The ESG Market

Question 1

Growth of ESG assets by region

Answer 1

• 2018: USD 30.7 tn (increase of 34 % in two years)
• Totals over time:
o 2012: 13.2 tn
o 2014: 18.2 tn
o 2016: 22.8 tn
• Regional proportion of managed assets:
o 18 % Japan
o 63 % Australia
o 46 % Europe
o 39 % USA
• Increases in all regions except Europe 2016-2018 – Europe decline due to stricter definitions

Question 2

ESG by strategy

Answer 2

• Largest: negative screening: USD 19.8 tn
• Second largest: ESG integration: USD 17.5 tn (up 69 % on prior 2 years)
• Regional largest AUM strategies:
o Europe: Negative screening
o USA, CAN, AUS, NZ: ESG integration
o Japan: Corporate engagement and shareholder action

Question 3

ESG by institutional vs. retail

Answer 3

• Investments managed by assets managers are either:
o Retail (individuals)
o Institutional (firms)
• Growing retail investors
o In 2012: retail investors held 11% vs. institutional 89 %
o In 2018: retail investors held 25% vs. institutional 75 %

Question 4

ESG by asset class

Answer 4

•	In 2018 breakdown:
o	Public equity: 51 %
o	Fixed income: 36 % 
o	Private equity: 3 % 
o	Real estate: 3 % 
o	Other: 7 % (hedge funds, cash, commodities, infrastructure) 
•	Reversal on 2016 in Europe and Canada:
o	64 % were fixed income
o	33 % were public equity

Question 5

Main stakeholders

Answer 5

•	Asset owners
o	Pension funds
o	Insurance
o	Individual investors and wealth management 
•	Asset managers
•	Fund promoters 
o	Investment consultants and retail investment advisors 
o	Investment platforms 
o	Fund labellers 
•	Financial services 
o	Investment banks 
o	Research and advisory firms
o	Stock exchanges
o	Financial and ESG rating agencies
•	Policymakers and regulators 
•	Investees
•	Government 
•	Civil society and academia

Question 6

Asset owners

Answer 6

• Institutional AUM: USD 54 tn (35 % concentrated in 100 largest asset owners)
• Approach owner takes depends on if investing:
o Directly or through asset managers
o Out of own account or acting on behalf of beneficiaries
• Asset owners steering investment value chain towards ESG depends on:
o Number of asset owners implementing responsible investment
o Total AUM of assets
o Quality of implementation across asset classes
• Investment mandates
o Establish contracts
o Define expectations around investment product
o 91 % of mandates include acting in accordance with policy for responsible investing
o 65 % of mandates include reporting on agreed responsible investment activities

Question 7

Pension funds

Overview

Answer 7

• 59 % of largest asset owners are pension funds
• Three internal players:
o Executives: manage day-to-day functioning
o Trustees: ultimate fiduciary responsibility, they act separate to employees
o Beneficiaries (members): pay into fund and benefit from assets
• Trustees and executives – policy and asset manager selection
• Beneficiaries – may question the investment decisions or sector selection

Question 8

Pension funds

Long-termism and ESG

Answer 8

• Actors recognised shortfalls of short-termism
• Trading practices with short-termism:
o Momentum
o Price movements
o Consequences for long term:
 Focus on quarterly returns
 Less focus on patient capital and R&D
 Prof. John Kay: promote bubbles, financial instability and general economic underperformance
• Pension funds – long-term and due to benefit – mandate long term metrics
• HSBC Bank UK pension scheme: passive smart beta fund – gives members exposure to companies at less risk of climate change (long-term)
• UK Environmental Agency Pension Fund – GBP 2.4 bn – 2014 looked for managers that had long-term approach to sustainability – “frequent communication should not lead to short-term pressure

Question 9

Pension funds

Litigation

Answer 9

• Trustees could face fiduciary legal risks and financial losses due to climate change
• 2019: Australia: member of the Retail Employees Superannuation Trust – took fund to court for failing to disclose impact of climate change on investments
• Fiduciary duty and regulations are key drivers for adopting ESG principles

Question 10

Insurance

Answer 10

• Divided into:
o Property and casualty (P&C): insurance from liabilities and damages to property
o Life: financial losses resulting from loss of life insured and retirement solutions
o Re-insurance: Provides insurance to an insurer, sharing proportion of insurer’s risk against payment of premium
• Aspects of ESG:
o Frequency of extreme weather (P&C)
o Changing demographics (life)
o Means insurers understand ESG as also have internal asset management businesses to reinvest premiums

Question 11

Individual (retail) investors and wealth management

Answer 11

• Millennials: Born after 1980 and reach adulthood in 2000s
• High net work millennials
o 2017: 90 % want to direct allocations to responsible investing in 5 years
o Younger: more likely to review the ESG impacts of holdings
o 82 % see ESG factors as a way to express personal values
• A large group:
o 75 million in US
o USD 30 tn intergenerational wealth transfer from baby boomers
• BofA-ML
o Next three decades
o Millennials could put between USD 15-20 tn to US-domiciled ESG investments

Question 12

Asset managers

Answer 12

Overview
• Select securities and offer a portfolio to asset owners
• ESG influences
o Selection
o Engagement with companies
o React to owners’ interest in ESG
• Role of fixed income
o Equity valuation derived from fixed income learnings
o Green bonds faster than infrastructure, real estate and private equity
Role of indices
• ESG integration in passive funds – 20 years after active
• Act as performance benchmarks – exchange-traded funds (ETFs)
• 1,000 ESG indices (1 % of the 3.7 m global indexes)
• ESG also integrated into factor investing, smart beta funds and derivatives

Question 13

Fund promoter

Answer 13

• Defined as:
o Investment consultants and retail financial advisors
o Investment platforms
o Fund labellers
• Interaction with institutional and individuals:
o Help set and meet long term goals
o Consider ESG characteristics of the funds and short-listing funds to clients
o Fund labellers – set standards to award labels

Question 14

Financial services

Answer 14

• Defined as
o Investment banks
o Investment research and advisory firms
o Stock exchanges
o Financial and ESG rating agencies
• Can increase quality of information around ESG:
o Support issuance of green bonds
o Sell-side analysts – consider ESG within analysis
o Stock exchanges can increase disclosure requirements on ESG data
o Proxy voting service providers (vote on behalf of shareholders at companies’ annual general meetings) – voting recommendations
o Rise of ESG market to provide ratings and risk

Question 15

Policymakers and regulators

Overview

Answer 15

• Objectives:
o Maintain orderly financial markets
o Safeguard investments in financial instruments, savings and investment vehicles
o Bring about expansion in financial sector
• Consider ESG factors impact on stability of economies and markets
• Strengthen disclosure of ESG factors: environment, labour, communities and governance
• Policymakers:
o Stability of the financial system (climate change)
o Risks to individual investor’s portfolio

Question 16

Three regulation themes

Answer 16

• Corporate disclosure
o From: government or stock exchanges
o Encourage: disclose information regarding material ESG risks
o Improves: ability of investors to consider risks
• Stewardship
o Governs: interactions between investors and investee companies
o Improves: protection of shareholders
o Mostly voluntary but mandatory introduced in Europe
• Asset owners
o Focused: on pension owners
o Some regulators: climate risks on insurance market and financial industry

Question 17

Regional regulation

Overview

Answer 17

• Europe:
o PRI – 97 % of new or revised policies developed after 2000
o Driven by EU Action Plan on Sustainable Growth
o Periodic revisions of stewardship and corporate governance
• North America:
o Policy is voluntary ‘comply or explain’
o Expectation will mature and move to mandatory, implementation and reporting
• China:
o 2016: People’s Bank of China in collab with 6 other government agencies
o Established green financial system

Question 18

USA Regulation

Answer 18

• Private sector retirement plans subject to Employee Retirement Income Security Act (ERISA)
• US Department of Labour (DOL) issues guidance on fiduciary responsibility – ERISA principles are benchmark for meeting standards in governance
• ERISA defines responsibilities of institutional investors:
o Act solely in interest of plan participants and beneficiaries
o Invest with care, skill and diligence
o Diversify plan investment to minimise risk of large losses. Any breaches will be held responsible
• DOL IB-1994-1:
o Economically targeted investments (ETI) that create societal benefits are compatible with ERISA fiduciary obligations
o So long as expected rate of return is the same and has similar risk characterstics
o Referred to as: ‘all things being equal’ test
• DOL IB-2008-01:
o DOL replaces 1994 IB with 2008 IB
o Selection of non-economic factors should be rare
o Discouraged fiduciaries considering ETIs and ESG factors
• DOL IB-2015-01:
o Expanded the use of ESG under ERISA
o Acknowledges ESG factors may have direct relationship to financial value of the plan’s investment
o ESG should be part of fiduciary’s primary analysis

Question 19

UK Regulation

Answer 19

• Post-2008, Prof. John Jay commissioned by UK government to review structure and operation of UK equity markets
• 2012: The Kay Review of UK Equity Markets and Long-Term Decision Making
o Culture of long-term decision making
o Trust and stewardship
o Highlighted damage being done by misinterpretation of fiduciary duty
• 2014: The Law Commission: Report: Fiduciary Duties of Investment Intermediaries
o Interpretation: Trustees may take into account ESG factors
o The report: Trustees should take into account ESG factors
o On ESG non-financial factors:
 Scheme members would share the concern
 The decision should not involve significant risk of financial detriment to the fund

Question 20

EU Regulation

Answer 20

• 2019: EU Action Plan on Sustainable Growth
o Mandatory disclosure of policies in relation to ESG risk for all firms and financial products
o Comply or explain disclosure of adverse impacts of investment on sustainability
o Enhanced disclosure obligations for firms promoting environmental or social objectives
• Technical Expert Group (TEG)
o Assists EC in technical development of sustainable finance regulation
o 2019: issued EU Taxonomy
 Voluntary EU Green Bond Standard
 Voluntary low-carbon benchmarks
 The Technical Report on EU Taxonomy – aimed to significantly advance shared understanding of activities that contribute to climate change
• 2019: EU’s Shareholder Rights Directive II
o Improve quality of engagement between investors and investees
o Alignment of executive pay with corporate performance
o Requires annual reporting of engagement policy and annual reports:
 How integrated to their investment strategy
 How the dialogue is done
 How voting rights executed
 How manager collaborates with other shareholders
 How conflicts of interests are dealt with
• 2016: Article 173: French Energy Transition Law
o Mandatory carbon disclosure requirements for listed companies

Question 21

China Regulation

Answer 21

• 2018: Asset Management Association of China (AMAC) released Guidelines for Green Investment
o ESG is strategy to establish green financial system
• AMAC expected to facilitate implementation of guidelines

Question 22

Challenges to integration of ESG

Answer 22

Challenges prior to implementing ESG
• Perceptions of negative impact on investment performance
• Fiduciary duty prevents ESG
• Advice given by investment consultants and retail financial advisers has not been supporitive
Challenges after decision to implement ESG
• No understanding how to build investment mandate to promote ESG
• Impression that significant lacking and expensive resources are needed
• Gap between marketing, commitment and delivery of funds

Question 23

Types of institutional investors

Answer 23

• Traditional investors
o ESG factors are not relevant to meet liabilities
o Implies they believe that ESG risks and opportunities are already priced into any potential investment
o This is in accordance with modern portfolio theory (MPT)
• Modern investors
o ESG integration enhances analytical capabilities
o Integrate ESG factors to the extent they impact corporate financial valuations
• Broader goals investors
o ESG factors are relevant for portfolio performance
o Fiduciary duty to include long term financial and non-financial considerations
o Accept financial sacrifice for support of ESG (i.e. tobacco)
• Universal investors
o Financial responsibility to support global economic health
o ESG factors drive systemic risks
o Align portfolios with ESG goals
o Often attach particular importance to environmental factors
• Traditional remain influential – moving to modern approach – not universal

Question 24

Portfolio returns challenge

Answer 24

• Screening, divestment and thematic involve ‘tilting’ underweight or overweight those that perform well in ESG
• Institutional investors say may hamper ability to invest prudently – straying from established benchmarks
• Increases tracking error (delta of active decisions and benchmark)
• Example: MSCI ACWI – benchmark for global equity funds
o Utilities, materials and energy – account for less than 15 % of portfolio weight
o Account for 80 % of overall carbon footprint
o The MSCI ACWI Low Carbon Target reduces annual carbon emissions of the portfolio by approximately 75% by overweighting companies with low carbon emission (relative to sales) and those with low potential carbon emissions (per dollar of market capitalisation)

Question 25

Investment consultants challenge

Answer 25

• Base advice on narrow interpretation of investment objectives
• Perceive lack of interest by asset owners and therefore less willing to integrate into their portfolios
• Can be solved: asset owners and individual retail investors can ensure ESG factors are standing items in meetings

Question 26

Once decision been made challenge

Answer 26

• Asset owners feel they don’t have scale or capacity to influence products from fund managers
• Unsure how to integrate ESG within mandates
• The international Corporate Governance Network (ICGN) – established Model Mandate Initiative
o Toolkit for establishing long-term and sustainable mandates

Question 27

Resource challenge

Answer 27

• Felt by those with funding constraints
• Building or buying ESG expertise: total external price could be EUR 100,000
• Even with financial resources: creating technical resources such as data sets, modelling capability and valuation techniques
• Data availability:
o Specialist providers
o Disclosure still problem: quality and scope
o No universal standard
• Modelling:
o Integrating ESG factors into traditional financial models
o Models extrapolate from historical data – less relevant for future ESG outcomes
o Historical theme – doesn’t account for breakthrough innovation
o Fewer tools for positive ESG performance
• Valuation techniques:
o Can vary this discount rate applied to future cash flows – raises question of how much discount to different ESG risks
o Could apply different valuation multiples, P/E – may lead to double counting if already priced by the market
• Must use qualitative – maybe even a quality score – less well respected – quantifying the input and its impact is generally a challenge

Question 28

Greenwashing

Answer 28

• Misleading claims about environmental practices, performance or product
• Also ESG and impact funds are greenwashed
• ESG funds have held controversial stocks previously which calls into question credibility
• EU introducing initiatives to standardise claims
• Voluntary action and initiatives needed to enhance implementation