Responsible investing

Written by: Dr Desne Masie Posted: 27/11/2023

ESG illo mainThe increasing importance of ESG in investment fund decision-making

The funds industry continues to push ahead with the implementation of increasingly onerous sustainable reporting and compliance measures – against the backdrop of a volatile geopolitical setting and fragile macroeconomic outlook. 

Extreme weather events, environmental destruction and rising inequality have also made sustainable investments more relevant than ever, for this generation and the next.

The mainstreaming of environmental, social and governance (ESG) measures will accelerate with the continuing policy impetus to shift capital to sustainable investments. 

Demand for ESG funds should therefore remain robust despite recent mutterings of political resistance in the US and UK.

Most regulatory developments have been primarily aimed at avoiding greenwashing – such as the European Union’s Sustainable Finance Disclosure Regulation (SFDR), effective from March 2021, and the UK’s Sustainability Disclosure Requirements (SDR), coming into force in July 2024. 

Further, the International Sustainability Standards Board (ISSB) issued its first Sustainability Disclosure Standards for climate and sustainability to set a global baseline of investor-focused sustainability from 1 January 2024. 

Meanwhile, in the UK, the Task Force on Climate-related Financial Disclosures (TCFD) reporting has been mandatory for asset managers since 1 January 2022. And in addition to all of this, the Taskforce for Nature-related Financial Disclosures (TNFD) requirements was launched in September. 

But are these numerous new provisions creating too much extra work for funds, adding to the cost of their administration and formation? Has the focus on ESG created too much emphasis on sustainability over returns? 

Industry figures are certainly vocal in their views. Yulia Manyutina, Associate Director, Climate and ESG, at RBS International, says: “While there are ongoing challenges associated with the rapidly changing regulatory environment, stringent reporting requirements and political sensitivity of the topic, confidence in ESG remains high.”

Ali Cambray, Advisory Director, ESG and Net Zero, at PwC Channel Islands, backs up that view on ESG trends. She cites data from PwC’s 2023 CEO survey, which shows an expectation of impact from climate change this year, primarily to cost profiles and supply chains.

“Business’s exposure to nature risk is extensive and recently becoming understood by private markets,” says Cambray. PwC’s analysis found that 55% of global GDP (around $58trn) is moderately or highly dependent on nature, meaning economic value from companies’ operations could be wiped out by disruption to natural ecosystems. 

“The opportunity to create value from investment in the transition to a more sustainable and inclusive economy remains the business opportunity of the century,” Cambray adds.

“The regulatory landscape continues to evolve, with some encouraging progress this year towards globally recognised standards. Double materiality – understanding and managing risks to and societal impacts of investments – is becoming increasingly important.”

ESG and funds illo2A concerted effort

The industry is making concerted efforts to ensure that it complies with its responsibilities and is educating its workforce at pace, according to Dipak Vashi, Business Advisory Services Senior Manager at Grant Thornton. 

He explains: “Many conversations around ‘what keeps you up at night’ often turn to ESG factors as number one, as well as [dominating] board time, showing the issue is front and centre.” 

Despite the progress, Joe Moynihan, CEO of Jersey Finance, says: “We have noticed an element of greenhushing, whereby some firms are wary of publicising their sustainability efforts regardless of how impressive and genuine they are, due to fear of reputational risks or the effect it could have on its share price due to political polarisation.”

However, he adds: “ESG has increasingly become a default position and a given, almost a minimum standard of acceptance, regardless of whether publicised or not and even more so with the increasing regulatory requirements that are forthcoming.”

A lot of the regulatory burden Moynihan mentions will fall upon CFOs and COOs. According to Manyutina, one of the key challenges that CFOs and COOs are facing at the moment is availability of reliable data and analytics. 

“It is expected that developments such as AI and machine learning will have a significant impact on ESG measurement and reporting in the near future,” she says. 

Indeed, a number of firms have proliferated to support the c-suite with the new reporting demands. The recent Reuters Impact conference in London included many such demonstrations of new reporting tools from providers such as Oliver Wyman, Wolters Kluwer and Eco Prism, all promising one-touch, high-tech sustainable compliance plug-ins for the financial statements.

Cambray says these developments mean “the CFO’s job description is being rewritten” and those who can’t keep up with the demands of sustainability could have a difficult time remaining relevant.

Kevin Smith, Executive Director at Ocorian, has seen an increasing trend of general partners and funds producing separate sustainability reports that “are pulling you outside of the financial requirements, and setting separate reports so the investors can get full visibility and transparency of the issues that are there”. 

But Smith says there has also been increased complexity for administrators, which filters down to investment decisions. 

“We’re definitely seeing across all our fund base, and promoters, an increase in the kind of ESG factorisation into their investment processes and into their structures. And that manifests itself in different ways from the outset. 

“For new investors coming in,” he adds, “we’re seeing increasing levels of the complexity of the due diligence questionnaires around ESG. So the investors themselves are much more querying about what is happening within the funds, within the supply chain, and also with the service providers of the funds.” 

With TNFD on the horizon, Smith highlights changes in Guernsey. “Last year a new designation was launched – the natural capital fund designation for funds that meet the specific natural capital requirements and criteria. These developments are definitely increasing and moving forward.” 

But Smith adds that it’s a difficult area to navigate, especially for determining hard KPIs and hard data, which will be essential to define. “You need to be able to do this in this day and age, and you need to substantiate it,” he says.

ESG and funds illo3Fuelling growth

Despite the avalanche of reporting and compliance required alongside ESG and the political backlash, the industry remains committed to implementation. The prevailing view is that ultimately ESG will not sacrifice returns over the long term, and may even improve returns. 

Felicia de Laat, from the Jersey Investment Funds team at Mourant, says that she hasn’t seen much growth in sustainable, Article 8 or 9 funds, but she has seen her own funds (those not ‘sustainable funds’ per se) placing much greater emphasis on sustainability. 

De Laat agrees that ESG is becoming embedded at all levels of fund operation and investment, including the strategies used by private equity funds to create value in their portfolio companies. 

She says: “For quite a long period, there has been a focus on using ESG to improve sustainability at portfolio company level. [But ultimately] funds still have a mandate to generate a return for their investors. They’re bound by their fiduciary duties.”

De Laat continues: “It is very much a moving target. This is because people are still working out exactly how SFDR needs to be applied and to which category their funds should belong. 

“Key areas of focus include disclosure, investor reporting and value creation at the level of investment.”

Moynihan says it is “a common misconception” that ESG is implemented at the sacrifice of returns.

“It is, in our view, even a false dichotomy. Companies with high ESG ratings are more often than not top-quality, forward-thinking companies that in the long term will achieve the greatest returns, as opposed to companies that may have had a recent but short-lived rise in share price, perhaps due to stranded assets,” he says. 

Vashi, Smith and Cambray believe that although politicised, long-term trends driven by clients will determine the trajectory of ESG. 

Says Smith: “Over the coming years, and this has already been happening, especially in the private wealth circles, we have the younger generations looking for the environmental ESG side of things as much, if not more than, the actual return side of things. It’s a trade-off position, so it will be interesting to see how that develops.” 

SFDR Article 6, 8 and 9 funds 

SFDR requires asset managers to provide more information on the sustainability risks and impact of their investment products sold in the EU. 
   The level of disclosure depends on whether these are defined by way of their prospectuses as Article 8,  having environmental and/or social characteristics (light green funds), or Article 9 funds, having a sustainable-investment objective (dark green funds). 
   Article 6, meanwhile, requires asset managers to disclose the integration of sustainability risks in their funds – regardless of whether the fund is promoted as ESG or not. 
   The Q2 2023 Morningstar review of Article 8 and 9 funds reported that overall, assets in Article 8 and Article 9 funds rose by 1.4% and for the first time passed the €5trn milestone. Article 8 funds, however, suffered net redemptions of €14.6bn in the second quarter of 2023, amid continued macroeconomic pressures. 
   Meanwhile, investors continued pouring net new money into Article 9 funds, but the €3.6bn these attracted in the last three months represent the lowest inflows on record. Reclassifications of funds from Article 8 to 9 or Article 6 to 8 slowed down over 2023.

Source: Morningstar


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