Market structure

Issues on both the supply and demand side of the market can contribute to a weak take-up of ESG: Fragmented demand side markets with relatively low buyer power and concentrated supply side with relatively low incentive to innovate services.

Demand side

Large well-resourced asset owners, endowments, and private wealth funds with strong commitments to responsible investment, have been able to demand that their investment consultants provide them with high quality ESG-related research and analysis. In these situations where the individual client has power or influence, investment consultants will tend to meet the client’s ESG requirements.

However, asset owners are mostly offered a relatively modest service in terms of ESG issues. When making fund or fund manager recommendations, consultants may ask questions of their clients about the importance of ESG issues in their investment beliefs and about the weight they should be assigned. Our research however suggests that most, but not all, consultants include questions about ESG issues in their fund manager due diligence processes. These are often optional, pitched at a high level, and not scrutinised with the same level of attention as other investment-related questions. Payment of additional service fees is generally required if asset owners require a more comprehensive service.

The details of the services offered by consultants are strongly influenced by the structure of national or regional investment markets. In markets where savings are concentrated in a smaller number of larger entities and where ESG issues are considered to be an important part of the investment process (e.g. Australia), there is greater pressure on investment consultants to develop their capacity and expertise on ESG issues and to proactively offer this to clients.

Conversely, in markets with a large number of small schemes, such as the UK, asset owners’ ability to demand ESG-related advice from investment consultants tends to be limited. The investment consultant interviewees for our research noted that, in these markets, they are rarely asked about their beliefs on ESG issues or the advice and support they can offer regarding them. From this consultants conclude that ESG issues are not important to their clients and there is less need for them to expand their capabilities and expertise on these issues. In turn this can mean that investment consultants are unwilling to raise ESG-related questions with their clients due to their lack of capacity or competency to respond on these issues.

“We try to nudge them along, but the power resides with the investor. It is very much the case of trying to understand what the client’s investment objectives are. No strategy is ‘off-the-table’.”

Finally, few asset owners globally have made commitments to responsible investment or to fully consider ESG issues in their investment process. Interviewees from global investment consulting firms noted that, across their business as a whole, ESG advice comprises a very small proportion of their fee income. This further reinforces the perception that ESG is an add-on to the products and services that are demanded by the market.

Supply side

The investment consulting market is concentrated. It is dominated by firms such as Aon Hewitt, Callan Associates, Cambridge Associates, Mercer, NEPC, Russell Investments and Willis Towers Watson. A relatively small number of investment consultants have come to dominate the market for various reasons:

• their recognised investment expertise;
• their understanding of asset owners f needs and interests;
• their ability to provide cost-effective access to information on a large range of investment managers and investment strategies – this is seen by asset owners as a unique competency of investment consultants and as such a key service offering;
• their credibility and reputation which allows asset owners to rely on advice provided by investment consultants to justify the decisions that they have made;
• their ability to offer a wide range of investment-related services and advice under a single company banner through the one or two consultants that work with individual clients.

These characteristics – which can be summarised as investment consultants offering what are seen as core products and services to their clients – represent important barriers to entry for new firms with new or different ideas or products. Asset owners are reluctant to work with investment consultants who have a less comprehensive coverage of asset managers. If asset owners do decide to move beyond the largest global firms, they tend to confine their work with these consultants to niche, specialist areas. These new firms are then unable to effectively break into the larger investment consulting market. Compounding these barriers to entry is the fact that investment consulting is a relationship orientated industry. Asset owners tend to develop strong relationships with investment consulting firms and with individuals within those firms.

“Outsource CIO is a scalable business, rather than advice.”

Together, these factors mean that the large investment consultants have established a strong position as expert and trusted advisers to asset owners, and asset owners have tended to stay with the same investment consultants for long periods of time (i.e. switching rates appear low).

A further issue is that, as employers move away from offering defined benefit (DB) schemes, investment consulting is now seen as a declining industry. This does not mean that it is unprofitable. Nor does it mean that investment consultants will cease to exist in a few years. However it does mean that investment consultants may be less willing to invest in what they see as a sunset business, or to develop new or innovative services, in particular (such as in the case of ESG) where it is not clear that these services will lead to a growth in fees or new business opportunities. Compounding this lack of incentive to innovate are the main points of differentiation between consultants; price, the breadth and depth of core services such as asset manager evaluation, and the perceived credibility of the investment consulting firm.

“On fiduciary management, in general, ESG is likely to be less integrated. Clients are less engaged, less resourced, less interested, less likely to care where the money comes from.”

One significant trend in the consulting market is the move towards fiduciary management. This is seeing investment consultants encouraging their clients and other asset owners to move from a consulting relationship to a fiduciary management relationship9. This potentially accelerates the decline of the investment consulting market. It may also mean that investment consultants find that they are in commercial relationships with many of the investment managers that they are assessing. From an ESG perspective, it is unclear whether fiduciary management is ‘better’ or ‘worse’. Regardless, what is clear is that the barriers and challenges of the market structure, industry practice and regulation will continue to apply.

“There are less than a handful of managers out there that are integrating ESG in a meaningful way. Beyond that there are a lot of gimmicky managers saying, ‘we can pick up some dollars if we put ESG on our product’. So you end up with a set of lower quality of managers.”