Conclusions Drawn from latest Market Intelligence paper ‘ESG Scrutiny: Lessons from Manager Selection’
Environmental, social and governance considerations continue to rise strongly in importance among investors with ESG criteria increasingly being used across all asset classes, not just public equity. Diversity of demand, with a huge variety in investors’ interpretations of ESG, makes standardisation difficult and suggests a bespoke approach to manager selection will yield the best results.
Overall, the universe of products and strategies is shifting away from negative screens towards bottom-up factor integration and active engagement, yet each of these can take many forms and exclusions remain vital for many institutions.
The number of ESG offerings continues to rise and the marketing has become more sophisticated but it’s increasingly important to distinguish between box ticking and substance.
These are the key conclusions revealed in bfinance’s latest Market Intelligence paper “ESG Scrutiny: Lessons from Manager Selection”.
The paper draws on insights from five recent customised manager searches in public and private markets, with detailed case studies on a Private Debt selection exercise for the UK Environment Agency Pension Fund and a Public Equity search for a European family office: two asset classes which sit at opposite ends of the spectrum in terms of the extent to which ESG has become embedded and marketed.
- When rating or scoring managers on ESG, an approach that is specific to the individual investor can significantly increase the universe of providers from which that investor can choose
- Culture, attitude and internal conflicts of interest can outweigh formal processes in relation to ESG factors. Avoid giving excessive weight to signs of commitment that may be superficial, which may include being a signatory to relevant bodies
- Universe of products and strategies expands, shifts away from exclusions and screens towards bottom-up factor integration and active engagement
- Increasingly, ESG-focused investors are making it a priority to move beyond equity and integrate relevant factors into their fixed income and alternative investments
- ESG integration should not, in theory, involve increased fees, however, the frequent need for customisation can add an extra layer of cost to ESG investment
Certainly there is a growing importance and continuing evolution in sustainable investment. What started as socially responsible investing, screening out ‘sin stocks’, such as tobacco and gambling, has evolved with deeper integration of ESG risks and opportunities into investment analysis, thematic ESG investing focusing on areas such as climate change and water scarcity, and impact investing, where the intention is to generate a beneficial social or environmental impact alongside financial return.
Bespoke approach to ESG significantly broadens universe of providers
Investors approach ESG from a variety of perspectives. Some have an ethical stance, others approach the subject from a pure risk management perspective. A number of investors may desire a high degree of activism, others do not. A significant portion of ESG-orientated investors are open to working with managers that are still refining their responsible investment approach, while others require strongly institutionalised processes.
Several European pension funds will only accept managers that are signatories to the Principles for Responsible Investment (PRI), however this can significantly reduce the number of managers in any particular search. Given these variations, generic ratings on the quality of a manager’s ESG practices do not map out easily so when scoring managers on ESG, an approach that is specific to the individual investor can significantly increase the universe of providers.
Investors are willing to be flexible when incorporating ESG into private markets
A good example is bfinance’s private debt manager search for the UK Environment Agency Pension Fund (EAPF). The fund was realistic, recognising that the typical sector mix in private debt limits how material ESG issues are in many cases and that the industry is generally at a fairly early stage on ESG integration. With this in view, bfinance allocated basic ESG indicators a relatively low weighting and implemented a scoring system that would not preclude managers without these blunt indicators from progressing and also took account of managers’ culture and practices. The winning debt manager, it is worth noting, was not rated by any of the large investment consultants and the manager was not a PRI signatory, although they indicated their intention to become one.
Universe of products and strategies shifts towards bottom-up ESG integration
This trend was clear from the searches that form the basis for the analysis in this paper and a good example was the Public Equity search for a major European family office.
Going beyond exclusion and basic categorisation, deeper quantitative analysis and qualitative analysis revealed multiple dimensions of ESG integration and managers can be roughly categorised as having a simple or more complex approach across a range of criteria.
Examples include whether research and inputs are external or are internally generated and proprietary, whether initial decision making is based on a straightforward overlay screen rather than being embodied in multiple dimensions, and whether the manager has generalists or specialist ESG personnel.
However, screening and negative exclusions are not going away any time soon. In the case of global equities, bfinance does not view exclusion lists as being necessarily detrimental to effective portfolio construction relative to a standard global equity benchmark, yet this may not be the case in other geographies or asset classes, e.g. a Canadian equity mandate that excluded oil-related stocks would not have access to around a quarter of the market. One particular area of growth within screening is the rise of Sharia-compliant strategies for listed equity. Further insight into this niche market can be found in the bfinance Market Intelligence white paper, DNA of a Manager Search: Global Sharia Equities.
ESG-focused investors prioritise the move beyond equities to alternatives and fixed income
Increasingly, ESG-focused investors are making it a priority to move beyond equities and integrate relevant factors into their fixed income and alternative investments.
For example, there is a conviction among asset owners that ESG aspects are often more advanced in many private market investments. Investors in unlisted real estate and infrastructure, who will hold assets for many years in concentrated portfolios, will be more likely to focus on sustainability reputation, environmental risks, governance and social factors as part of their risk management. Indeed many of the strongest examples of thematic and impact investing lie in the unlisted sphere though investors can face difficulty in finding sufficient choice and availability of asset managers in relevant niches. In a search for a renewable infrastructure manager, the bfinance process secured a 200% increase on the longlist that would have been available for the client through their conventional process and one of the winning managers has never been rated by any consultant or responded to any RFP.
Among public bond managers, there is a nascent universe of ESG-branded strategies, mostly in the corporate bond space. This is particularly true in the case of corporate bonds in emerging markets where governance considerations can pose significantly greater risks. bfinance notes a rise in “thematic” public fixed income, particularly with the issuance of an increasing volume of “green bonds” used to fund environmentally friendly projects.
ESG integration should not, in theory, involve increased fees
ESG integration should not, in theory, involve increased fees. That being said the frequent need for customisation around ESG integration, even among investors that prefer pooled fund structures, can add an extra layer of cost to ESG investment. However, in the case of the private debt search, the fee range was competitive relative to other private debt searches and illustrates that incorporating ESG considerations should not involve higher fees. Quoted fees for global equity searches in 2016 show that the figures for the fees for the Public Equity ESG mandate were broadly in line with non-ESG averages. In both cases there was considerable scope for negotiation further down the process with the winning managers offering meaningful reductions versus initial quotes.
The number of ESG offerings continues to rise and the marketing has become more sophisticated but it’s increasingly challenging to distinguish between box ticking and substance
Kathryn Saklatvala, Global Content Director and report co-author, commented:
“Clearly investors are giving greater weight to ESG criteria, not only in equities but increasingly across all asset classes. Yet their needs and priorities are very different, leading to greater fragmentation of the sustainable investing industry even as it grows. The number of ESG offerings continues to rise and the marketing has become more sophisticated but it’s increasingly challenging to distinguish between box ticking and substance. There is a need in manager searches to dig beneath increasingly sophisticated window dressing to assess actual practices.”
Niels Bodenheim, Director of Private Markets, commented:
“In searches such as the one we conducted for the Environmental Agency Pension Fund, we allocated a relatively low weighting to basic ESG indicators in the initial assessment and implemented an approach that would not preclude managers without these blunt indicators from progressing to the later stages of the process, where ESG considerations came to the fore.
One manager in the final ten in the Environment Agency Pension Fund’s private debt search claimed to be very focused on ESG. They are members of many relevant organisations including PRI, they have a dedicated impact team and they are scored highly on this issue by other consultants. But when you dig into the role that the team plays in the process you get a different picture. You also need to hear from a range of people: if the ESG person comes and presents then of course you will hear that ESG is fundamental. You need to question the people that are doing the transactions day to day. You also need to hear from the people who do the monitoring. The approach to work-out – how the manager treats distressed situations – is very important with private debt and very much has an ESG dimension: is it consistent with ESG principles, i.e. not fee-generative but really involving working with the companies to make sure sustainability and governance aspects are high priority?”
Joey Alcock, Senior Associate, Public Markets Advisory team, commented:
“While there are clearly a myriad of different reasons driving this heightened interest from asset owners in ESG-integrated investment approaches over recent years, we strongly emphasise that the assessment of a manager’s ability to generate performance should still remain front and centre for trustees. Investment management is an expensive service and regardless of capabilities around ESG, retaining a manager delivering persistently mediocre performance is not in the net interests of beneficiaries. As the universe of managers offering active ESG-integrated equity strategies continues to expand, the challenge to identify those which will deliver on both dimensions becomes increasingly complex.”
For investors taking their first steps into ESG-integrated investing, it doesn’t hurt to navel-gaze a while beforehand so as to ensure that all objectives being targeted (including non-return/risk related objectives) can be achieved consistently with one another. For example, it is arguably difficult to reconcile a desire to effect positive change at ESG-challenged companies through engagement with the systematic screening of such companies from the portfolio via an exclusion list. Equally important is the need to clearly articulate these objectives to your asset consultant and potential investment managers so expectations are clear up front.”
Green Tech Start-Ups: Are they the Future?
Endless innovations are occurring in green companies, reinventing the industries they belong to. Gradually, they are beginning to amass more success and popularity. Consequently, these factors serve as a good indicator for green technology businesses, and their development must begin somewhere.
Green tech start-ups boast a wide array of opportunities for the economy and environment, while boosting recruitment openings with valuable services. While the technology industry is littered with high revenues and competition, the green tech start-ups are the clear sign of a cleaner future.
Fulfilling a Genuine Need
Many tech companies will market themselves as the ultimate tech giants to shift stock and make profit. As they all vie for attention through warped corporate rhetoric, there is only one ethical winner; the start-up green tech company.
Some argue that mainstream tech businesses have grown far too big, branching out into other industries and standing between the consumer and practically everything they do. However, green tech start-ups go beyond the shallow ambitions of a company, answering a call to sincerely help the customer and climate in any way they can. Of course, this is an attractive business model, putting customers at ease as they contribute to a humanitarian cause that is genuine through and through.
After all, empathy is a striking trait to have in business, and green tech start-ups maintain this composure by their very nature and purpose.
Despite the pursuits for clean energy still needing more awareness, green tech is an area that is ripe for contribution and expansion. There’s no need to copy another company or be a business of cheap knockoffs; green tech start-ups can add a new voice to the economy by being fresh, fearless and entrepreneurial.
Technology is at its most useful when it breaks new ground, an awe that eco-friendly innovations have by default in their operations. Of course, green tech start-ups have the chance to build on this foundation and create harmony instead of climate crisis. Ultimately, the tech advancements are what revolutionise clean energy as more than an activist niche, putting theory into practice.
Despite the US gradually becoming more disengaged with green technology, others such as China and Canada recognise the potential in green technology for creating jobs and growth in their respective economies. The slack of others spurs them on, which creates a constant influx of prospects for the green tech sector. Put simply, their services are always required, able to thrive from country to country.
A Fundamental Foresight
Mainstream technology can seem repetitive and dull, tinkering with what has come before rather than turning tech on its head. Since 2011, technology has been accused of stagnation, something which the internet and petty app services seem to disguise in short reaching ideas of creativity.
However, green tech start-ups aren’t just winging it, and operate with a roadmap of climate change in the years ahead to strategize accordingly. In other words, they aren’t simply looking to make a quick profit by sticking to a trend, but have the long-term future in mind. Consequently, the green tech start-up will be there from the very start, building up from the foundational level to only grow as more and more people inevitably go green.
They can additionally forecast their finances too, with the ability to access online platforms despite the differing levels of experience, keeping them in the loop. Consequently, with an eye for the future, green tech startups are the ones who will eventually usher in the new era.
Green Companies Find Innovative Ways to Generate Capital to Expand
Green business is a booming opportunity for shrewd, environmentally conscious entrepreneurs. According to a white paper by the Association for Enterprise Opportunity, green businesses in the food service industry and other verticals are growing up to seven times faster than their conventional competitors.
“Green market segments in the United States are growing fast. Growth rates of “green” segments are outpacing conventional segments in every industry where we collected data – for example, over the decade ending in 2011, the U.S. organic food category grew at a rate of 238% compared to 33% growth for the overall food market, and most forecasts indicate that the shift to green will only accelerate across industries. Green business opportunities will be even more prolific over the next few years, because millennials are placing greater emphasis on environmentally friendly solutions.”
Unfortunately, many promising green companies are struggling to generate revenue. They need to be more creative to find funding opportunities in 2017.
Funding challenges green businesses face
After the financial crisis struck in 2008, banks and other traditional lending institutions became much more conservative about lending money. Many green businesses turned to grants provided by the Obama administration for funding. However, most of those grants have since been suspended under the Trump administration. Congress had difficulty resuming them, because most of the green businesses that were funded had a lower survival rate than the national average.
Without funding from either traditional banks or government grants, green businesses were forced to look for other financing options. Here are some options they have available.
Other lending institutions
While corporate banks are less likely to finance new businesses these days, many smaller financial institutions are more likely to assume the risk. Specialty lending institutions and credit unions with a strong social mission are often willing to invest in promising green businesses.
However, these lenders still require perspective borrowers to submit formal business plans and proposals on how they will use their funding. Too many of them have been burned by poorly managed green companies, so they must be cautious with lending to them.
Many other countries are more invested in green development than the United States. Companies with a presence in Norway or other European countries should consider seeking loans from lenders in those jurisdictions, such as Lånemegleren.
Green bonds are new financial instruments that have been developed specifically for financing green businesses. The Climate Bond Standard introduced a number of policies to ensure green bonds would be safe for investors and a reliable funding opportunity for green businesses around the world. By balancing the needs of both stakeholders, they have helped facilitate green financing.
The market for green bonds nearly quadrupled between 2013 and 2014. It rose to over $100 billion in 2015.
Green entrepreneur should find out if their business model is compliant with the climate Bond standard. They may be able to tap a growing source of funding.
Crowdfunding is another very popular way for all types of businesses to generate capital. Green businesses tend to benefit more than most other organizations, because crowdfunding investors tend to be more socially conscious. They are more eager to invest in companies that align with their outlooks on social causes. Since consumers are becoming more concerned about climate change and environmental preservation, they are more willing to invest in green businesses.
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