Building confidence in ESG

Even as environmental, social and governance (ESG) investing continues to grow, questions about its legitimacy highlight the need for fund managers and regulators to strengthen the framework supporting the industry. Philippe Renard, CEO at Luxembourg-based RBC Investor Services Bank S.A., provides his insights on how the industry can overcome some of the challenges facing ESG investing.

Growth and pragmatism go hand-in-hand

Investors are allocating huge sums to ESG funds. Bloomberg and the Global Sustainable Investment Alliance estimate that the total ESG market is worth around USD 40 trillion, adding that it could reach USD 50 trillion by as soon as 2025.1 In addition, Morningstar estimates that ESG funds are managing approximately USD 2.7 trillion in assets but the data provider recently withdrew its coveted ESG accreditation from a large number of managers, causing assets under management in the ESG fund universe to fall by more than $1 trillion.2

The total ESG market could reach $50 trillion by as soon as 2025

The Morningstar action is indicative of current challenges facing the ESG market. Most notably, investors and regulators are becoming increasingly concerned about lingering uncertainties around ESG and how such concern may be creating an environment that is ripe for greenwashing. So, what can fund managers do to avoid this?

Investing in a healthy mix of green and brown assets is key

Most importantly, managers need to be pragmatic about ESG. They also need to be open with clients about their approach to ESG.

Investing exclusively in so-called green assets—those aligned with environmentally-friendly business practices—is not practical for managers. Green assets currently comprise a relatively small proportion of total assets, so only having exposure to these assets creates problems for managers from a performance, risk management and diversification perspective.

This is why many asset managers are now investing in brown assets, including polluting companies or sectors that are greening their businesses by transitioning to a lower-carbon economic model. Excluding brown assets from portfolios means these companies will have limited incentive to become more sustainable. By acquiring positions in such companies, asset managers gain the ability to apply pressure on C-suite executives and board directors to implement meaningful changes around ESG and sustainability. It is important for managers to have a combination of green and brown investments in their portfolios.

Reporting plays an important role in eliminating the risk of greenwashing

As investors look for greater transparency about ESG, managers must respond by sharing more information. This could, for example, include details of their voting behaviour at corporate annual general meetings. It is vital that fund managers are clear and concise when conveying ESG information to underlying clients.

ESG reporting is not as easy as it sounds

On the retail side, many investors just want simple key performance indicators on which to benchmark their managers—something that is not always possible given the complexities of quantifying ESG. For example, a company might obtain all of its energy from renewable sources but, at the same time, manufacture carbon-intensive products for mass consumption. Such contradictions make ESG reporting subjective and open to interpretation.

Many investors just want simple key performance indicators

ESG reporting is further constrained by the multiplicity of industry standards, lack of agreed-upon methodologies and absence of prescriptive regulations. Yet the problems inherent in ESG benchmarking and reporting do need addressing, so how can it be done?

To move forward, ESG data complexities must be resolved

The global funds industry needs to think about collaborating and adopting a common standard that best suits its requirements, as opposed to leveraging numerous, different standards. A potential candidate for this single standard might be the Financial Stability Board's Task Force on Climate-Related Financial Disclosures (TCFD), a template that is already used extensively by issuers and investors globally.

Although it is unlikely that global ESG regulation will ever be fully harmonized, US authorities are taking steps to stamp out greenwashing and other jurisdictions are expected to follow with their own actions. The EU and UK are developing taxonomies to help fund managers and institutions benchmark and report on their ESG investments as part of efforts to remove some of the ambiguities when measuring ESG. All major markets should be following suit.

A technology-led approach can help improve ESG reporting

Improvements to ESG reporting can also be facilitated through the adoption of nascent technologies. Through careful and thoughtful data aggregation and consolidation, managers can use technologies such as artificial intelligence to analyze their holdings, before reporting the information to end investors. Managers that communicate their ESG strategies to investors succinctly will be among the net beneficiaries moving forward.

Improvements to ESG reporting can be facilitated through the adoption of nascent technologies

Such enhanced reporting will help managers in their efforts to raise money from prospective clients, many of whom are now prioritizing ESG during mandate selection.

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