The world is facing major challenges in the form of climate change, rising inequality and conflict. Climate change is the highest priority ESG issue facing institutional investors since it exacerbates existing issues around energy, resource and food security and increases the likelihood of extreme weather events.
Limiting global warming will require institutional investors, companies and governments to work together to achieve the objectives of the Paris Agreement. To meet Europe’s climate goals, the European Commission has estimated that an additional private capital injection of up to €290 billion a year will be required over the next ten years.
Aligning investments with values
Regulations have started to emerge to encourage institutional investors to disclose their ESG integration. The EU Action Plan on Sustainable Finance encourages more accountability by requiring institutional investors to report on the environmental and social impacts of their products.
Meanwhile, there is a growing recognition of the power of capital to address social and environmental challenges. An increasing number of institutional investors are demanding that their capital be used for more than just generating financial gain – more than one in four dollars of professionally managed assets in the US now considers sustainability principles.
BNP Paribas’ 2019 ESG global survey found that improved long-term returns was the most important motivation for ESG integration (referenced by 52% of respondents), followed by brand and reputation (47%) and decreased investment risk, which was chosen by 37% of survey respondents.
Institutional investors increasingly want to align investments with values that support sustainability, realising that doing otherwise can have important reputational and material implications. The United Nations-supported
Principles for Responsible Investment now has around 2,800 signatories across the world representing $90 trillion in assets under management.
Enhancing transparency with ESG analytics
While institutional investors are setting targets and regulations are evolving fast there are still challenges around ESG integration and disclosure. Some of the major challenges to ESG investment highlighted in our survey were data and the high cost of technology.
“One barrier that we all are talking about is access to data,” states Charlotte Hormgard, senior manager at AP3 in her response to our survey. “There are lots of data. The challenge is finding the right data in the right format and knowing how to use it.”
As ESG metrics represent a new type of data, there are still challenges around company disclosure processes, integration, methodology harmonisation and coverage.
These metrics need to be rigorously analysed and there is a growing necessity to build tools that can assess ESG risk in the context of traditional risk and performance. Institutional investors are looking for broader environmental metrics and integrating them alongside social and governance issues in a holistic strategy.
With appropriate transparency and harmonised ESG analysis for both direct and delegated investments, asset owners can measure their ESG performance, set targets and track improvements. This has become a priority as asset owners can better influence asset managers and on how they engage with companies.
ESG data harmonisation is crucial
A lack of data methodology standardisation makes ESG integration challenging. Even for a single issuer in a developed market, two different data providers may derive significantly different ESG scores. Divergence of methodologies among data providers makes it difficult to conduct uniform analysis across the market.
One of the objectives of new regulations is to bring a common language and harmonised methodologies to ESG integration. In June, the European Commission’s technical expert group on sustainable finance published a report setting out the basis for a future EU taxonomy in legislation.
The European Commission hopes its guidance will provide companies with practical recommendations on how to better report the environmental impact of their activities in addition to the potential impact of climate change on their businesses.
The taxonomy's core purpose is to contribute to the development of a common language between institutional investors, issuers and policymakers that can build confidence that investments are meeting robust environmental standards and are consistent with high level policy commitments such as the Paris Agreement.
Achieving a global standard such as an ISO standard is crucial. However, this would not happen overnight. The EU Taxonomy is therefore a strong starting point.
In September 2019, the UN launched the Net-Zero Asset Owner Alliance, committing to reduce carbon emissions of their investment portfolios to net-zero by 2050 – yet another indication of institutional investors joining forces and setting ESG targets to tackle global sustainability issues.
Climate-related metrics: embracing a holistic strategy
Spurred on by regulatory initiatives and investor pressure, companies are being required to be more transparent in respect of their carbon footprint metrics. This will enable institutional investors to make better informed decisions on where and how they want to allocate their capital. Furthermore, lenders, insurers and underwriters will be better able to evaluate their risks and exposures over the short, medium and long term.
Carbon footprint metrics represent the level of emissions for which an institutional investor is responsible. As a rule of thumb, if an institutional investor holds 10% of a company, they will be considered accountable for 10% of that company’s emissions.
Asset owners can measure the carbon emissions of their investment portfolios, which can then be used to compare portfolio emissions to global benchmarks, identify priority areas for reduction - including the largest carbon emitters and the most carbon intensive companies - and engage with fund managers and companies on reducing carbon emissions and improving disclosure standards.
The selection of companies with a lower carbon footprint remains the most widely-used practice in ESG selection, while company engagement is another powerful option. More and more institutional investors are building strategies to minimise the carbon footprint of their portfolios.
While the market is innovating at a fast pace, global initiatives such as the GHG Protocol and the FSB Taskforce on Climate–Related Financial Disclosure (TCFD) have created an international framework to guide institutional investors on climate related metrics disclosure.
The recommendations from the TCFD in particular provide a common international framework through which institutional investors and companies can make informed decisions about their exposure to climate-related risks and opportunities in their businesses and future capital allocation plans.
While carbon footprint represents a snapshot of a company, other metrics are needed to understand the trajectory of the business, its low carbon strategy and exposure to transition and physical risk.
Institutional investors are starting to implement holistic strategies: while lowering carbon emissions, they are looking at broader environmental metrics (such as waste and water management and biodiversity impact) and integrating them alongside social and governance issues.
Embedding ESG into investment processes
Regulations from all over the world are emerging to encourage institutional investors to integrate and disclose their level of ESG integration. As part of the EU Action Plan, from 2021, financial market participants will be required to report on the level of environmental and social impact of their products thus holding the institutional investment industry more accountable for its investment choices.
Investment teams are running out of time to get to grips with ESG integration. With so many institutional investors referring to the growing influence of ESG on their investment decisions, the next 12 months will be a critical period for managers to put the right structure, leadership and skills in place.