Will the changing dynamics of ESG investing dispel the perception of greenwashing?

ESG (Environmental, Social, and Corporate Governance) investing[1], has reached ever higher levels with European ESG fund assets passing the £1 trillion barrier in 2021. The Ukraine crisis is bringing ESG back to the forefront, as it calls into question the commitment to the regulation and the proper governance from the highest echelons of government. This has highlighted the need for greater scrutiny in all parts of society, including in the Wealth and Asset Management industry, which has already faced accusations of greenwashing. This despite all the great efforts made within an environment where there still is a lack of ESG standards, and despite the introduction of the EU taxonomy (although not finalised yet).

Frustrating as this may be, there is plenty of optimism to be found. There are measures in place to prevent this perceived greenwashing. The ESG framework for European financial services firms for example, which is part of the EU’s capital Markets Union project, has been and continues to be harmonised more and more through ESG regulation such as:

• the Sustainable Finance Disclosure Regulation (SFDR);
• sustainable finance taxonomy;
• low carbon benchmark regulation; and
• amendments to AIFMD, UCITS and MiFID

The UK government has also announced it will publish a sustainable finance taxonomy based on the EU’s text and will join the European Commission’s international platform for sustainable finance to help develop common international taxonomies. Add to that the steps that are being taken by the IFRS, and although these ESG regulations are not without their criticism for (currently) excluding social and governance factors and a lack of alignment with other rules, these are important steps to create the more common standards for ESG implementation and reporting.

Standards for ESG – how to control them?

There are some who are pushing for companies’ ESG claims to be independently audited. This is a grey area which can likely only be answered if a commonly accepted framework and standard for how ESG is agreed upon.

Looking elsewhere we can see Certified B Corporations[2] undergo a rigorous audit to attain the B standard, but for those wanting some kind of ESG stamp of approval there is nothing other than the regulatory frameworks we are currently working with in the market.

Being a signatory to the many different initiatives that are undertaken in the ESG space be it the well known UNPRI or others have and are playing a fundamental role in improving investment decisions of asset owners and asset managers. However, a company does not get certified and being a signatory does not necessarily say anything about the follow through of asset managers.

And how would an ESG audit look like? Would it relate to the process, procedures and way of execution in a company?

Various initiatives are underway and are bearing their first fruits, with the European Commission’s creation of EU-wide ESG reporting standards, and the International Organisation of Securities Commissions making progress on the creation of an ESG version of the International Financial Reporting Standards. These are aimed at creating transparency and reporting requirements in Investment Management firms at both a product and asset manager level.

These regulatory developments suggest that ESG investing is neither a trend nor a subjective exercise. What this means is, it is important to understand how to integrate ESG effectively and proportionately in your organisation.

Defining your ESG Principles

With the regulatory environment starting to create a framework for ESG it remains important for any company to define the principles (within this developing framework) of what form the ESG objectives for the company and its clients should take.

Here are some considerations to take into account when defining your principles:

Working in tandem

It is important to take an holistic approach. Fundamental analysis cannot be disconnected from ESG consideration and must be considered in tandem, augmenting the fundamental investment analysis.

Is the glass half full or half empty?

Do you see ESG as mainly a potential risk input or do you go beyond and look how a company is managing it and try to identify the interesting upside potential?

Risk mitigation or the needle in the haystack

Is the objective of your ESG framework to reduce risk by trading the known good ESG trade (Quality), or do you want to equally identify the rising star (potential Return) and diversify your portfolio(s)?

Engagement and dialogue (Stewardship)

Do you want to be an active or more passive owner? How active can you at all be, given your size? How can and will you engage with the companies you are invested in, on your own or will you potentially look at partnering with other investors or organisations. What actions will you take (from proxy voting to divesting) if this engagement does not reduce ESG risk or achieve its potential within certain timeframes.

With these factors in mind and having set your objectives for ESG integration in your company how can you practically put an ESG framework in place?

Creating your ESG Framework

Here is an example of what an ESG framework could include. Clearly the elements of it are also defined by the size of your company and the resources that can be put towards it.

• Your Scope, Vision and Objectives: what is it that the company wants to achieve with its ESG framework: compliance with regulation, integrate it in all investment decisions or only in specific investment management strategies, do you as company want to be seen as a force for ESG good for example?
• Define the roles and responsibilities; what will be the governance: who sets the framework, makes changes to it, oversees implementation, sets companywide strategy, reviews the outcomes and ensures engagement and ownership in the organisation, prioritises ESG topics, ensures regulatory compliance, sets engagement guidance with stakeholders, business partners, NGOs. Depending on the size of the company consider the creation of an ESG Board, an ESG office, working groups, operating entities and so on.
• Approach: This should cover elements like ESG corporate standards, analytical process, business guidelines, scoring approach, active ownership, risk dialogue, exclusion policy, business opportunities, engagement process?
• ESG business integration: how is it going to be practically integrated in your organisation, a blanket versus selective approach, what tools will you be offering, how will you measure the outcomes?

There is not one ESG framework that fits all; it will depend on your business and investment structure. Your ESG framework should be guided by what your ESG aim is (taking into account upcoming regulation and the ESG initiatives you have signed up to), your client objectives, asset class, investment style and strategy, time horizon and so forth.

State of change

What should be remembered is ESG is not set in stone, as recently highlighted by the Ukraine crisis. The definition and regulation will change and mature over time with changing market sentiments, socio economic dynamics, scientific developments, regulations, client needs and industry (best) practice. What is acceptable today might no longer be tomorrow and hence your ESG framework should cater to this and be dynamic.

[1] i.e., the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions

[2] B Corp Certification is a designation that a business is meeting high standards of verified performance, accountability, and transparency on factors from employee benefits and charitable giving to supply chain practices and input materials.