Leadership in ESG incorporation – asset owners

ESG incorporation best practice

Climate change and the rapid transition to a net-zero global economy continues to be one of the most pressing ESG considerations for corporates, issuers, asset managers and asset owners. While net-zero commitments are becoming increasingly common and high-level frameworks and tools are being developed to help guide action, there continues to be an unfulfilled need for more detailed and practical guidance specifically for asset owners and asset managers.

The translation of ESG policy commitments into meaningful investment decisions will be an important indicator of ESG leadership over the coming years.

However, due to the diversity of institutional investors combined with constantly evolving beneficiary expectations and regulatory landscape, determining best practice among asset owners will increase in complexity and hence become more challenging. In addition, differences in fund type, size, geography and policy settings will have considerable influence over what asset owners are able to realistically achieve.

The translation of ESG policy commitments into meaningful investment decisions will be an important indicator of ESG leadership over the coming years

Despite these challenges, there are some practical steps relating to manager selection and portfolio construction that leading asset owners are incorporating into their investment decision-making processes. For example, over the last twelve months, many leading asset owners have announced medium- and long-term emissions reduction targets focused on real-world outcomes that are aligned with holding the global average temperature rise to below 1.5C. Increasingly, these targets apply to a large proportion of asset owner portfolios generally rather than to specifically designed niche products. Importantly, these whole of portfolio emissions reduction targets tend to be supported by comprehensive transition plans which extend beyond stewardship strategies to draw on a combination of other levers which include:

• Investing in climate solutions, with material investment allocations made to assets that will help mitigate climate change.
• Incorporating carbon pricing into modelling, applying a cost of carbon to investment analysis.
• Being active stewards, involving collective and collaborative action to help achieve climate change related targets.
• Private market engagement, where investors engage with management, boards and managers of unlisted assets to set net-zero targets.
• Considering divestment, where investors are prepared to sell assets that are not viable and/or cannot be adequately restructured in a low-carbon economy.
• Portfolio monitoring, establishing robust processes to track progress against portfolio emissions reduction targets.
• Reporting annually on progress against emissions reduction targets.
• TCFD commitments, whereby investors undertake reporting that is fully aligned with the recommendations of the Task Force on Climate-related Financial Disclosures.
• Adapting KPIs to link climate outcomes to investment team key performance indicators.

For asset owners, one of the crucial leverage points in delivering positive climate outcomes lies in how they select, appoint and monitor asset managers. To meet their climate change commitments, asset owners will need to develop increasingly sophisticated systematic approaches to assessing and benchmarking the alignment of prospective managers. Leading asset owners are starting to develop:

• Minimum ESG standards that asset managers must meet to be considered eligible for selection.
• ESG integration throughout the investment process, with an increased focus on the alignment with managers’ portfolio-level climate action and the rigour of their ESG integration across all investment processes.
• Reporting on progress, where the alignment of an asset manager’s portfolio emissions profile is compared with the asset owner’s emissions reduction targets and profile.
• New language in RFPs, where asset owners clearly set out detailed ESG expectations and requirements for asset managers in their selection process documentation.
• New peer benchmarking and analytics, which enable the asset owner to assess the extent to which its formal ESG commitments and regulatory requirements are underpinned by the ESG practices of a prospective manager.

As asset owners increase their climate change ambitions and commitments, asset managers will need to move in lock step with the changing needs of their client base. Practical first steps could include identifying common ESG goals and targets across their client base, as well as ensuring that their governance, training, public commitments, investment horizons and investment practices align accordingly.

As asset owners increase their climate change ambitions and commitments, asset managers will need to move in lock step with the changing needs of their client base

Despite ESG considerations being part of the investment landscape for over a decade, the implementation of leading ESG practices today still requires a significant commitment on the part of both asset owners and asset managers.

Here, the PRI has a significant role to play in lowering the barriers to implementation of leading ESG practices for all asset owners and asset managers. For example, this could include expanding the PRI database and analytics available to members, addressing the rise of green-washing, developing more detailed asset class and thematic integration guidance to encourage the adoption of standardised practices and facilitating targeted collective action programs.

Looking forward

Regulators are becoming increasingly aware of ESG risks. So, it is likely that ESG related claims made by asset managers and asset owners, will be progressively tested as regulators recognise the need to formally define what is ‘green’ and ‘sustainable’ and introduce mandatory reporting requirements. This trend is clear.

Collective asset owner action remains crucial to achieving real world outcomes, driving sector-level change, tackling challenging policy settings and addressing anti-climate lobbying. Asset managers with a leading approach to sustainable investment and stewardship will be best placed to support asset owner needs in the years ahead.

Collective asset owner action remains crucial to achieving real world outcomes, driving sector-level change, tackling challenging policy settings and addressing anti-climate lobbying

Fulfilling net-zero commitments will remain a real focal point for asset owners in the coming years. However, due to the rise in implementation of modern slavery related legislative frameworks, we might also expect to see modern slavery move higher up the agenda. This topic is likely to require asset owners to develop and refine a systematic approach to addressing potential modern slavery risks in their supply chains. As a result, asset owners can expect to continue playing a key role in the broader advancement of both of these issues with corporates, governments, asset managers and ultimately, their beneficiaries.

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].