Amid criticism that the financial sector has been slower than most to embrace ESG, pressure is mounting on alternative fund managers to scrutinise their investment activities. And science-based targets (SBTs) could be poised to fill the gap left by the lack of a universal framework in the sustainable finance space
Few Channel Islanders will have failed to notice the extreme temperatures reached so far this summer. July 2022 was the hottest ever experienced in Jersey, while Guernsey is predicted to beat all records as the mercury passes August 2003’s 32.4ºC.
But while such stifling conditions are a shock to the system when they arrive, they are not unexpected.
The 2021 Intergovernmental Panel on Climate Change (IPCC) report stated: “The world had experienced the 10 warmest years on record since 2005.”
And it made clear this was “directly linked to an increase in atmospheric greenhouse gasses, driven primarily by the extensive burning of fossil fuels and other industrial processes”.
Last November, financial institutions, captains of industry and policymakers participated in Glasgow’s COP26 climate conference, establishing myriad initiatives and alliances designed to mitigate climate change by advancing the transition to a net-zero carbon economy by 2050.
Yet, according to consultancy the Environmental Defense Fund, one major segment of the financial sector was “conspicuously missing” from the debate, and it accused the world’s largest private equity firms of “staying silent”.
Current state of play
According to research conducted by RBS International, this inertia of climate change typifies the alternative investment fund (AIF) sector.
The bank surveyed 125 key influencers in the AIF industry to understand the extent to which they are adopting science-based targets (SBTs), which provide companies with a clearly defined path to reduce emissions in line with the Paris Agreement goals.
The results show that more than four-fifths (82%) of AIFs claim SBTs are important to their fund today, yet take-up amounts to just two-fifths (42%).
Further, the majority (58%) are still in the planning process and nearly a quarter (23%) do not yet have a timescale.
The results also show the AIF sector to be significantly lagging the companies in which they invest; seven in 10 respondents say net-zero targets are more focused on corporates than AIFs.
Bradley Davidson, ESG Lead at RBS International, says it is imperative that AIFs raise their game if the world is to limit warming to 1.5ºC.
“Financial institutions are the lifeblood of the economy through capital allocation. If they make sustainable decisions, they can utilise that influence to accelerate our path to net zero. They have fallen behind [corporates in adopting SBTs] but they still have an incredibly important role to play.”
Davidson says AIFs can provide the catalyst needed to achieve net zero by driving capital to clean energy projects, greening the commercial real estate sector and funding innovation. He adds: “The influence of private equity funds that target small and medium enterprises for growth is incredibly impactful.”
Meeting the skills challenge
The challenges for AIFs in taking a more scientific approach to sustainability are many and varied (see chart above), according to the RBS International research. However, a clear commonality between respondents was the lack of in-house expertise needed to adopt SBTs.
“The lack of in-house skills or expertise creates a serious challenge in the market. There’s a huge fight for ESG talent because this hadn’t been a focus area for the majority of funds previously. It takes time to train up individuals and for new talents to flow through, so of course it’s going to be a sticking point,” the report states.
Davidson advises AIFs to invest in educating their entire workforce on ESG issues to ensure sustainable strategies are successfully implemented.
“AIFs need to make sure they are not just looking at a small set of employees, but are investing in all of their employees, so they’ve got the skills to really apply their knowledge towards their strategy.”
He also suggests hiring external advisers for specialist support.
However, that comes at a cost, and more than a third (38%) of AIFs say adopting SBTs is a drain on resources, while 18% say there is no proven return on investment.
Yet Caroline Phillips, Partner at law firm Slaughter & May, believes that failure to invest in SBTs is a false economy.
“I don’t think you should underestimate the level of scrutiny that your ESG credentials are going to come under,” she says. “If KPIs are based on science-based targets, then that can be really helpful to give investors confidence.”
This view is upheld by Henry Morgan, Sustainable Investment Lead at alternative fund manager Foresight Group, who told RBS International: “The greater level of scrutiny on sustainability and ESG in the investment and fund management space is largely led by the institutional investors. They are in turn led by their own stakeholders.”
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Phillips also points out the importance of SBTs to driving future ESG strategy.
“[SBTs are] not just a day-one benefit; they are also a benefit when you look forward.
"If you have a science-based KPI and your strategy changes, or the science develops, then an amendment process will be facilitated by using the science-based targets – either avoiding a consent threshold altogether or having a lower consent threshold among your banks, because they have confidence in the targets that you’re selecting,” she says.
Despite all the commercial and climate imperatives in adopting SBTs, AIFs must still navigate inconsistent data sources.
Elisabeth Hermann Frederiksen, Head of Sustainability at real estate manager NREP, says: “We have several hundreds of assets in our funds and each of these assets needs to be set up to give the right data and documentation.
“Sometimes the data doesn’t belong to us but belongs to our tenants, so then we need to work through tenants to get access to data.”
Davidson acknowledges the issues with data gathering but says regulation – the Sustainable Finance Disclosure Requirement, green taxonomy introduced by the EU, and the UK’s mandatory climate reporting in line with the Task Force on Climate-Related Financial Disclosure – makes it more straightforward for financial institutions to implement SBTs.
“There have been significant strides from policymakers and regulators to make quantifying climate risk much easier,” RBS International’s Bradley says. “We aren’t fully there yet, but the pursuit of perfection should not get in the way of progress.”
Science Based Targets initiative (SBTi)
Without verification and consistency, science-based targets for eliminating carbon emissions and other harmful greenhouse gasses offer limited credibility.
The Science Based Targets initiative (SBTi), set up in 2014, defines and promotes best practice in science-based targets, and independently assesses and approves companies’ targets in line with strict criteria.
The initiative offers target-setting resources and guidance, including those particularly designed for alternative investment funds.
Bradley Davidson, ESG lead at RBS International, says SBTi provides a consistent framework and verification of ESG strategies that add credibility. “Using the SBTi framework actually empowers market participants and investors to make responsible investment decisions because they compare targets that are consistent across the alternative investment fund market.
“The more transparency that we have for investors to make educated decisions, the more efficient the market will be.”
Caroline Phillips, Partner at Slaughter & May, adds: “The advantage of using science-based targets is that they have validation through the Science Based Targets initiative. So, if you’re going to get a third-party opinion, that can really help speed up the process and make you one step ahead of the game.”