As environmental, social and governance (ESG) thinking gets embedded in business strategies and cultures, the asset management industry will undergo profound changes in how investments are decided, and how portfolios are managed, especially in the light of how portfolios have performed during COVID-19.
The past few years have seen the global consensus emerge — that not only is climate change the biggest risk mankind has ever faced but also that everyone has a role to play in solving the problems. Climate change-related environmental threats comprise the top five long-term global risks in the World Economic Forum’s (WEF) 2020 Global Risk Report1. The WEF has called on policy makers and business to work together to develop sustainable, integrated solutions.
To mitigate climate change within the Asia Pacific region, the United Nations estimates that US$1.5 trillion2 is needed annually. Governments in the region cannot afford to make these investments alone. Private capital is needed to support the financing of lower carbon solutions and underpin sustainable economic growth. The asset management industry is key to promoting this transition.
As ESG thinking becomes more mainstream, and the impact on portfolios of COVID-19 becomes clearer, the asset management industry itself will undergo profound changes — from how securities are selected through, how portfolios are managed, to how asset allocation decisions are made.
Some governments in the region are taking the lead in promoting ESG as part of their agendas for economic growth, with Hong Kong (SAR) and Singapore chief among them.
Hong Kong (SAR) is seeking to develop the city as a regional hub for sustainable banking and green finance, with 2019 seeing the Hong Kong Monetary Authority (HKMA) introduce several measures in these areas. Hong Kong (SAR)’s stock exchange regulator (HKEX)3 is contributing to this movement by introducing ESG-focused listing requirements, enhancing corporate governance and transparency, and updating its reporting guidelines.
These initiatives are expected to grow in scope in Hong Kong (SAR) and the Asia Pacific region more broadly if the Chinese government puts a priority on climate change in its 14th 5-year plan, to be announced this year. A signal that Beijing is putting sustainability at the forefront of corporate policy could shift vast sums of capital toward ESG-managed assets across the globe.
Singapore is also placing its bets on sustainability. In August 2019, for example, the country’s prime minister highlighted ESG’s importance to the nation’s economic progress in his 2019 Rally Day speech.4 In November 2019, the Monetary Authority of Singapore laid out plans to invest US$2 billion in developing the country as a green finance hub and promote sustainable financing in the financial sector.5
Like Hong Kong (SAR), Singapore’s stock exchange has introduced sustainability reporting guidelines for listed companies, and sustainability is a key pillar supporting Singapore’s 2020 budget initiatives. This budget puts priority on spreading ESG principles and practices across all economic sectors. It sets broad strategies for transforming industry, the economy and society, and lays out ambitious plans for reducing harmful emissions, adopting low-carbon technologies and effective international collaboration.
Temasek, the Singapore-based global investment company, has explicitly committed to achieving carbon neutrality, sending a strong message on this direction of travel to corporations and the financial markets. In 2019, Temasek set up ABC World Asia Fund to serve as a private equity fund focused on investments in the region that generate positive social or environmental impact as well as profit.
Japan’s Government Pension Investment Fund (GPIF), the world’s largest pension fund, has similarly put ESG at the heart of its investment strategy, for example, by investing in sustainable indexes, promoting innovative investment practices and improving ESG standards in its passive portfolios.
Other countries and jurisdictions in step with this trend include Indonesia and Taiwan, whose governments are also promoting green finance products and practices, and India, which is seeing more of a push from large corporations, for example, to nurture a market for green bonds.
Initiatives like these across the Asia Pacific region will channel significant capital flows toward a lower-carbon economy, and to those industries and companies that enable and embrace it.
Asset managers and companies are now accelerating how they integrate ESG into their everyday activities; with this comes significant activity and debate over common definitions and metrics for quantifying ESG costs and benefits. Different rating agencies use different criteria to score companies’ ESG performance. This can be frustrating for companies who find they score well with one agency but less so with others. The differences are equally confusing for asset managers and other investors seeking reliable information on investees and targets.
For Asia Pacific countries engaged in the green finance movement, the European Union’s taxonomy for sustainable business activities may provide common, comparable criteria. Introduced in 2019, the taxonomy sets detailed screening criteria for activities across eight sectors that substantially contribute to climate change mitigation. As the Asia Pacific region attracts investment from most major economies, such a common language will become increasingly important.
Large asset managers operating globally face additional challenges in developing ESG risk monitoring and reporting frameworks. These frameworks need to consider risks specific to each region; this makes it difficult to identify consistent benchmarks for ESG performance across not only regions but also sectors and between companies whose operations may cross sector definitions. As more of this data becomes digitised and standardised, its quality and the access asset managers have to it will vastly improve. One would hope that the investor capital becomes more accurately deployed to those firms whose activities are driving more sustainable outcomes.
Asset managers and companies integrate ESG, there has been significant activity and debate over common definitions and metrics for quantifying ESG costs and benefits.
Asset managers may choose to address ESG portfolio risk with simple exclusion policies that avoid entirely investments in certain activities and assets. Moving beyond this somewhat blunt approach, and in moving to integrate ESG goals more broadly in their portfolios, many asset managers are investing in their engagement/stewardship functions. Stewardship-driven, so-called ‘inclusion policies’ are fast gaining interest from institutional investors; rather than investing elsewhere and leaving firms’ ESG shortcomings in place, inclusive policies set realistic metrics for activities and processes that aim to achieve positive ESG change. Asset managers, through their stewardship teams, then work with investee companies to improve their ESG ratings and sustainability outcomes.
In fact, some large funds, such as Dutch pension plan ABP, actively look for companies that have room to improve. They then look to generate excess returns by helping these companies do better on ESG measures. For managers running mostly index portfolios that may be used to being somewhat hands-off in terms of their engagement with investee companies, this active approach to stewardship requires a significant change as they acquire and deploy new ESG expertise, skills and resources for portfolio management.
In this current environment, investee companies cannot approach ESG monitoring and reporting as a box-ticking exercise. Companies need to deliver detailed information about their ESG strategy and performance to financiers, investors and asset managers, and ensure they can explain the facts underlying their ESG performance. Increasingly knowledgeable stakeholders can already see when a company’s disclosures are only skin deep, and a lack of credibility on ESG matters will deter investors, harm corporate reputations and destroy shareholder value.
Leading companies are centralising their ESG data collection, communication and outreach within a single function. These teams have the knowledge to answer tough new questions about, for example, how they manage risk, whether they are sufficiently diversified, how their supply chains are managed, and how well senior management engages with governments and industry on policy development. They also act as an expert resource to the company’s lines of business.
With an increased focus on sustainable finance, markets will reward companies with strong ESG records backed by high-quality disclosures. Against this backdrop, asset managers will be the ones where the board and senior leadership of the firm lead a cultural shift to embed ESG not only in the firm’s core investment process and across the assets they manage, but also in how they manage the asset management business as a corporate enterprise.