(Kiley Miller/ESG Head, Envestnet) Environmental, social, and governance (ESG) information, in its simplest form, is just more information about the way that companies interact with the world around us. How are companies exacerbating gender inequity or racial injustice? How are they contributing to climate change? As sustainable investors, we want the full picture of the companies we allocate our dollars to.
Despite what the media might indicate, ESG information does not exist with the objective to label companies as “good ESG” or “bad ESG” companies. Investors have misinterpreted ESG ratings in this way. A decade ago, hardly anyone knew or used ESG ratings. Today, investors, companies, the media, and the public all expect ESG ratings to help answer an overwhelming number of questions. The reality is an ESG rating should be viewed as more of a sell-side analyst rating than a credit rating. Like an analyst rating, which is ultimately more subjective and less uniform than a credit rating, each ESG ratings provider has a different objective and as a result is measuring different things. There are frameworks that focus on evaluating positive impact, measuring negative impact, identifying emerging risks and opportunities, assessing operational risk exposures, or homing in on the impact of a company’s products and services. Crucially, ESG ratings are not meant to be a conclusive ending, but a starting point on which to build.
At its core, ESG is a framework for managing externalities, which all companies have. Externalities are benefits for society which are not fully compensated and costs on society which are not fully paid for. Today, what was once extraneous to a business is increasingly affecting corporate revenues, costs, and risk profiles. With the help of ESG data, asset managers are developing a more comprehensive understanding of these externalities. Some are incorporating those insights into company valuations or engaging with companies to address these risks. As this occurs, there is a need for transparency from managers in the framing of their intended outcomes and clear articulation of their sustainable investment approach. Standardization in the language with which managers communicate their approach will coalesce around industry taxonomies as regulatory guidance develops.
Regulatory clarity improves transparency
“Imagine a world without generally accepted accounting principles. It would be chaos. That’s essentially where we are now”.
Michael Jantzi, Founder and CEO, Sustainalytics, January 10, 2022 1
In the U.S., we are awaiting guidance from the SEC on recommendations for ESG disclosures for investment products and companies. There are already more than 30 international ESG taxonomies and regimes in existence that are being considered by the SEC. The United Kingdom’s sustainable disclosure requirements could serve as a blueprint in the U.S. because their requirements combine aspects of the EU’s Sustainable Finance Disclosure Regulation with their own country specific requirements. Similarly, the SEC could look to the CFA Institute’s Global ESG Disclosure Standards, which take a comprehensive approach to include all types of investment vehicles and are not limited to a specific geography. Communication from the SEC will prompt more rigor from asset managers on how intended outcomes are framed.
For ESG disclosure from companies, the SEC has had discussions with standard-setting organizations like the Value Reporting Foundation, the Task Force for Climate-Related Financial Disclosures (TCFD), and international organizations like the International Financial Reporting Standards’ (IFRS), which has created the International Sustainability Standards Board. While it’s unlikely that the SEC will explicitly adopt one of these, they will undoubtedly learn and be informed by these frameworks.
As companies and asset managers disclose more ESG related information, there must be enforcement to ensure that information is being reported consistently and accurately. Earlier this year, the SEC announced an enforcement task force on climate change and ESG to examine how issuers and asset managers have adhered to their statements and commitments.
ESG integration is about measuring and managing financially material risks, which is a fiduciary obligation. ESG information is just additional information. When there is new information, we adjust. What is considered material has and will continue to evolve. This is a reflection of the sophistication and evolution in sustainable investing.
We wrote a piece about recent regulatory developments that you can access here to learn more.
Climate crisis touches more than just the environment
The climate crisis is an asset management crisis. Capital allocation is one of the keys to mitigating the impacts of this crisis – namely by directing asset flows away from polluters and towards the solutions creators.
Climate change highlights the interconnectedness of our systems; it influences so many other issues we face today, like biodiversity loss, deforestation, inequality, and threats to human health. A healthy and resilient planet is critical to supporting healthy and resilient species. There is evidence that we are at higher risk of more frequent pandemics because of climate change, and that air pollution makes COVID-19 more severe.2 There is now a much more obvious intersection between ecological sustainability, social health, and economic health. Previously, investors didn’t have the information they needed to price risks of climate change. This is changing as measurement frameworks and data improves. Now more than ever, investors are linking companies to the external systems that they operate in.
Asset flows into climate aware investment products on the Envestnet Platform reached $22.5B in December 2021, up 60 percent for the year. Nineteen new climate funds were launched from January to September 2021.3 In 2022, we may see more targeted climate focused strategies, specifically around climate mitigation, adaptation, and transition. There are already many approaches to investing in this way, whether it’s taking a low carbon approach, a fossil fuel free approach, or allocating to climate solutions such as clean energy, energy efficiency, green buildings, or green transportation. Climate change is an issue that permeates many other ESG issues. It’s a topic that resonates with so many individuals, and an area of opportunity for advisors to consider within client portfolios.
Clients want personal conversations
Countless polls, surveys and studies in recent years point to the fact that investors are interested in sustainable investing. And according to Cerulli, most financial advisors are currently using or plan to use sustainable investment products.
And yet, financial advisors still feel uncomfortable talking about sustainable investing with their clients. What gets lost in this discomfort is the opportunity to take something usually foreign to a client, financial markets and investing, and make it deeply personal. People care about the forest fires that are a threat to their community, or about whether air pollution is making their kids sick, or about putting an end to systemic racism. Making these personal connections may result in deeper, more meaningful relationships with clients. People want to hear about how the companies in their portfolio are working to improve financial inclusion, make affordable housing more accessible, and develop solutions to mitigate climate change. According to a recent survey done by Nuveen, 79 percent of investors say they would be much more loyal to a financial advisor who actively helps them invest in a way that also has positive impact on the world.4 Discussing environmental and social issues will resonate with many clients.
Investors expect customization in almost everything
Cerulli predicts direct indexing will grow faster than mutual funds and ETFs over the next five years.5 Fractional share capabilities, APIs, large amounts of ESG data, and the shift from active to passive investing has created a welcoming environment for portfolio customization via direct indexing. ESG data is catalyzing the ability to curate a menu of sustainable investment options that an advisor can walk through with their client, an opportunity to tighten the advisor-client bond and unlock tailored portfolio personalization. Picture the customized approach an advisor could take in conjunction with their client to develop a portfolio that emphasizes renewable energy, battery technology, or sustainable agriculture. Or religious beliefs like Catholic or Muslim values. Or the ability to select specific screens like tobacco or nuclear energy or address the refugee crisis or water stress. This is now within reach to a much broader array of high-net-worth investors. Direct indexing assets comprised almost 20 percent, or $362 billion, of retail SMA assets in 2020.5 Investors are demanding more value, which includes tax management, risk customization, and sustainable investment customization.
There’s a lot in store for sustainable investing in 2022. Reach out to our team via the Digital Dashboard to connect on how we can support you and your clients.
Sources:
1. Michael Jantzi, “5 Sustainability Themes to Expect in 2022,” Sustainalytics Blog, January 10, 2022, https://www.sustainalytics.com/esg-research/resource/investors-esg-blog/5-sustainability-themes-to-expect-in-2022
2. “Coronavirus and Air Pollution,” Harvard T.H. Chan School of Public Health, accessed March 3, 2022, https://www.hsph.harvard.edu/c-change/subtopics/coronavirus-and-pollution/
3. Jon Hale and Hortense Bioy, “How can you invest in climate funds?”, Morningstar.com, October 28, 2021, https://www.morningstar.com/articles/1063628/how-can-you-invest-in-climate-funds
4. “Education is key to driving investor interest in responsible investing,” Nuveen, December 16, 2021, https://www.nuveen.com/en-us/insights/responsible-investing/sixth-annual-responsible-investing-survey
5. “Direct Indexing Growth Projected to Outpace ETFs, Mutual Funds, and Separate Accounts Over Next Five Years, According to Cerulli,” Cerulli Associates, August 16, 2021, https://www.cerulli.com/news/direct-indexing-growth-projected-to-outpace-etfs-mutual-funds-and-separate-accounts-over-next-five-years-according-to-cerulli
