Chapter 2: The ESG Market

Question 1

World Commission on Environment and Development (WCED)/ Brundtland Commission

Answer 1

An international group of environmental experts, politicians and civil servants convened by the UN in 1983, in response to the mounting concern surrounding ozone depletion, global warming and other environmental problems associated with raising the living standards of the world’s population.

The WCED/ 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.

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.

Question 2

Rio Summit/ the UN Conference on Environment and Development (UNCED)

Answer 2

Held in 1992. 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

Socially Responsible Investment (SRI)

Answer 3

One of the subsets of ESG investing. Generally used as a catch-all term for investments made with a conscious desire for lower exposure to assets deemed to be less sustainable or responsible, and/or increased exposure to those displaying greater sustainability or responsibility.

Question 4

The Sullivan Principles

Answer 4

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 value-based or exclusionary, primarily considered ethical behaviour.

Question 5

2002 Sarbanes-Oxley Act

Answer 5

In the early 2000s, a renewed interest and desire for a more concrete definition of SRI (including corporate governance) emerged, in addition to financial, social and environmental factors. The widespread fraud at Enron and other companies resulted in an increasing emphasis on the importance of good corporate governance and in specific regulation such as the USA’s 2002 Sarbanes-Oxley Act.

Question 6

The Stern Report

Answer 6

At the request of the UK 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 7

The main stakeholders are:

Answer 7

A. Asset owners.

1. Pension funds.
2. Insurance.
3. Sovereign wealth funds, endowment funds and foundations.
4. Individual (retail) investors and wealth management.

B. Asset managers.

C. Fund promoters.

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

D. Financial services (investment banks, investment research and advisory firms, stock exchanges, financial and ESG rating agencies).

E. Policymakers and regulators.

F. Investees.

G. Government.

H. Civil society and academia.

Question 8

Shareholders

Answer 8

Shareholders hold a direct equity position in a firm, and both individual persons and financial institutions can be shareholders. The term comes from the individual or investment firm literally having a share of the company. It is most commonly used when talking about the rights and responsibilities that come with being an ‘owner’ of a company, such as stewardship, voting and engagement. This differentiates it from a situation where an individual or an investment firm lends money or invests in a bond – in other words, they are not an equity holder of a company. As these investors do not have a share and are not owners of a company, they cannot vote. Nonetheless, expectations around engagement are increasing for those who invest in loans and bonds as well, making the difference between the two terms more subtle.

Question 9

Investors

Answer 9

Investors is a very generic term that refers to parties – both retail investors and institutional investors – that hold a financial stake in an asset. Investors can invest in any type of asset class, be it debt or equity, and an investor can be an asset owner or an asset manager.

Question 10

Investment managers

Answer 10

Investment managers refer to a person or an organisation who/that invests on behalf of their/its clients under an investment mandate that has been agreed with those clients.

Question 11

Asset owners

Answer 11

Asset owners include pension funds, insurance companies, sovereign wealth funds, foundations 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 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.

Question 12

Differences between asset owners, asset manager and intermediaries

Answer 12

Asset owners
• 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 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.

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 13

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

Answer 13

▶ the number of asset owners implementing responsible investment;
▶ the total AUM of these assets; and
▶ the quality of implementation across the different asset classes.

Question 14

Investment mandates

Answer 14

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 15

Pension funds

Answer 15

Of the 100 largest asset owners, 59% are pension funds.5 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 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) who pay into the fund or are pensioners benefitting from the assets.

Question 16

Short-termism

Answer 16

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.

Because of the adverse effects mentioned, regulators are catching up and taking action. For example, the Shareholder Rights Directive (SRD) was issued by the European Union (EU) in September 2020, requiring investors to be active owners and to act with a more long-term focus.

Question 17

Pension fund trustees

Answer 17

Pension fund trustees, as fiduciaries of the pension fund members, have a responsibility to act in the best interests of the beneficiaries. Regulation regarding fiduciary duty defines a significant part of their role and responsibilities, and thus, its interpretation can have a significant impact on whether trustees feel they can, must, or must not integrate ESG within their fund policies and processes.

Question 18

Litigation

Answer 18

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

Question 19

Pension fund members

Answer 19

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 20

Insurance

Answer 20

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 that 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 21

Sovereign wealth

Answer 21

Sovereign wealth is wealth managed through a state-owned investment fund – a sovereign wealth fund (SWF).

The amount of investment capital is usually large and is held by a sovereign state. The global volume of assets under management by sovereign wealth funds was estimated to be US$8tn (£5.8tn) in 2020.

Often the wealth comes from such a state’s capital surpluses.

Sovereign wealth funds are often mandated in line with mid- to long-term objectives of their state, which might go beyond optimising financial return and include broader policy objectives, such as:
▶ economic stabilisation;
▶ securing wealth for future generations;
▶ strategic development of the state’s territory; and
▶ other objectives.

These objectives can, but don’t necessarily have to, align with ESG concerns. There is some evidence that SWFs take ESG into account in asset selection and investor engagement in listed equities, but this evidence is mainly driven by observation of the practices of some of the more transparent SWFs.

Question 22

Endowment funds

Answer 22

Endowment funds are funds set up in a foundation by institutions (universities or hospitals, for example) that wish to fund their ongoing operations through withdrawals from the fund. Given the often societal purpose of endowments, there is an active debate on how to align the ongoing operational funding with topics such as divestment. Examples of this debate can be found in the UK where universities are pressured by their students to have more sustainable investments in their endowments.

Question 23

Foundations and public charities

Answer 23

In countries such as the USA, private foundations and public charities are charitable organisations that invest their capital to fund charitable causes.

Usually for both, the legal form of organisation (LFO) is a ‘foundation’, but the difference between the two is that:
▶ private foundations originate their capital through one funder (typically a family or a business); whereas
▶ public charities originate their capital through publicly collected funds.

Foundations can have ESG exposures through their investment as well as ESG objectives through their charitable work.

Question 24

Asset managers

Answer 24

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.

ESG offerings by asset managers generally began with active-listed equities, but recently evolved to other asset classes. The knowledge gained with integrating ESG within the equity valuation of companies was, to a certain extent, transferred to that of corporate bonds. As fixed income funds also include non-corporate issuers (such as supra-nationals, governments and municipalities), methodologies to integrate ESG expanded to enable the ESG analysis to incorporate all the issuers of the fund.

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.

Some of the challenges faced by asset managers in integrating ESG include:
▶ a lack of clear signals from asset owners that they are interested in ESG;
▶ a very narrow interpretation of investment objectives on which consultants and advisers base their advice to owners; and
▶ resource challenges, especially for investors who see ESG investing as separate from the core investment process (e.g. marketing or compliance).

Question 25

Fund promoters

Answer 25

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. They can consider ESG characteristics of the funds in their screening and short-listing of funds to clients.

Fund labellers can set standards to award labels to investment vehicles after the assessment of its ESG process and performance.

Question 26

Investment consultants and retail financial advisers

Answer 26

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.

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.

Within their manager selection role, consultants can help asset owners design a proposal and formulate a mandate that integrates their investment beliefs on ESG as well as expectations on implementation.

Finally, consultants can include asset managers’ capabilities and processes related to ESG within their research, screening, selection and appointment processes. Advisers can play a similar role with individual investors, proactively providing relevant information on ESG as well as including ESG within their offer and advice.

Question 27

Investment platforms

Answer 27

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 28

Fund labellers

Answer 28

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.
Nonetheless, in practice it is not necessarily associated with a marketing strategy in line with the fund’s promises. A quarter of the funds certified on ESG criteria in Europe do not have a name reflecting a sustainable approach and around thirty are thematic environmental funds.

Question 29

Financial services

Answer 29

Financial services are defined as including:

▶ investment banks;
▶ custodial 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.

Question 30

Financial regulators

Answer 30

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.

Question 31

Policymakers

Answer 31

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 32

Regulations generally involve three themes:

Answer 32

1. 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.
2. 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.
3. 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 33

EU Taxonomy Regulation

Answer 33

The EU Taxonomy Regulation, published on 22 June 2020, established a framework that states conditions for an economic activity to be considered environmentally sustainable. These include:

▶ contributing substantially to at least one of the environmental objectives;
▶ ‘doing no significant harm’ to any of the other environmental objectives; and
▶ complying with minimum social and governance safeguards.

The Taxonomy Regulation establishes six environmental objectives:

1. Climate change mitigation.
2. Climate change adaptation.
3. The sustainable use and protection of water and marine resources.
4. The transition to a circular economy.
5. Pollution prevention and control.
6. The protection and restoration of biodiversity and ecosystem.

EU Sustainable Finance Disclosure Regulation (SFDR), published in December 2019, created requirements to promote consideration of environmental and social risks that may affect investments. These disclosures aim to enhance transparency of sustainably invested products to prevent green washing. It identifies principal adverse indicators that have a negative impact on the environmental and social issues stemming from investment decisions.

Question 34

Task Force on Climate-related Financial Disclosures

Answer 34

In 2017, the Task Force on Climate-related Financial Disclosures (TCFD) released climate-related financial disclosure recommendations to help firms disclose information to support capital allocation. The TCFD recommendations centre on four key areas:

1. Governance.
2. Strategy.
3. Risk management.
4. Metrics and targets.

Question 35

Investees

Answer 35

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/regions, 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 36

Government

Answer 36

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 37

Civil society and academia

Answer 37

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.