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Roundtable: Understanding context to make sense of ESG

Pension funds, asset managers and servicers discuss the lack of interesting sustainable investment opportunities, the SFDR’s impact on UK investors and managers, and why contextualising data is key.

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Magdalena Håkansson (Head of ESG, Första AP-fonden (AP1))
Padmesh Shukla (Head of investments, Transport for London Pension Fund)
Patrick O’Hara (Director of responsible investment and engagement, LGPS Central)
Cliodhna Murphy (Executive director – product development, MUFG Investor Services)
Joe Bello (Head of UK asset management sales, BlackRock)
Mark Guirey (Executive director – asset owner client coverage, MSCI)

Funds Europe – In 2020, more than 50% of inflows into European funds were invested in ESG-related funds despite initial fears that Covid-19 would slow the pace of sustainable investing. What are your expectations for ESG inflows over the next 18-24 months?

Patrick O’Hara, LGPS Central – I think we need to be careful when reviewing statistics around the inflow into ESG mandates. As we know, there’s a general lack of consensus about what an ESG mandate is and there is a wide variety of approaches to ESG integration. At this point in time, those sorts of statistics can be questioned. Having said that, the interest in sustainable investment is growing, the signals around climate change are getting stronger and I expect this trend to continue.

You’re going to see an increased flow into what you could define as sustainable mandates and sustainable investments. I see infrastructure in particular as an area where investors will look to invest, partly because of the [UK] government’s commitments to build back better post-Covid and the obvious need to restart economies, but not in the unsustainable way they existed prior to the pandemic.

We know that there are lots of issues around climate change and the transition to a lower-carbon economy that need to be addressed and it’s essential that we don’t go back to the trajectory that we were on before. This presents an enormous opportunity for us to reconsider how we want capital to be allocated and to bring about a different type of economics and capitalism than we had before.

Pension funds are looking for more opportunities in infrastructure and renewables – you could question whether there’s sufficient opportunity out there in terms of the size required for pension funds to really allocate to the extent they want to in these strategies.

Magdalena Håkansson, Första AP-fonden (AP1) – On the inflows into funds, it’s always about playing with the numbers – how you define things and make things up in the world. When it comes to funds considering ESG aspects and funds that are engaging as active owners, there’s an increasing momentum and it’s becoming more mainstream rather than a separate fund category. Then we have the more niche thematic sustainable funds which are directed towards more sustainable products and solutions. Here there is rather a lack of interesting investment opportunities – for us as a pension fund at least – than there is a lack of capital wanting to invest in these opportunities.

Cliodhna Murphy, MUFG Investor Services – In terms of the inflows, I echo the sentiment that there is a lot of capital that is being deployed. One area to look at is the transition to and growth of wealth by the younger generations who have a keen focus on responsible investment and are looking for those opportunities in terms of searching for products and funds to invest in. There is definitely a lack of products and funds currently across the spectrum from an investor perspective, and that needs to be a key focus for the asset management community.

Funds Europe – Where do you see demand but a lack of investable opportunities?

Håkansson – One example is the green bond market. Most of the issuances that have come to the market over the last couple of years are very oversubscribed and investors end up paying a premium for those. The question then is, is there actually a premium to them or is it more a consequence of the supply and demand in the market?

Murphy – One area that has been very positive is the huge amount of collaboration between investors, asset managers and regulators in terms of trying to solve problems, and I see echoes in that in how we’ve approached the pandemic and the vaccination programme. I’d like to see it continue in a positive way as we look to go forward, such as the UK saying that it would look to give surplus vaccines to Ireland and more collaboration between governments, technology and science to reflect that positive collaboration in the ESG space.

Joe Bello, BlackRock – Last year our CEO, Larry Fink, wrote in his annual letter that climate risk is investment risk and suggested that markets would start pricing climate risk into the value of securities, and we would then see a fundamental reallocation of capital. This year, he wrote that the reallocation of capital, the ‘tectonic shift’, accelerated even faster than he anticipated. Global sustainable ETFs had a record year in 2020 – we had US$86 billion of inflows, which is nearly triple where it stood a year before. So far in 2021, we’ve seen $42 billion (€35 billion) come in, and again this is global ETFs, so nearly 50% of last year’s record, according to BlackRock’s 2021 SFDR memo.

Last year we saw about 40% of our Ucits ETF flows being allocated to sustainable, and this year that number is near 58%. By 2030, BlackRock is suggesting that sustainable assets under management (AuM) will grow to $1 trillion from $200 billion today. Assets in iShares sustainable ETFs and index funds rose to $110 billion in 2020, with $81 billion in global iShares ETFs and $29 billion in iShares index mutual funds; iShares sustainable ETF and index fund assets more than tripled from $34 billion a year ago, and are up from $10 billion two years ago, this year’s iShares investor progress report shows. That acceleration is coming from a lot of different countries and client segments, but the trend is exceptionally clear, and we expect it to accelerate.

Mark Guirey, MSCI – The adoption of ESG or sustainable-type investments has been exponential over the last couple of years. To Joe’s point around the statistics, it somewhat depends on what you’re measuring. If you’re looking at equity, fixed income or thinking about infrastructure as an investment, dependent on the asset class that you’re talking about, the rate of adoption might be different due to the availability of solutions. In the ESG equity space there are a number of solutions in the ETF or pooled world that can be invested into today that would be classified as Article 8 or 9 funds from a Sustainable Financial Disclosure Regulation (SFDR) standpoint, so some of those solutions are there. There are some indexes and funds that are ESG and sustainable in the fixed income space, but less than equity. When you move into private asset classes, there are even fewer solutions, they are coming onstream and that probably reflects some of the differences in that rate of adoption.

Padmesh Shukla, TfL Pension Fund – On the institutional side, particularly large asset holders like pension schemes and asset managers, not thinking about net zero is not a choice anymore. As we all know, the Task Force on Climate-related Financial Disclosures (TCFD) obligations are going live for UK pension scheme with over £5 billion (€5.75 billion) in assets from October 2021.When you think of carbon net zero, it’s an interesting concept because one has to go back to the basics of what net zero is actually telling you to do. Net zero doesn’t mean no carbon-emitting asset in the portfolio. Although it takes you in that direction, it’s not saying that your portfolio shouldn’t have any carbon as it’s not an absolute zero target, so terminology is important. To focus on a net-zero 2050 target, you almost have to work backwards. This can’t be a set-and-forget 30-year target – one has to break down it down by intermediate timeframes. What we have seen, at least in our industry, is targets being broken down for 2030, 2040 and 2050, then those targets being subsequently sub-divided into different asset categories and almost thinking through a sector-focused lens.

We haven’t set a target, as yet, but we are working in that direction and we are learning from both good and bad examples of targets being announced. When you start unpacking them, details are thin on how they will be delivered behind many of the announcements.

Funds Europe – How have you been preparing for the EU’s Action Plan on Sustainable Finance and how big a headwind is Brexit and the UK’s decision to introduce its own taxonomy for sustainability – or is it additional competition in a race to the top?

Håkansson – Since last year, we have had an internal working group monitoring all the developments within the EU’s Sustainable Action Plan, it’s not just the SFDR that will impact us. Having said that, from our perspective, we are more interested in understanding how the Action Plan will indirectly impact us and the companies and investments we make, and of course the products we invest in, so that’s the main objective from our end in terms of understanding.

We have been in discussions with fund managers on the different aspects of SFDR reporting. It’s been quite interesting to follow the development and hear the differences within the EU on how to define and how to categorise Article 6, 8 and 9 funds. That varies from my perspective. Over time, the interpretation of the SFDR will gradually align, but initially there will most likely be some differences across the market on how to interpret the regulation and how the different products are defined.

Murphy – We’re helping our clients to understand the impact of the SFDR on their funds, how they’ve been categorising them and the reporting requirements. I’ve seen a majority of managers look to categorise within Article 6, so non-ESG funds, and I’ve been trying to understand and ask questions around why so many have opted for Article 6. It’s partly due to the split between Level 1 and Level 2 and people were concerned – although they had already integrated ESG into their portfolios – as to whether they would ultimately classify as Article 8 funds.

Despite this milestone on March 10, it’s a very ambitious piece of legislation and is ultimately a call to arms to the investment management community. It’s going to become more of a focus, particularly as the Level 2 requirements come into play next year and for reporting the year after.

From a Brexit perspective and the UK’s own taxonomy, we still need to learn a lot more about exactly what the government is planning to do. I personally don’t think it’s helpful to have multiple different taxonomies – it’s better to have standardisation and consensus which will ultimately help investors understand what those disclosures mean, so I would hope that there is significant alignment with the EU taxonomy as well as other governments as they look to bring this in in the US or Asia.

O’Hara – The UK government has been very focused on the TCFD, and Chancellor Rishi Sunak made announcements towards the end of last year about mandating that across the UK economy. The Department for Work and Pensions (DWP) have consulted on mandating it and we’ve had conversations with the Department for Housing, Communities and Local Government, which is the relevant department for our pool. So, our focus has been mostly on the TCFD and TCFD reporting as being the immediate challenge for us, and we feel like we’re in a comfortable place with that. We’ve also done a lot of work with our partner funds to help them assess climate risk, communicate their approach, put governance in place and comply with the TCFD.

Where this immediately is relevant for us is the conversations that we have with the large portfolio managers, the large asset managers around mandates. We’re looking for opportunities to invest in more sustainable strategies and sustainability-focused strategies. It’s hard when communicating with the pools and the beneficiaries about what they might look like and how we would define those and categorise those, and the separation between the different strategies. That’s been quite challenging but even UK-based asset managers will need to embrace the SFDR, particularly if they want to sell products in Europe. Their categorisation of their products is going to help to inform our understanding of what they are doing and trying to achieve, it’s going to help to inform the conversation we have with our beneficiaries and the pools

In terms of us having to comply with it ourselves, with the UK government’s decision not to mandate it at this point in time, it’s not something that is of immediate concern to us, but certainly using it to inform and improve our communications around sustainable investing and sustainability is important. We do thorough due diligence on these funds before we invest, and refresh this on an ongoing basis through monitoring. It’s more of a language and communications point for us at this moment in time in terms of those discussions.

Shukla – The UK chose not to onshore the SFDR into some legislation, so strictly speaking, UK funds don’t have to do anything, but as we all know, fund management is a global industry, so I’d be very surprised if UK-based fund managers are not complying, because if you want to sell your product in the EU, you have to do it.

The Financial Conduct Authority (FCA) is due to consult on its own sustainable finance regime this year. As a UK final salary scheme, the focus has been on the TCFD and the government has been quite clear on what it expects the large schemes to do, and so in some ways our hands are full in terms of making sure that we are covering the climate change risk.

Even though we are not required to comply with the SFDR, there are some very clear impacts that are coming from that. Classifications like these are helpful in terms of our understanding of green products and strategies, which helps to improve our communication with our members and trustees. Despite not having to comply, it’s a very helpful thing to have.

Having said that, it would be helpful to have some degree of regulatory standardisation on this matter and hopefully they focus on principles as opposed to detailed rules as any decarbonisation path will be dynamic. So, the EU guidelines run over 192 pages – if you need that many pages to explain what sustainable investment is, then that can be challenging. That’s just the EU – we might have our own version in the UK, and that is before we even talk of what may come out of the US. What would be unhelpful is if we have a fragmentation of these different expectations from different jurisdictions. It may make everyone’s life difficult in terms of watching multiple actors and trying to understand what the common thread is. I hope there is a bit more connected thinking and implementation when it comes to the regulatory action, otherwise it would be a huge wasted opportunity for everyone to come up with their own version for something that is a global issue. There is a need for standardisation here and I hope the regulators are listening.

Bello – Taxonomy is the desired goal for most people, for most of our clients that we’re seeing and hearing from. The SFDR aims to harmonise standards and increase transparency for all investors and as the SFDR regulatory structure evolves, we’re going to see that further centralisation of definitions and concepts which is going to be crucial for the advancement of sustainable investing altogether.

We’re expecting the final disclosure rules to come out by the end of this year, and for large asset managers like BlackRock, anybody managing greater than £50 billion in AuM will have to abide by those rules by as soon as 2022, so the bar is quickly being set as per the UK Treasury’s interim report in November 2020.Guirey – MSCI has clients across the entire ecosystem, so we’re trying to help facilitate both their and our own understanding of the requirements. From August 2020, we held a series of workshops that were attended by clients across the EMEA region and we provided one-on-one discussions looking at solutions and how the taxonomy could end up being translated into data and needs to facilitate the reporting around those aspects.

We did an online survey as well with over 900 clients participating, so we collated feedback from clients, and we created a landing page on sustainable finance on MSCI’s website.

There were some key highlights that came from this, particularly around the classifications and what Article 8 means – again, most people would consider that as funds integrating ESG considerations and being more focused on financial materiality – while Article 9 funds are seen as more focused on sustainability, impact, reduction of carbon emissions and more in line with the Paris Agreement. Definitions and how fund providers were interpreting the regulations and how they then might report on that is something that we worked extensively with our clients on from the summer of 2020 to date.

Funds Europe – Joe, you mentioned setting a bar, so if the SFDR implementation represents a starting point for ESG data disclosure, how important is it that funds go beyond collecting the mandatory data, given the scope of the requirements is likely to increase as the regulation develops, as well as the greater understanding of what is financially material?

Bello – In terms of what other reporting needs to happen, the data being collected now is only just proliferating and the question becomes: what do clients want to see reporting on and do they want to see it getting more siloed? Momentum for investing sustainably is now building, and the SFDR obligations that apply from today will be a key catalyst to accelerate this trend in Europe. As the SFDR regulatory structure evolves in the coming months, we see further standardisation of definitions and concepts as crucial for advancing sustainable investing.

Our 2021 Stewardship Engagement Priorities are mapped to specific United Nations Sustainable Development Goals (UN SDGs) given the significant intersection. We believe there’s value in identifying how a company’s business practices, products and services might contribute to certain UN SDGs as per our SFDR playbook.

Funds Europe – Do you sometimes have trouble defining those when it comes to issues that intersect, for example social justice and the environment?
Bello – It will come down to how you define and measure it. When it comes to the environment, this is a question we receive often in terms of the ultimate goals. Do you understand what your exposures look like in your portfolio? Can you evaluate the investment trade-offs? Can you stress-test the portfolio? The most important thing is reporting, so can you report back to your investors in terms of where you are on that trajectory and achieving those goals? The standards will ultimately depend on how you define them.

Shukla – On whether we need more data – there is already lots of data being collected, so my focus would be more on the quality as opposed to quantity. There’s data coming out from multiple providers, they’ve done a fabulous job in pushing the envelope forward.

The other area is the coverage of the data itself, because as we all know, the quality of data and even the quantity of data is definitely a lot better when it comes to the publicly quoted market, be it equities or bonds, but the private markets is a different story – we are barely scratching the surface there. Clearly, there is the ESG inability as more and more pension funds are holding non-public assets, it’s the holistic nature of our disclosures that matter to our members.

Finally, on data collection: clearly ESG and carbon are two very important lenses when it comes to our disclosures, but what also matters is the real impact our investments are having on the ground. For us, the 17 SDG goals are important in being able to convey the true impact our investments are delivering in a wider socio-economic framework – a really helpful metric for us when engaging with our members.

Funds Europe – Padmesh, you mentioned that there is data, but how do you view the growth of what constitutes financial materiality when we look at some of the real-world events that have taken place last year; for example, companies’ lobbying activities, and whether that matches up with some of the social claims that they might make in public?

Shukla – That’s a very fair observation, and I go back to the point that we made about the pros and cons of, for example, the EU SFDR legislation – prescriptive, a helpful aspect in terms of standardisation, but prescriptive to a point that it may make the outcomes quite binary, i.e. green or not green, when in truth many sectors and companies are somewhere on that spectrum and it is too early from an innovation and technology standpoint to be slotting them in boxes.

The world of investment is quite dynamic and things are moving all the time, so being very prescriptive about what is good and what is bad sometimes may hamstring you from thinking more effectively around the questions that you have raised. Likewise, every sector will have its own nuances, and in our case, we use the Sustainability Accounting Standards Board (SASB) as a tool to determine what’s important and what’s financially material for a sector. You still have to look around for best practices and some of these may not be coming from these regulatory nudges that we are seeing – whether it’s the EU or someone else.

Håkansson – What’s very important when it comes to data is context – you can’t just aggregate numbers and provide KPIs and different metrics without really understanding the context. If you have a broad, global and well-diversified portfolio, it’s likely to have a different footprint or KPI performance than if you are investing in an actively managed equity fund in the Nordics. There are regional differences, and there are also different investment strategies and styles, all with different ESG outcomes. That discussion is lacking when you are trying to aggregate data at a portfolio level. For us, if we were to just provide KPIs at an aggregate level, it wouldn’t really say anything because the devil is in the details. You need to dig deeper and understand the context for the data to make sense.

When it comes to using and collecting ESG data, it’s also important that investment managers use data which they believe is most relevant for their beliefs, processes and strategies. We don’t expect our portfolio managers – internally or externally – to use the same data or use the same ratings or scores, for that matter. Different ratings should be used for different purposes. It’s therefore important for rating and solutions providers to be transparent as to what their products and services do and don’t do, because there are pros and cons to each methodology, and they can be used for different purposes.

When we work with our internal portfolio managers on defining their ESG strategies, it’s important that they buy into the data. That is to understand it, know what it does and doesn’t do, and how it can be combined with the other aspects they are considering as part of the investment process. We use different data points for different purposes both internally and externally.

When it comes to disclosures, we are mainly interested in understanding if the performance of a manager is actually what we were expecting. If we buy into a product which has a specific ESG strategy or way of integrating ESG, then the outcome of the fund’s ESG performance should be in line with the specific strategy. We don’t expect the fund to show something completely different. There are multiple ways of doing things and in the age of standardisation, we believe it is important that we continue to allow for different ESG strategies.

Murphy – I think back to the point around mandatory versus the additional data points. Initially we thought that the legislation would have more data points that would be mandatory, more like 32, when in fact at the end, it was 18 data points, but in total there are 66 data points. It depends on your strategy in terms of looking at not just the mandatory data points, but also the additional data points, and it’s a requirement for all the investment managers to understand all of them and think about what is most relevant for their strategy and how they would apply them.

One of the things we’ve been focused on is helping our asset managers. If that’s in the public space where there are a lot of data sources that already exist, it’s about helping them to identify those data sources, looking at the best coverage for their portfolios, aggregating that data and then helping them apply that to their portfolios – it’s very important to provide ESG transparency to underlying investors. In the private market space where the data does not exist, it’s important to go out and help them collect, analyse, monitor and report on that data, so this is a key requirement in terms of helping our clients to understand and report that data.

Guirey – Data is something that MSCI does and I absolutely hear what you’re saying with regards to coverage and data quality, there are lots of providers, lots of data. To Magdalena’s point, the portfolio managers or asset owners knowing the difference, understanding the difference, utilising different providers for different means makes sense if you truly understand the nuances between providers and the data.

The market is striving to provide coverage into private assets. In the listed space, the coverage has improved significantly and is in a much better place now than it was a number of years ago, but the private asset space is a challenge. By its very nature, being private makes it challenging to provide that coverage, but providers like MSCI and others are working to try and achieve better coverage in the private asset space. Real estate is an area where the coverage and the models are good, particularly if you’re measuring the portfolios, but into private equity, private debt, etc, whilst models can exist, without data it’s a challenge.

O’Hara – It’s important to remember why we require this disclosure and why we require this data. Ultimately the case for ESG is that it provides fund managers with an opportunity to differentiate themselves from others, to find edge, to generate alpha, to manage downside risks better, to identify opportunities that are going to provide attractive investment returns, and that’s ultimately why we’re trying to get additional data and disclosure from corporations. There’s a recognition that corporates aren’t going to give us everything we need to know because they’re not going to necessarily give us a relative view, they’re not going to volunteer information around some of the challenges and the headwinds that they’re really concerned about, so we need to go out and get some of that ourselves from different sources – regulatory bodies, news and other sources – and where there are gaps in disclosure, we go and get that from the companies and ask them additional questions.

In terms of materiality – and I speak in terms of the active equities space more than other asset classes – fund managers generally have a good feeling as to whether something is material or not and what the gaps in their knowledge and understanding are, and part of the role of ESG is to help them go and find that additional information. This is one of the dangers with regulation and mandating regulation, it establishes de minimis levels and we think perhaps the job is done, but there’s always a need for investors to go over and above that and find that edge. It goes back to what Magdalena said – it’s about how you analyse that data then and how you interpret it that gives you the advantage over other investors.

There are other activities that we will do to be good stewards of those companies in terms of engaging with them about their negative impacts. There are plenty of opportunities to improve the performance of corporations that don’t necessarily provide, in the short term at least, upside in terms of financial performance or share price improvements, but they certainly don’t provide downside risk, they’re not going to detract from the corporate performance, there are things that they can do better, and that falls within the remit of our stewardship activities and our voting.

Overall, in the long term, we think managing these issues better will help to enhance or maintain corporate performance, but it is hard to quantify the benefit. We shouldn’t just be voting on corporate governance issues; we should be voting on the whole ESG performance of the corporation and where it might be lacking or where disclosure might be lacking. You can vote against the report and accounts, that’s ultimately the conduit through which we have a vote and that talks to corporate disclosure, and if you think these things are material then that’s where we can vote against or abstain. You can also vote against individual directors or the chair.

Funds Europe – We have been living with the Covid-19 crisis for a year and have seen both sustainable and unsustainable business practices. How are you reflecting sustainability metrics into manager compensation as a result of what’s taking place at a micro level within companies? In our roundtable discussion last year, Patrick, you mentioned that at this year’s AGMs, things that will be factored into discussions are things such as remuneration and how workers have been treated and whether they were put in a situation that compromised their health and safety.

O’Hara – Last year’s voting season was a little bit early in some respects to gauge the corporate behaviour during Covid-19, and now we can look back on how the corporates behaved and were managed during that period. Did they get government aid? Did they cut the dividend? Did they lay lots of people off and furlough lots of people and then did they pay enormous remuneration packages to senior management which was really inconsistent with what they were telling us about how the business was challenged during that period? We can now gauge the consistency of the message and the behaviour over the period and integrate that into our voting.

I don’t know how well we will be served in terms of the proxy voting providers and the other ESG research providers out there in terms of engaging and understanding that, maybe we’ll have to do some of that work ourselves in terms of the newspaper articles and what we were told at the time, but I think it’s an important consideration now in terms of how not only did they behave during that period, what’s the plan going forward as well?

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