play a key role in influencing the investment market.

Pension funds are responsible for the management of pension savings of and pay-outs to individuals. Given the long-term nature of their liabilities, ESG factors – more long-term in nature – are particularly relevant to their investments.

Pension funds as institutions are driven by three internal players:

1. Executives, who manage the fund’s day-to-day functioning.
2. Trustees, who hold the ultimate fiduciary responsibility. They act separately from the employer and hold the assets in the trust for the beneficiaries of the scheme.
3. Beneficiaries (or members) pay into the fund or are pensioners who benefit from the assets.

Similar to the board of a company, the board of trustees is responsible for ensuring that the pension scheme is run properly, and that members’ benefits are secure.

The level of delegation between trustees and executives (on matters such as policy and asset manager selection) varies depending on the governance of the pension fund.

The level of alignment between them also varies significantly across pension funds.

Question 28

Sovereign Wealth Funds

Answer 28

Federal and state governments are also often among the largest institutional investors – typically through pension schemes or sovereign wealth funds.

When governments align their policy intent with their own direct investment influence, there is scope for significant impetus to be added towards ESG integration.

Some governments and investment funds have recognised this.

Question 29

Beneficiaries

Answer 29

Beneficiaries are generally not aware of the details of investment decisions, but may enquire why their pension funds are invested in a company contravening human rights, or engaging with their pensions to divest from nuclear weapons. As a result, these actors have different roles and at times, different interests, but may all help advance pensions’ fund policy and implementation of responsible investment.

Question 30

Long-termism and ESG

Many actors in the investment value chain have recognised the shortfalls of short-termism in investment practice and have sought to increase awareness of the value of long-termism and encourage this approach.

Answer 30

Short-termism covers a wide range of activities; for the purpose of this topic, the most relevant one is related to trading practices, where investors trade based on short-term momentum and price movements rather than long-term value.

Review conducted on the UK equity market and long-term decision-making by Professor John Kay for the UK Government in 2012.

Instead of productive investment
in the real economy, short-termism may promote bubbles, financial instability and general economic underperformance.

Furthermore, short-term investment strategies tend to ignore factors that are considered more long-term, such as ESG factors

Question 31

Pension Funds and Long-Termism

Answer 31

Pension funds can integrate long-termism into their investment belief statements.

They can, for example, set up investment mandates that place value on long-termism and demand long-term metrics from asset managers and underlying assets.

The requirement to consider ESG factors within investment mandates also reinforces the asset owners’ appreciation for the link between ESG factors and long-term returns.

___

In theory, asset owners with long-term liabilities (like pension funds) are well aligned with long-term investing and are due to benefit from it.

In practice, they at times help create the problem by rewarding managers and companies for short-term

Question 32

HSBC Bank UK Pension Schemes

Answer 32

In 2016, the HSBC Bank UK pension schemes transitioned the equity component of its defined contribution (DC) default investment strategy to a passive smart beta fund that integrates ESG by embedding climate tilts.

An HSBC comment piece on the product notes:
“Investment performance does not need to be negatively impacted…This is critical, because although investors are increasingly demanding that funds are allocated responsibly, they are not necessarily prepared to compromise on performance”.

In fact, the scheme aims to provide a better risk-adjusted return than is available from a conventional market cap-weighted index.

The inclusion of the climate tilts give scheme members greater relative exposure to firms less at risk from climate change.

Question 33

Pension fund trustees

Answer 33

Are Fiduciaries of the pension fund members, have a responsibility to act in the best interests of the beneficiaries.

Question 34

Litigation (Australia and UK)

Answer 34

Pension fund trustees may face fiduciary legal risks from financial losses caused by climate change.

Lawyers have been commissioned in Australia and the UK to assess the matter.

They have found that pension fund trustees may be failing to take sufficient steps to address climate risk and therefore, fail to manage the scheme’s investments in a manner consistent with the members’ best interests.

This could result in trustees exposing themselves to the possibility of legal challenges for breach of their fiduciary duties.

__

The risk of legal action is highlighted by a 2019 case in Australia8 where a member of the Retail Employees Superannuation Trust took his pension fund to court for failing to disclose information on the impact of climate change on his investments and how they were addressing the issue.

As a result, fiduciary duty is a driver for trustees and their pensions to act on ESG.

__

A survey, which was conducted among more than 300 global institutional investors, reveals that 46% of respondents cited the need to meet fiduciary duty and regulations as a key driver for adopting ESG principles.

Question 35

Pension Fund Members

Answer 35

While pension fund members are not investment professionals, they can influence pension fund decisions
as they are the ultimate beneficiaries.

Interpretation of fiduciary duty in some jurisdictions recognises that ‘acting in the interest’ of pension fund beneficiaries is not necessarily restricted to financial outcomes, and may incorporate their other interests, such as ethical preferences.

Though still rare in the industry, some pension funds have started to use feedback from members to fine-tune their sustainable investment policies.

Question 36

Surveys by Dutch pension funds

Answer 36

The €26.4bn (£22.4bn) Dutch multi-sector pension fund, PGB, conducts an annual survey into responsible investment among its participants.

In order to make decisions based on its members’ input, the fund conducted a mandatory survey into the members’ risk appetite, and included an additional questionnaire that related to ESG.

Of the 3,500 respondents, 90% indicated a preference for investments in sustainable energy, whereas just 14% supported investments in arms.

As a result, PGB excluded tobacco firms and companies selling firearms to civilians from its investment universe.

Question 37

Insurance

Answer 37

Insurance is divided into:

▶ property and casualty (P&C). This includes insurance from liabilities and damages to property (due to calamities or from legal liabilities in the home, vehicle, etc.).

▶ life. This covers financial losses resulting from loss of life of the insured, as well as offering retirement solutions.

▶ re-insurance. In other words, a reinsurer provides insurance to an insurer, sharing a portion of an insurer’s risk against payment of some premium.
Insurers are by nature sensitive to certain aspects of ESG due to factors impacting insurance products, such as:

▶ frequency and strength of extreme weather events (P&C); and

▶ demographic changes (life insurance).
This has contributed to insurers having developed a very advanced understanding around these issues.

Many insurers have an (internal) asset management business which invests the insurance premiums.

The interactions between the insurance business and the internal asset management business within insurance companies led to these** asset managers advancing rapidly in their understanding of ESG**.

Question 38

Munich RE

Answer 38

Pricing for re-insurance is thus heavily reliant on knowledge of these exact probabilities.

As a result, Munich Re has:
» invested significantly in climate change research and modelling;
» built a climate change research centre; and
» established an extensive natural catastrophe database.

Question 39

Individual (retail) investors and wealth management

Answer 39

The adoption of retail investors has been generally slower than that of institutional investors.

Despite the effort put into marketing responsible investing products for retail investors, a study on German savers on whether they place any importance on sustainability identified that only a few people do:

▶ only 18% of investors in the 60+ age bracket agreed it was important;
▶ only 20% in the 40–49 age bracket felt the same; and
▶ just 31% among the 18–29-year-olds agreed.

This compares to 75% of the German institutional investors who were surveyed.

In the USA, only US$161bn (£124bn) of the USA’s US$22.1tn (£17.1tn) in assets have gone to those referencing ESG at the end of 2018.

This percentage is much smaller than institutional investors.

Question 40

Inflows, Repurposing, Rebranding

Answer 40

ESG Inflows have been increasing.

In 2019, they were over US$18bn (£14bn) while inflows in 2018, then at a record high, reached US$5.5bn (£4.3bn).

Morningstar, a research firm which offers an investment platform for retail investors, reports that 2018 saw an increase over two years of 60% in ESG fund launches.

Moreover, the rate at which funds are being repurposed into ESG strategies is also very high, with double the amount (40%) in 2018 over the previous years.

Question 41

Millenials

Answer 41

Millennials are usually defined as those born after 1980 and who reached adulthood in the 2000s.

Studies and surveys have generally found that millennials are quite interested in ESG investing:

▶ A 2017 study of high-net-worth investors16 stated that 90% of millennials want to direct their allocations to responsible investments in the next five years.

▶ Another study17 found that 75% of individual investors in the USA were interested in sustainable investment; the percentage of millennials was higher, at 86%.

▶ Younger high-net-worth investors are most likely to review the ESG impact of their investment holdings, including 88% of millennials and 70% of Generation X.

82% of high-net-worth investors who make investment decisions based on ESG factors see investing as one way of expressing their personal values.

Millennials are a large demographic, representing 75 million people in the USA alone, and the future recipient of an expected US$30tn (£23tn) intergenerational wealth transfer from baby boomers.

Question 42

Next Two Decades Millenials::

Answer 42

Bank of America Merrill Lynch predicts that over the next two to three decades, millennials could put between US$15tn (£12tn) and US$20tn (£15tn) into US-domiciled ESG investments….

….. which would roughly double the size of the entire US equity market…..

Question 43

Asset managers

Answer 43

Asset managers select securities and offer a portfolio of those to asset owners.

They influence the ESG characteristics of the portfolio through selection, as well as engaging with investee companies to improve their ESG performance.

While they react to asset owners’ interest in ESG, they can also play a key role in proposing new products and approaches to considering ESG. Asset managers are central in the investment value chain.

Question 44

Green Bonds

Versus

infrastructure, real estate, private equity and private credit.

Answer 44

Over the past ten years, the rise of green bonds has further propelled fixed income as an asset class of interest to responsible investors.

Funds of infrastructure, real estate, private equity and private credit have been slower to systematically and explicitly conduct ESG integration.

Nonetheless, real estate, private equity and private credit have been instrumental in the structuring of impact investing funds.

Question 45

first ESG index

Answer 45

The first ESG index, the Domini 400 Social Index (now called MSCI KLD 400 Social Index), was launched by KLD Research & Analytics in 1990.

In recent years, the trend toward passive investment, and particularly investors’ preferences for ETFs, together with the increased availability of ESG data and research, have seen the market’s development of ESG indices.

Question 46

Passive funds with ESG integration

ETFs

Answer 46

The offering of indices and passive funds with ESG integration by asset managers started 20 years after
that of active investments.

The use of indices is nonetheless critical for the investment industry – they are performance benchmarks and the basis for passive investment funds, such as exchange-traded funds (ETFs).

___
Today, there are over 1,000 ESG indices (roughly 1% of the 3.7m indices that are globally available according to the Index Industry Association), reflecting the growing appetite of investors for ESG products and the need for measurement.

Question 47

Differentiation towards ESG.

Answer 47

Asset managers who wish to differentiate themselves have been investing significantly in ESG-related resources.

Some have merged with, or acquired, asset managers specialising in ESG or impact investing; others have invested significant amounts in technology, using data science to develop their in-house scoring systems and dashboards.

One global investor, for example, has built a proprietary system to measure the progress of fixed income issuers against specific ESG-related objectives.

Asset managers have also expanded their human resources, with some responsible investment teams increasing to over 20 people.

Question 48

Fund promoter

Answer 48

For this purpose, the fund promoter is defined as including:

1. investment consultants and retail financial advisers;
2. investment platforms; and
3. fund labellers.

Investment consultants and retail financial advisers are investment professionals who help institutions and individuals, respectively, set and meet long-term financial goals, usually through the proposal of investment funds.

Question 49

1 and 2.

Investment consultants and retail financial advisers

Answer 49

Ensuring that investment consultants and retail financial advisers incorporate ESG factors into their core service provision is crucial for the next wave of responsible investment.

These two groups are considered
the gatekeepers for the expansion of ESG investing, as they advise asset owners and individual investors, respectively.

As a trusted source of knowledge to trustees (particularly for small- and medium-sized asset owners) and retail investors, the PRI’s* aim is for consultants and advisers to understand the investment implications of ESG issues and turn them into investment recommendations, as their advice is often accepted with little hesitation.

However, a review by the PRI21 concluded that most consultants are failing to consider ESG issues in investment practice. There is much that consultants can do.

With regards to investment strategy, they can:

▶ aid trustees in understanding their fiduciary obligations;

▶ formulate a strategy inclusive of ESG; and

▶ draft investment principles and policies in line with the strategy and fiduciary obligations.

Question 50

Investment Platforms

Answer 50

Investment platforms’ research and recommendations can be highly influential in the asset-management industry, and can be a positive or negative recommendation driving significant amount of capital into, or away from, any given fund.

Morningstar, one of the main investment platforms, offers a service where it rates asset managers and their funds. In 2016, the platform started integrating ESG ratings within its offer.

Investment platforms can integrate the extent and depth which funds integrate ESG to:

▶ increase awareness of ESG funds to both retail and institutional investors; and

▶ enable easier identification of and information on these funds.

Question 51

Fund Labeller

Answer 51

Labels provide benchmarks and quality guarantees for both practitioners and clients. In just over a decade, sustainable finance has led to the creation of eight specialised labels just in Europe.

Labels are usually either general, looking at ESG as a whole; or thematic, usually focused on environment or climate.

Few labels have been applied to multiple countries, creating challenges for global investors seeking to offer certified ESG funds across multiple jurisdictions.

Certifications have been perceived as a marketing tool by some actors.

Question 52

D. Financial services

Answer 52

Financial services are defined as including:

▶ investment banks;
▶ investment research and advisory firms;
▶ stock exchanges; and
▶ financial and ESG rating agencies.

Financial service companies are important enablers of responsible investment as they make significant contributions to the availability of securities with higher ESG quality, and increase the quality of information about ESG characteristics of securities and assets in general.

For example:
▶ Investment banks can support a company issuing a green bond (a bond where proceedings are specifically earmarked to be used for climate and environmental projects).

▶ Sell-side analysts and rating agencies can consider ESG within their analysis, recommendations and ratings.

▶ Stock exchanges can increase disclosure requirements on ESG data by listed companies (as encouraged by the
Sustainable Stock Exchange Initiative).

▶ Proxy voting service providers, those who vote on behalf of shareholders at companies’ annual general meetings, can integrate ESG considerations within their voting and voting recommendations.

Improvements in ESG data sourcing and analysis have contributed to the growth of the ESG market.

Analysis and ratings of investees from an ESG perspective have been dominated by traditional credit rating companies, as well as a handful of specialist firms.

One-theme consultants, such as those specialised in helping investors understand and quantify the risk posed by climate change to their portfolios are also well established, though many new ones continue to enter the market. T

he rise and consolidation (through partnerships, mergers
and acquisitions) has increased both investors’ ability to further implement ESG and help policymakers and regulators reassure themselves that requirements to assess ESG risk and reporting on it is increasingly possible.

Question 53

E. Policymakers and regulators

Answer 53

The financial regulators’ objectives are to:

▶ maintain orderly financial markets;

▶ safeguard investments in financial instruments, savings/pensions and investment vehicles;
and
▶ bring about an orderly expansion of activities of the financial sector.

Financial regulators consider how ESG factors might impact the stability of economies and the financial markets, and how these factors might influence the long-term risk-return profile of financial instruments.

They also encourage and enable the growth of certain ESG products, such as green bonds, and require disclosure on ESG characteristics.

Other regulators can influence the ESG characteristics of companies by strengthening matters regarding environment, labour, communities and governance, and require further disclosure on those.

Policymakers are responding to the growing urgency of sustainability topics. Some issues can have a profound impact on:

▶ the stability of the financial system (for example, climate change, as well as emerging issues such as biodiversity and resource scarcity); or

▶ the risks to an individual investor’s portfolio.

Question 54

Regulations generally involve three themes:

Corporate disclosure.
Stewardship.
Asset owners.

Answer 54

▶Corporate disclosure. Guidelines on corporate disclosure typically come from government or stock exchanges to encourage or require investee companies to disclose information on material ESG risks. While this does not impose any requirement on investors themselves, it improves their ability to consider these risks within their investment decisions.

▶ Stewardship. Regulation on stewardship governs the interactions between investors and investee companies, and seeks to protect shareholders and beneficiaries as well as the health and stability of the market. In most jurisdictions, stewardship codes remain voluntary, though mandatory regulation was recently approved in Europe.

▶ Asset owners. Regulation on asset owners typically focuses on pension funds, requiring them to integrate ESG and disclose the process and outcome. Some regulators, such as those in the UK, are also beginning to consider climate risk for the insurance market and the financial industry more widely.

Question 55

PRI and EUROPE and ASIA

Answer 55

In a review conducted by the PRI on sustainable finance policy in 2019, 97% of the new or revised policies were developed after 2000.

The continued acceleration has been driven by the rapid development in Europe (with many initiatives being developed under the EU Action Plan on Sustainable Growth) and Asia* (where markets have seen significant updates to reporting requirements and corporate governance expectations).

Another significant factor has been periodic revisions of stewardship and corporate governance codes, with national authorities introducing or periodically strengthening ESG expectations.

Question 56

CHINA

Answer 56

In 2016, the People’s Bank of China, in collaboration with six other government agencies, issued guidelines establishing the green financial system.

These guidelines marked a turning point for a sustainable finance policy.

Question 57

North America

Answer 57

In certain regions, particularly in North America, policies remain voluntary or ‘comply or explain’, which lead some investors to continue to challenge the assertion that ESG integration is a requirement. However, it is anticipated that as policies on ESG and financial regulation reach maturity, an increasing number of governments will recognise the importance of moving to stronger requirements, moving away from:

▶ ‘comply or explain’ to ‘comply and explain’;
▶ voluntary to mandatory; and
▶ policy to implementation and reporting.

Question 58

Network for Greening the Financial System

Answer 58

For example, the Network for Greening the Financial System, a group of 42 central banks and supervisors established in 2017, explicitly recognises climate risks as relevant to a supervisory mandate and it has challenged policymakers, other central banks and supervisors to act to limit the catastrophic impacts of runaway climate change.

Question 59

USA and Employee Retirement Income Security Act (ERISA)

Answer 59

ERISA defines the responsibilities of institutional investors entrusted with retirement assets. Chief among these is the obligation to always act to protect the interests of plan participants and beneficiaries. Under ERISA, plan sponsors and other fiduciaries generally must:

1. Act solely in the interest of the plan participants and beneficiaries.
2. Invest with the care, skill and diligence of a prudent person with knowledge of such matters.
3. Diversify plan investments to minimise the risk of large losses. Plan sponsors that breach any of these fiduciary duties may be held personally liable.

Question 60

UK and John Kay

Answer 60

After the 2008 global financial crisis, Professor John Kay was commissioned by the UK Government to conduct a review of the structure and operation of UK equity markets.

His report, The Kay Review of UK Equity Markets and Long-Term Decision Making: Final Report, published in July 2012, emphasised the need for a culture of long-term decision-making, trust and stewardship to protect savers’ interests.

The report recognised the essential role that fiduciary duties play in the promotion of such a culture, but highlighted the damage being done by misinterpretations and misapplications of fiduciary duty in practice.

In response, the Government asked the Law Commission to investigate the subject of fiduciary duty in more detail.

In 2014, the Law Commission published its report, Fiduciary Duties of Investment Intermediaries.

On financial factors, the report concluded that:
“Whilst it is clear that trustees may take into account environmental, social and governance factors in making investment decisions where they are financially material, we think the law goes further: trustees should take into account financially material factors.”

On non-financial factors, the Law commission’s term for ESG factors, the report concludes that:

“By ‘non-financial’ factors we mean factors which might influence investment decisions motivated by other (non-financial) concerns, such as improving members’ quality of life or showing disapproval of certain industries. In broad terms, trustees should take into account financially relevant factors. However, the circumstances
in which trustees may make non-financially related decisions are more limited. In general, non-financial factors may only be taken into account if two tests are met:

1. trustees should have good reason to think that scheme members would share the concern; and
2. the decision should not involve a risk of significant financial detriment to the fund.”

Question 61

The EU, the EU Action Plan on Financing Sustainable Growth, and the Technical Expert Group.

Answer 61

EU
The EU Action Plan on Financing Sustainable Growth, agreed in 2019, requires the following:

» Mandatory disclosure of policies in relation to ESG risk (consistent with the PRI’s fiduciary duty
recommendations) for all firms and financial products.

» Comply or explain disclosure of the principal adverse impacts of the investment on sustainability factors (mandatory for firms with more than 500 staff) at firm and product level.

» Enhanced disclosure obligations for firms promoting specific environmental or social objectives.
The Technical Expert Group (TEG) was established to assist the European Commission in the technical development of various delegated aspects of sustainable finance regulation.

In June 2019, the TEG issued reports on an EU Taxonomy, a voluntary EU Green Bond Standard and voluntary low-carbon benchmarks.

The Technical Report on EU Taxonomy aimed to significantly advance a shared understanding across investors on activities and sectors that contribute to climate change mitigation and adaptation.

Question 62

EU’s Shareholder Rights Directive II 2019

Answer 62

EU’s Shareholder Rights Directive II, which came into force in 2019, seeks to improve the level and quality of engagement of investors with their investee companies, better aligning executive pay with corporate performance and increasing disclosure on how an asset manager’s investment decisions contribute to the medium- to long-term performance of investee companies.

In order to achieve that, it requires investors to have an engagement policy and annually report on:

» how this is integrated into their investment strategy;
» how the dialogue is done;
» how voting rights and shareholder rights are being executed;
» how the manager collaborates with other shareholders; and
» how potential conflicts of interest are dealt with.

Question 63

Article 173 of the French Energy Transition Law 2016

Answer 63

Article 173 of the French Energy Transition Law, which came into force in 2016, strengthened mandatory carbon disclosure requirements for listed companies and introduced carbon reporting for fund managers and asset owners.

Question 64

China Guidelines for Green Investment

Answer 64

In 2018, the Asset Management Association of China (AMAC) released the Guidelines for Green Investment, which states that:
“ESG is an emerging investment strategy in the asset management industry and an important initiative for the investment fund industry to implement the green development concept and establish a green financial system”.

Foreseeably, the AMAC will make great efforts to facilitate the implementation of the Guidelines.

Question 65

F. Investees

Answer 65

Investees include all entities in which investments can be made. Among others, these include:

▶ companies;

▶ projects (such as infrastructure projects and joint-ventures);

▶ agencies (including World Bank and International Finance Corporation); and

▶ jurisdictions (for instance, countries, provinces and cities).

Decision-makers in these entities can influence how they manage ESG risks and the impact they have on the environment and society.

Furthermore, they decide on the level of disclosure of ESG factors to provide to existing and potential investors.

In fact, one of the most pressing issues for ESG investing is a lack of access to reliable and consistent ESG data.

Various reporting initiatives exist to try to address this issue.

Question 66

G. Government

Answer 66

Governments in general have recognised three main ways in which the investment industry, and responsible investment more specifically, play a significant role in achieving positive outcomes for society.

1. Social security systems and public pensions are in a predicament in many countries, and their citizens are thus turning to corporate or private pension plans for financial stability later in life.
2. Many countries, developed or developing, need to build or restore public infrastructure (such as water systems, transportation means and energy distribution), which is usually costly for government treasuries.
3. Many governments have recognised that a transition to a low-carbon economy will require significant shifts in capital.

These are all areas where governments can encourage the consideration of financial materiality of ESG and social and environmental impact of investments to advance national priorities.

Question 67

H. Civil society and academia

Answer 67

Civil society, including non-governmental organisations (NGOs), has played a major role in pushing for increased sustainability at company level and, more recently, in demanding increased transparency and consideration around the impact that investment has on society and the environment.

Some partner with investment firms and regulators to help improve their understanding of specific ESG matters, while others bring to light actions that are deemed insufficient to address global challenges.

–

Academic research has been influential in validating the business case for integrating ESG within the investment process.

Academia can continue to increase the studies focusing on the various aspects of ESG factors and their integration to investment decisions, as well as their impact on investment returns and the financial market more broadly.

Question 68

Challenges to Implementing ESG

Answer 68

Prior to wishing to implement ESG:

▶ The perception that implementing ESG may have a negative impact on investment performance.

▶ The interpretation that fiduciary duty prevents investors from integrating ESG.

▶ The advice given by investment consultants and retail financial advisers, has many times not been supportive of products which integrate ESG.

Once the decision has been made to implement ESG:

▶ The lack of understanding of how to build an investment mandate that effectively promotes ESG or lack of understanding of what are the needs of asset owners regarding ESG.

▶ The impression that significant resources, which may be lacking in the market or expensive, are needed. These include human resources, technical capability, data and tools.

▶ The gap between marketing, commitment and delivery of funds regarding their ESG performance.

Some investors still question whether considering ESG issues can add value to investment decision-making despite wide dissemination of research that demonstrates that ESG integration can help limit volatility and enhance returns.

Interviews conducted by the PRI note that investment professionals place a greater weight on experience from their own careers than they do on third-party evidence.

It can thus be helpful for an internal evidence base to be built, or to engage with direct peers on ESG processes and investment benefits.

Interpretations of fiduciary duty are partially related to perception of the impact on ESG investing on risk- adjusted returns.

Despite regulators in various jurisdictions clarifying a modern interpretation of fiduciary duty, contrasting views remain as to how ESG integration fits with institutional investors’ duties.

Some institutional investors remain reluctant to adapt their governance processes because they see a conflict between their responsibility to protect the financial interests of their beneficiaries and the consideration of ESG factors.

For those who consider ESG factors as ‘non-financial’, it may be difficult to integrate ESG factors into conventional financial and risk models.

ESG factors may also be perceived as long-term factors, whereas investment mandates tend to focus on financial performance over a three- or five-year horizon.

Question 69

An OECD report classifies institutional investors into four types according to their investment policy focus and how they integrate ESG factors into their portfolio decisions:

Answer 69

▶ Traditional investors, who believe that ESG factors are not relevant to their ability to meet their liabilities – or may even harm financial performance – will not integrate ESG factors. This implies that they believe that all ESG risks and opportunities are already priced into any potential investment, in accordance with modern portfolio theory (MPT).

▶ Modern investors, who believe that ESG integration can enhance their analytical capabilities. They will integrate ESG factors to the extent that they impact corporate financial valuations and so, portfolio returns.

▶ Broader goals investors, who believe that ESG factors are relevant to portfolio performance, but also feel that their duties to their beneficiaries include consideration of their long-term financial and non-financial well-being. They will accept some financial sacrifice in order to support ESG-related beliefs (such as excluding tobacco stocks).

▶ Universal investors, believe that they have a financial responsibility to support global economic health and that ESG factors are drivers of future systemic risk. They will fully integrate ESG factors into their investment governance and align their portfolios with ESG goals.

However, they do not consider these to be non-financial goals (or ‘broader goals investors’) because of the impact of ESG factors on both macro-economic performance and the financial health of the corporate sector. Universal investors often attach particular importance to environmental factors and seek out investments that have a positive environmental impact.

The traditional interpretation remains influential. Asset managers report that clients are increasingly moving from a traditional to modern approach, driven by greater awareness of ESG investment strategies and peer pressure in particular. This evolution, however, is not universal.

Question 70

Tilting, Challenges, Tracking, Benchmark.

Answer 70

The challenge is not only regarding the impact of ESG investing in portfolio returns.

Screening, divestment and thematic investment strategies involve ‘tilting’ the portfolio towards desired ESG characteristics by

overweighting or underweighting

sectors or companies that either perform well or poorly in those areas. Institutional investors may feel that this conflicts with their obligation to invest prudently, as it involves straying from established market benchmarks.

This increases the tracking error, a key measure of active risk widely used by the industry that is due to active management decisions versus the benchmark made by the portfolio manager.

Question 71

Investor-Led Initiatives (Cambridge)

Answer 71

There are investor-led initiatives which hope to address this.

The International Corporate Governance Network (ICGN) established a Model Mandate Initiative;

the University of Cambridge Institute for Sustainability Leadership developed a toolkit for establishing long-term, sustainable mandates;

and

the PRI has published numerous guidance documents to support asset owners in incorporating ESG into manager selection and investment mandates.

Question 72

Challenge of Resources

Answer 72

The challenge of resource is especially prominent for asset owners who have funding constraints, or investors who see ESG investing as separate from the core investment process (e.g. marketing or compliance). In addition to the costs of building or buying expertise in ESG, investors may face other costs for items such as research, data, monitoring and reporting. The European Fund and Asset Management Association estimated the average total price of external data for an investor to be €100,000 (£84,800)

Question 73

Data availability:

Answer 73

Although ESG data from investees is increasingly available from specialised providers, disclosure is still a significant challenge, especially in asset classes other than listed equities.

Investment analysis thus remains limited by corporate disclosure, which varies in quality and scope.

It is also limited by investors’ understanding of that data and which metrics are financially material.

There is considerable effort by the private sector and policymakers to reach a consensus on what degree and type of corporate disclosure is needed, but no single standard is universally implemented.

Question 74

Modelling:

Answer 74

It can be challenging to integrate ESG factors into traditional financial models, as they do not always have a **short-term financial impact.

Furthermore, most financial analysts’ models extrapolate from historical data, which may be less relevant for forecasting future ESG-related outcomes.

For example, measuring a company’s past and current carbon footprint does not give as much information about its future valuation as understanding its strategy for reducing its carbon intensity.

Similarly, it is hard to estimate the viability or impact of a breakthrough technological innovation based on *historic patterns.

Notably, a lot of ESG models focus on risks, there are fewer tools for assessing positive ESG performance.

Question 75

▶ Valuation techniques:

Answer 75

Equity investors can adjust corporate valuations for ESG factors in a number of ways.

Investors could vary the discount rate applied to future corporate cash flows – which raises the question of how much of a discount should be applied to various kinds of ESG risk.

Alternatively, they could apply higher or lower multiples to valuation ratios (such as price-to-earnings or book value), which might lead to double- counting if ESG factors are already partially priced by the market.

As a result of these difficulties, ESG analysis often takes the form of a qualitative input that is used alongside traditional quantitative models.

The portfolio manager might use the quality score just for information, or might set a hurdle for a stock to be included in the portfolio.

These types of metric risk are less well respected by portfolio managers than financial analysis because quantifying the input and its impact is generally a challenge.

Question 76

Greenwashing !!!!!

Answer 76

A growing challenge to the industry is GREENWASHING.

Greenwashing originally described misleading claims about environmental practices, performance or product, but has been used more widely to incorporate ESG factors more broadly.

The phenomenon is not restricted to the investment industry, but, with the rise of a plethora of new ESG-type funds, including impact funds, the challenge of how to spot and avoid greenwashing has become more prevalent.

Asset owners, but also individual retail investors, have questioned why certain stocks, either involved in significant controversies or with controversial activities, are part of the top holdings of ESG funds, which has at times impacted the **credibility of efforts in responsible investment.

Part of the frustration comes from the lack of a greater standard in the industry to differentiate between an

**investment lens based on ESG integration, which is concerned with the financial materiality of ESG matters,
with those based on **impact or ethics.

While a fund can incorporate both lenses, some funds incorporate only one or the other;

effective disclosure and education are required in order to properly manage investors’ expectations regarding these different approaches to responsible investment.

Question 77

European Union launched green and ESG credential of funds and indices.

Answer 77

The European Union has recently launched various initiatives to standardise claims around the green and ESG credential of funds and indices, which
will contribute to a clampdown on greenwashing.

Further advancements from the governments of other jurisdictions, as well as voluntary action and initiatives of investors themselves, would contribute to maintaining and enhancing the implementation and credibility of responsible investment.