ESG INTEGRATION & STEWARDSHIP

*Investing, engaging, excluding *

IN THIS CHAPTER

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ESG PHILOSOPHY & APPROACH

INTEGRATION

STEWARDSHIP

Edina Molnar, an Associate within our Sustainable Consulting/Sustainable Investment Team who specialises in Sustainable Investment, discusses the trends we've identified in relation to ESG philosophies and policies, and whether these are actually being actioned.

Asset owner poll: To what extent do you agree with this statement, 'On balance, asset managers are doing a good job of integrating ESG into their investment processes'?

Strongly agree
Agree
Disagree
Strongly disagree

ESG PHILOSOPHY & APPROACH

SI philosophy

Almost every asset manager (98%) now has an ESG policy. However, that's not the whole picture: for 20% of managers, their ESG policy doesn’t apply to all strategies.

It’s clear that the majority of asset managers recognise the value of incorporating ESG factors into the investment process. Liability-driven investment (LDI) and liquid alternatives strategies are the areas where managers seem least convinced. However, it’s only in a small number of liquid alternatives and equity funds where ESG is felt to be wholly irrelevant to the investment process – likely reflecting the overall investment style.

Does the firm's ESG policy apply
to all strategies?

Similarly, when looking at the importance of engagement to investment strategies, it’s again LDI and liquid alternatives where the commitment is least apparent. In both cases, the path to engagement is certainly less clear given the nature of the portfolios. Beyond these asset classes, the majority feel that engagement is highly important and almost all feel it’s either highly or somewhat important. However, we see a wider spread of views that engagement is irrelevant than we do with integration.

How important is ESG integration
to this strategy?

One positive result in this regard is that all LDI managers view engagement to be somewhat, if not highly, important. This is a significant departure from last year, when 29% of LDI managers believed engagement to be completely irrelevant to their strategy. This indicates a deeper understanding of how stewardship can go beyond voting on listed equities, adding value across asset classes.

How important is engagement to this strategy?

SI resourcing

Over the past year, we've seen asset managers supporting their ESG commitments by expanding their SI capabilities. Having dedicated ESG staff is common across strategies, with only 20% of asset managers having no dedicated headcount. The average SI team size consists of 20 people – though the range varies considerably, from 1 person to 250.

ESG teams tend to be growing: 71% of asset managers have hired SI staff over the past 12 months, with a variation in approach between hiring a select number of senior ESG specialists or adding depth to SI teams.

Do you have headcount dedicated to ESG/sustainable investment?

Have you made any dedicated ESG/sustainable investment
hires in the past 12 months?

But does dedicated headcount equal effective ESG integration? The better evidence to look at may be the alignment of remuneration policies with SI metrics, ensuring that employees are incentivised to integrate ESG. 62% of managers report having taken this approach. One question we could ask is whether we can have confidence in the effective delivery of ESG integration by the 38% that haven’t.

Similarly, the increased awareness of the importance of engagement is also being supported at the firm level. Over half of the surveyed asset managers now have dedicated stewardship and engagement headcount, with almost 80% of those firms having added to this headcount in the past 12 months.

Asset managers are also expanding their ESG capabilities in other ways, with over 50% of firms providing ESG training or updates to employees on an annual basis, and approximately 35% of firms providing such training at more regular intervals.

We support these efforts as routine ESG updates indicate top-down support and encourage greater buy-in across investment teams, which should lead to better results.

Do you have an ESG remuneration policy?

Do you provide regular ESG training/updates to your employees?

ESG INTEGRATION

Given SI’s rapid evolution, asset managers have taken various approaches to integrate ESG into investment processes, with most asset managers using a combination of integration routes. Unsurprisingly, given their importance in establishing an SI philosophy, the application of overarching ESG policies is most common. ESG bottom-up analysis is widespread, reflecting the addition of sustainability into the well-established fundamental research process. However, only 57% of asset managers state that they have an exit strategy, posing questions about whether negative ESG performance has material consequences.

Method of ESG factor incorporation into strategy

As expected, the continued growth in client demand for ESG has led firms to refine their ESG integration approach, with 61% of asset managers having made changes over the year.

Who holds the reins on integration can often reflect the importance asset managers place on ESG. When ESG sits with the portfolio manager, it often suggests a high level of integration. This is most common in liquid alternatives (48%), illiquid alternatives (58%) and equities (53%). Greater variation is found in fixed income and illiquid credit. When ESG integration sits with analysts and ESG specialists, effective communication processes are key to ensuring effective integration of sustainability risks. Asset managers who responded with ‘Other’ tended to be referring to a shared responsibility of ESG integration across the three main groups (portfolio managers, ESG specialists and research analysts), but this lack of clear ownership raises concerns in our analysis as it can result in ESG being neglected.

Have there been any changes to the integration of ESG
in the investment process over the last 12 months?

Who is primarily responsible for ESG integration?

ESG exclusions

In the early stages of the expansion of SI, exclusions were a popular approach to ESG integration. However, this approach risks screening out significant proportions of the investment universe and may not help to achieve meaningful behavioural change – for example, in high greenhouse gas-emitting companies. Nevertheless, baseline exclusions are still frequent, with well over half of the surveyed asset managers having such an approach.

The most common factors for exclusion are controversial weapons, tobacco, coal and UNGC violations. Perhaps the lower profile of environmental exclusions reflects a recognition by the investment community of the need to drive the climate transition through stewardship.

Private markets tend to incorporate a broader range of exclusions, while public markets incorporate fewer, implying a greater willingness to engage with poorly scoring sectors.

Do you apply a baseline exclusion policy to this strategy?

When we compare the existence of ESG exclusions at the firm and strategy level, there’s a significant discrepancy. Exclusions are more prevalent at the strategy level, suggesting that blanket exclusion policies across firms are rare. Such an approach allows firms to offer a sustainable version of a fund whilst also having the option available for clients to access returns from poor ESG-scoring opportunities.

Firm vs. strategy-level ESG exclusions (weighted)

Outcomes of ESG integration

What matters within integration is changing investment practices on the ground. ‘Outcomes’, as the UK Stewardship Code likes to refer to them, is one area where we found a misalignment between reality and manager rhetoric. Asset managers tell us that in most asset classes, most of the time, most investment recommendations are influenced by ESG factors. For example, in equity (78%) and fixed income (84%), environmental issues impact analysts’ recommendations each or most times.

But while we’re told this is happening most of the time, many asset managers struggle to provide even a single example of a buy or sell decision in the whole of last year that was driven by an ESG view. And of the examples that were given, some lacked the depth we would expect – for example, buying a Green RMBS on a cement company due to it having carbon transition targets and plan. 57% of the surveyed asset managers provided examples of reducing investments, such as selling Turkish government bonds due to human rights concerns and divesting from a Chinese solar panel maker due to fears of forced labour in the supply chain.

ESG issues impact an analyst's recommendation each time or most of the time

Strategy-level exclusions by type (weighted average)

We further investigated the outcomes of negative ESG views by asking asset managers about the conflicts that can manifest between financial analysis and ESG analysis.

Private market managers responded most stringently, with 52% of illiquid credit and 42% of illiquid alternatives stating they wouldn’t invest in a financially attractive opportunity if it had poor ESG credentials. In contrast, only 6% of liquid alternatives wouldn’t invest. For equities and fixed income, 88% and 82% of asset managers, respectively, said they would or would sometimes invest.

Can you provide an example of a negative/positive ESG view that led to decreased/increased exposure in the last 12 months?

If an opportunity is attractive from a financial perspective but has poor ESG qualities, would you still invest?

57% of the surveyed asset managers provided examples of reducing investments.

STEWARDSHIP

Paul Lee, our Head of Stewardship and Sustainable Investment Strategy, assesses the responses to the stewardship section of our survey, highlighting crucial areas for development.

Asset owner survey: In your view, the biggest barrier to effective reporting on engagement activity and outcomes is:

Inconsistency of definitions
Concerns around putting too much information into the public domain
Uncertainty around the links between outcomes and activity
Lack of effective technology to capture and report on activity

With climate change, the cost of living crisis and geopolitical uncertainty at the forefront of our minds, the interrelations and interdependencies between the financial system, society and the planet are becoming increasingly clear. The investment industry has an incredible amount of clout (by way of capital), and we should use this influence to catalyse positive change for the benefit of all stakeholders. For asset managers, being a responsible steward of capital means creating long-term value for clients and beneficiaries through, for example, thoughtful engagement with relevant parties on material topics.

Engagement

Given the importance of engagement to long-term returns and the delivery of real-world outcomes, how do managers approach stewardship, who do they engage with and what mechanisms do they use to exert their influence as active owners of invested capital?

For asset managers, being a responsible steward of capital means creating long-term value for clients.

The approach

It’s encouraging that only 4% of the surveyed asset managers deem stewardship not to be applicable to them. The remaining 96% apply stewardship at the firm and/or strategy level.

Of particular note is that two-thirds of asset managers report engaging with relevant parties at both the strategy and firm level. We believe strategy-level stewardship is critical to addressing the most pertinent issues for a given strategy in the best interest of investors. While firm-level stewardship enables alignment with firmwide priorities and a larger platform to push for meaningful change. Ignoring either approach risks an investor not wielding the full influence available.

Do you apply stewardship and engagement
at the firm level, strategy level, or both?

We believe strategy-level stewardship is critical to addressing the most pertinent issues for a given strategy in the best interest of investors.

The targets

The trends for firm and strategy-level engagement are remarkably similar regarding who asset managers engage with. Corporates see the greatest proportion of engagement by asset managers, with over 90% of firms and almost 80% of strategies having engaged with them over the past year. This makes sense given corporates are usually the party that investors are directly trying to influence. We also see a relatively high proportion of engagements with industry bodies.

It’s encouraging to see such a high proportion of the surveyed asset managers participating in initiatives to influence best practice – 84% in the past year. We believe this type of engagement is crucial to bringing about widescale change and encouraging investors not just to join organisations but to actively participate in the development of best practices.

Who have you engaged with over the past 12 months?

In 2021, did you participate in the development of ESG best practices as an investor through work with investment industry organisations or otherwise?

The methods

Asset managers tend to engage on a direct or one-to-one basis, with structured meetings, informal dialogue and letter writing being most popular. We hope to see greater collective engagement as the pooling of capital allows for a more substantial influence of engaged parties. While written communication can have some impact as part of a wider dialogue, we doubt the effect of letter writing on its own is sufficient.

It’s encouraging to see an apparent increase in commitment towards stewardship. What matters, though, is the effectiveness of these activities and the achieved outcomes. Without real-world results, stewardship doesn’t amount to very much.

How do you engage?

Without real-world results, stewardship doesn’t amount to very much.

Reporting

Unfortunately, this is where the holes in our survey responses start to appear. We understand some of the data may be skewed as many managers are yet to develop systematic ways to report on engagement activities. But without systematically capturing engagement activities and processes, it‘s hard to see how stewardship is effective: to deliver real change, you need to know what change you were seeking to deliver and how to measure your progress against that.

Only half of the asset managers that approach stewardship at the strategy level track and report on engagement activities with portfolio constituents (or counterparties).

The available data tends to suggest a gap between rhetoric and reality, as the following chart illustrates.

We do expect to see some variation between ambition and action, but it’s disappointing to see such stark differences between engagement priorities and engagement activities across the board. There are several themes showing less than half of respondents engaging at all, despite the high levels of stated commitment (this is true of biodiversity, pollution & waste, employment quality and business ethics). This raises questions about authenticity and concerns about greenwashing. The ‘Other themes’ category is a bit of an outlier, with only 22% of managers claiming to prioritise themes not already listed, but over 50% of asset managers claiming to have engaged on other themes at least once in the past 12 months. We assume this is a result of managers categorising their engagements differently.

We hope to see improved stewardship reporting from managers in the future to enable us to hold them to account for their engagement priorities and activities.

What managers say vs. what they do (of those managers that approach, track and report on stewardship at the strategy level)

Outcomes of engagements for change (strategy)

Outcomes

Looking now at the outcomes of manager engagement – particularly those identified as ‘Engagements for Change’ (which can be characterised as purposeful dialogue to influence positive change), with defined objectives to address material risks/opportunities. The surveyed asset managers classify 32% of all strategy-level engagements and 22% of firm-level engagements as engagements for change. This suggests that the majority of reported engagement activity may not have influence and impact.

Digging into the results of those activities reported as engagements for change, it’s evident that firm-level engagement has more success, with engaged entities either developing credible strategies to achieve the stewardship objective or fully implementing a solution to address the issue (43% firm vs. 28% strategy). This exemplifies the power of coordinated efforts to influence real-world change.

However, most engagements for change reported at both the strategy and firm level don’t appear to result in tangible outcomes – rather a mere acknowledgement of concern with no promise of progress. This may be a stepping stone to future development, but we really expect managers to have mechanisms in place to hold engaged entities to account, including appropriate escalation routes in the event of inaction or negative response. A stepping stone needs to be moved on from, and managers must be able to measure progress.

Outcomes of engagements for change (firm)

Escalation

In cases where engaged entities are unresponsive or provide a negative response, we expect managers to put an appropriate escalation strategy in place. Unfortunately, this is an area where managers are lacking. Less than half of respondents could supply us with an example of escalation in the past 12 months, with illiquid alternatives providing the least evidence (15%). 83% of asset managers have examples of direct engagement, and 53% have examples of collaborative engagement.

While these numbers are lower than we’d hope for, it’s the lack of escalation evidence, in particular, that brings into question managers’ genuine commitment to stewardship.

We want managers to have conviction in their engagement priorities and activities, and to follow up appropriately should engaged entities not meet their expectations.

Can you provide an example of 'X' in the past 12 months?

In cases where engaged entities are unresponsive or provide a negative response, we expect managers to put an appropriate escalation strategy in place.

Stewardship and voting

Although we firmly believe that stewardship needs to be viewed holistically across asset classes, we recognise that voting is a crucial tool – especially for public equity managers – as a signal of support or sanction for corporate behaviour.

The voting statistics of listed equity managers haven’t changed all that much from last year’s survey.

The exception to this is the proportion of asset managers who have voted on 100% of resolutions. Only 26% of respondents report having done so this year. This is extremely disappointing, especially in contrast to the 2021 results, where 43% of respondents with voting rights voted on all resolutions. Managers should exercise their voting rights to the greatest extent possible and make full use of the tools at their disposal to positively influence company management.

2021 vs. 2022 voting statistics

Managers should exercise their voting rights to the greatest extent possible and make full use of the tools at their disposal to positively influence company management.

Who’s leading on ESG?

No less than 53% of the surveyed asset managers believe themselves to be leading in their ESG integration processes relative to peers. Simple mathematics suggests that managers are overestimating their ESG capabilities, and this reflects our experience too. While we’ve seen asset managers take positive steps, we believe that significant progress is still required by the majority.

Asset managers have a slightly less generous view of their delivery of stewardship, with only 44% rating themselves as leading.

Only in liquid alternatives did significant numbers rate themselves as only nascent in their ESG journey.

Although the industry has made positive strides regarding both ESG integration and stewardship philosophy and processes, there’s a long way to go in relation to their activities and outcomes. An obvious gap lies in measurement and reporting: how can asset managers legitimately claim to be meeting or leading in their practices when just over half that approach stewardship at the strategy level actually track and report engagement activities and outcomes? How can asset managers truly be delivering integration when so many cannot provide specific examples of buy or sell decisions influenced by ESG factors in the last year?

We remain sceptical of any claims where relevant evidence is sparse and anecdotal.

Manager self-assessment: ESG integration vs. stewardship

Systemic risk and conflicts

In November 2021, the Financial Reporting Council (FRC) released a paper reviewing stewardship reporting in line with the UK Stewardship Code 2020. They found that some of the weakest sections reported were related to market and systemic-wide risks and conflicts of interest.

Looking at systemic risk, only 30% of respondents engaged with regulators over the past year – with larger firms participating in proportionally more consultations. We believe input into regulation via public consultation is a crucial way for investors to exert influence over areas that have vital significance to their clients’ long-term returns and scope to invest. We therefore hope to see this figure increase over time.

In 2021, did you formally respond to at least one consultation
by regulators in your role as an investor?

We believe input into regulation via public consultation is a crucial way for investors to exert influence over areas that have vital significance to their clients’ long-term returns and scope to invest.

Regarding conflicts of interest, it’s surprising to see that less than half of the surveyed asset managers have a firm-level, stewardship-specific conflict of interest policy. We believe that such a policy is crucial for asset managers to be fair stewards of investor capital and expect managers to do better in this area. More positively, three-quarters of managers with a conflict of interest policy are able to provide anecdotal evidence of applying the policy in practice.

Do you have a firmwide, stewardship-specific conflict of interest policy?

Of those with a firmwide, stewardship-specific conflict of interest policy, can you provide one or more examples of its implementation in 2021?