Stockholm (NordSIP) – For all the buzz and enthusiasm about the strides made in ESG implementation and its emergence as a seemingly insuperable industry norm in recent years, considerable misgivings are still held by managers and investors alike as to the nature of its boundaries, the absence of standardised benchmarks, and the instruments and mechanisms employed to generate ratings (and thus, industry norms).
Most significantly, a sticking point remains as to the clarity of the potential impact on returns not least due to the lack of transparency resulting from the difficulty in applying standardised ESG norms to an infinitely variegated universe of investment firms and strategies. A clear disjunction exists between recent research finding high levels of satisfaction with the performance of ESG investments, and the levels of concern among investors as to the lack of available tools and data with which to measure that performance.
Some 80% of investors claim to have some form of ESG strategy within their portfolio, according to a recent report from State Street Global Advisors (in cooperation with Longitude Research). Buoyed by the Principles for Responsible Investment, investors are also starting to see ESG factors as opportunities, as opposed to primarily as good deeds requiring considerable risk-adjustment. Considerations such as climate change, working conditions, the rise of social media intrusion into good or bad corporate behaviour and other factors are compelling investment firms to increasingly analyse their investments in accordance with ESG criteria and markets. Simultaneously, factors such as company culture, communication, education, engagement and partnerships are seen as key to the successful implementation of ESG strategies, with those institutions working the longest and hardest at it more successfully embedding these cultural factors within their organisations.
However, though the State Street Performing for the Future study found that investors are largely satisfied with the benefits to performance of their ESG strategies, overall exposure remains low. Just one third of investments incorporate ESG criteria on average, even as investors expect that proportion to grow over the next two years to around 40% of portfolios on average. Such averages, however, belie a universe that can range between 70% and 20% of investor exposure, pointing to a relative lack of ambition, potentially due to the murkiness surrounding measurements and the range of instruments employed.
(The Performing for the Future report was based on a study conducted between December 2016 and January 2017, surveyed senior executives with asset allocation responsibilities at 475 institutions globally, including private and public pension funds, endowments and official institutions.)
“Among adopters, alignment among many institutions around their ESG strategies appear patchy overall and there is confusion internally about what ESG means in practice,” the report finds. “Over half the adopters (56%) say there is a lack of clarity over ESG terminology within their institutions. And while the alignment with ESG strategies is high among boards (77%), senior managers (76%) and investment teams (74%), there is some way to go before all staff are aligned (only about two thirds).” The study showed 30% of institutional investors citing explicit support from senior management as a way to overcome barriers to ESG integration, suggesting active management as a crucial factor correlating with ESG adoption. The resistance faced, concurrently, is correlated with the lack of clear standards as to how ESG is evaluated in the first place.
Take ratings. An entire new industry has arisen selling investors company ratings based on ESG factors and funds dedicated to rated companies, as Reuters reports this week. The scores, however, “are in some cases being used in a way they are not really designed for. It’s problematic to bolt them on to an investment process,” Dan Hanson, a portfolio manager at Jarislowsky Fraser Global Investment Management, told Reuters. It follows that investors and funds can wind up relying too much on scores provided by a singular rating firm. ESG ratings vary greatly, however, meaning investors can be protected in one area but not in another without knowing per se what has been accounted for in the ratings. In addition, correlations between ratings provided by ratings companies to firms in the S&P 1200 index are relatively weak, whereas credit ratings are more tightly aligned, the reason being that credit ratings rely on financial disclosures, while sustainability ratings may reflect different weightings attributed to different factors, such as carbon emissions, corporate and social responsibility or reactions to real-time events.
Another impediment is the lack of standardised benchmarks. According to the State Street report, concern is most widely voiced when it comes to the lack of available data and tools pertaining to how ESG performance is actually measured. According to Lori Heinel, Deputy Global CIO with State Street, there is a wide range of performance metrics employed by investors, with 49% benchmarking against their own past performance, 47% against a common benchmark index and 46% against peers with comparable portfolios, making a common measure constituting best practice harder to identify. “Just 24% cite non-financial measures, which conforms the foci by investors in the financial performance of ESG strategies,” said Ms Heinel.
The survey also found, among other things, that over 50% of participants found difficulty in benchmarking performance of their ESG strategies against their peers, an aspect of unpredictability added to by the notion that “the more deeply ingrained the ESG strategy, the greater the difficulty of measuring its performance,” and that the more exposure investors have to ESG within their portfolios, the more difficulty they have in benchmarking performance by comparison to those with less exposure. “It may be that the more experienced group has a greater appreciation of the challenges associated with benchmarking than those with lower exposure, or more recently established programmes,” the study suggested.
The problem is compounded in gauging the performance of specific areas within the portfolio. “Often it is hard to understand how accurate some of the measures are at providing us with the full picture,” Andrew Howard, CIO at VicSuper, the Australian superannuation and pension fund, was quoted as saying in the report. “Yearly Trucost reports [-Trucost is a provider of data, tools and insights needed by companies, investors and policymakers to deliver the transition to a low-carbon, resource efficient economy – Ed.], for example, are valuable in measuring the carbon intensity of our equity portfolio, but only to a point. The information only looks at climate impacts and does not take long-term resilience, the strategic direction of the company in terms of transition and upside exposures into account. Therefore, it does not give you a full indication of a company’s carbon risk exposure,” Mr Howard said.
Over half (56%) of investors also say they lack the capability to assess the performance of external managers, according to the study, with definitions of ESG risks and their measurement and evaluation differing among managers and research units, in turn requiring a multiplicity of methods to assess corporate ESG performance as a whole. The inconsistency of these measures can lead to a degree of frustration and constitute a barrier to further ESG adoption, even though lack of standardisation in the performance assessment is part of an evolutionary process in what is still a relatively nascent investment framework.
One sector in which there has been notable ESG growth, however, has been among institutional investors, where the attitude has shifted from considering ESG factors as predominantly a risk element to one in which they are considered positively in terms of returns (or at least with more equanimity), with most institutional investors having invested in ESG strategies for four to five years at this stage, or more. “That reflects, perhaps, a diversity of interpretations of ESG, [capturing] a range of potential styles and tools with which investors can implement their responsible inverting objectives,” Ms Heinel commented. There are, however, holdouts, with 71% of the 20% who do not yet have ESG exposure still not actively considering it.
“It is very difficult to evaluate impact and pick out the right stocks from an ESG perspective,” says Marie Giertz, chief economist at Kåpan, the Swedish public pension fund. “A traditional approach looking at different macro and micro components, such as balance sheets, profits and political risks on a country, sector or company level, are still the main focus for us. But we are adding the ESG criteria to the investment decisions.”
“There is a proliferation of different types of ratings and other measures and we expect that they may give conflicting results,” says Annie Bersagel, acting head of responsible investments at Norwegian mutual pension fund and insurance company KLP. “We are currently in a process of disruption that is really necessary to clarify how to measure investments on ESG quality. Eventually, the best standard will win. But we are not there yet.”
Ultimately, the predominant concern for investors and asset managers still remains the need to gauge and measure the balance of values-based objectives with broader risk-adjusted return objectives. “The value proposition of ESG needs to be quantified,” the report concludes. “But ongoing ambiguity around the evaluation and reliability of ESG performance measures create uncertainty for investors across the adoption spectrum. Meanwhile, the depth of internal capabilities and alignment of stakeholder perspectives also weigh heavily. Most institutions will struggle or adapt or find solutions to these challenges by themselves. Quality partnerships and ongoing dialogue – with both peers and providers – will be crucial to helping more investors to harness the potential of ESG.”