Responsible investing: Lack of benchmarks hampers ESG adoption

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 12, 2017 - June 18, 2017.
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Institutional investors have benefited from environmental, social and governance (ESG) based investments, but the exposure is low because of the absence of standardised benchmarks, according to State Street Global Advisors and Longitude Research’s Performing for the Future report. 

The report states that while the overall satisfaction with the performance of ESG investments appears to be strong, many investors have expressed concern about the lack of available data and tools with which to measure that performance.

“Our survey highlights a wide range of performance metrics employed by investors. Nearly half (49%) benchmark against their own past performance, 47% against a common benchmark index and 46% against peers with comparable portfolios. So, the market is clearly some way off determining which type of measure constitutes best practice. Just 24% cite non-financial measures, which confirms the focus by investors on the financial performance of ESG strategies,” says the report.

The researchers concur that this impediment is expected, considering that ESG as a performance driver and its evolving role in portfolios are a fairly nascent strategy. “A little more than half agree that they have difficulty benchmarking the performance of their ESG strategy against peers,” they say in the report.

“Less predictable, however, is the finding that the more deeply ingrained the ESG strategy, the greater the difficulty of measuring its performance. Investors with the most exposure to ESG within their portfolios are more likely to agree that they have difficulty benchmarking their performance (61%) than those with the least exposure (52%). It may be that this more experienced group has a greater appreciation of the challenges associated with benchmarking than those with lower exposure or more recently established programmes.”

Attempting to gauge the performance of specific areas of the portfolio is also problematic, they highlight. Andrew Howard, chief investment officer at VicSuper, Australia’s superannuation and pension fund, was quoted in the report as saying, “Often, it is hard to understand how accurate some of the measures are at providing us with the full picture.

“Yearly Trucost reports, for example, are valuable in measuring the carbon intensity of our equity portfolio, but only to a point. The information only looks at climate impacts and does not take long-term resilience, the strategic direction of the company in terms of transition and upside exposures into account. Therefore, it does not give you a full indication of a company’s carbon risk exposure.” 

Trucost provides data, tools and insights needed by companies, investors and policymakers to deliver the transition to a low-carbon, resource-efficient economy. 

The survey also shows that investors do not only struggle with performance at the portfolio level. More than half (56%) say they lack the capability to assess the performance of external managers. For example, the definitions of ESG risks and how to measure and evaluate such risks differ among managers and external research firms or teams, states the report.

For many investors, the lack of standardised tools for performance measurement means that they often have to use a variety of methods to assess corporate ESG performance. To this Marie Giertz, chief economist at Swedish public pension fund Kåpan, explains, “It is very difficult to evaluate impact and pick out the right stocks from an ESG perspective. A traditional approach looking at different macro and micro components, such as balance sheets, profits and political risks on a country, sector or company level, are still the main focus for us. But we are adding the ESG criteria to the investment decisions.”

The study notes that while the lack of standardisation on performance assessment is part of the evolution process for what is a relatively new investment framework, it is clear that the inconsistent measures lead to a degree of frustration and constitute a barrier to the further adoption of ESG. 

“There is a proliferation of different types of ratings and other measures and we expect that they may give conflicting results,” says Annie Bersagel, acting head of responsible investments at Norwegian mutual pension fund and insurance company KLP. 

“We are currently in a process of disruption that is really necessary to clarify how to measure investments on ESG quality. Eventually, the best standard will win. But we are not there yet.”

Adoption driven by performance

According to the report, 80% of the survey respondents say they have some form of ESG strategy within their portfolios. “Institutional investors’ attitude towards responsible investing has come a long way in a very short time. While institutions assessing investments have in the past considered ESG factors to some degree, few were considering them explicitly and most would have placed them firmly in the risk bucket,” it says. 

“That reflects, perhaps, a diversity of interpretations of ESG. It captures a range of potential styles and tools with which investors can implement their responsible investing objectives. 

“Most have been investing in ESG strategies for four to five years, although a quarter have had an ESG component for more than five years. Among the 20% who do not yet have exposure to ESG strategies, the results reveal an entrenched group of non-adopters (71%) that are not actively considering them.”

The report says developments such as the United Nations’ Principles for Responsible Investing have had a profound impact on getting investors to see ESG factors as both opportunity and risk. It also says other considerations, such as climate change, media attention on areas such as child labour and working conditions, and the rise of social media as a reporting tool for good and bad corporate behaviour, are forcing investment firms to analyse and measure their investments according to ESG markers. 

However, although investors are satisfied with the performance benefits of their ESG strategies, the overall exposure remains low. On average, only a third of the adopters’ investments incorporate ESG criteria.

“Our results suggest that investors expect that proportion to grow over the next two years to around 40% of their portfolio. On average, the ‘ideal’ proportion suggested by investors is only marginally higher,” says the report.

“The averages belie the full range of ideals among investors in the survey — some are looking to achieve an exposure of around 70% of their portfolio. But the results do point to a lack of ambition among many institutions. Indeed, some investors envisage an ideal exposure level of just 20%. 

“ESG exposure could transform these investors’ long-term financial results, risk mitigation and exposure to volatility. So, they need to become more ambitious and consider increasing their ideal 

exposure levels.”

Factors such as company culture, communication, education, engagement and partnerships are key to the implementation of ESG strategies. For example, the study found that institutions where ESG strategies were pursued the longest and constituted a larger part of their portfolios have embedded the consideration of cultural factors more deeply in the organisation. Some 77% of these investors say their staff are well aligned with their ESG investment strategies.

“Among the adopters, alignment among many institutions around their ESG strategies appear patchy overall and there is confusion internally about what ESG means in practice. Over half of the adopters (56%) say there is a lack of clarity over ESG terminology within their institutions,” says the report. 

“And while alignment with ESG strategies is high among boards (77%), senior managers (76%) and investment teams (74%), there is some way to go before all staff are aligned (only about two-thirds). In a recent State Street study, 30% of institutional investors cited explicit support from senior management as a way to overcome barriers to ESG integration.” 

While satisfaction among investors with exposure to ESG criteria in their portfolio is high, the average exposure — both actual and intended — is low, says the report. “The capacity or willingness of investors to commit larger proportions of their investments to an ESG lens appears constrained.”

The predominant concern is the need to gauge and measure the balance of values-based goals with broader risk-adjusted return objectives. “The value proposition of ESG needs to be quantified. But ongoing ambiguity around evaluation and the reliability of ESG performance measures create uncertainty for investors across the adoption spectrum,” says the report.

“Meanwhile, the depth of internal capabilities and alignment of stakeholder perspectives also weigh heavily. Most institutions will struggle to adapt or find solutions to these challenges by themselves. Quality partnerships and ongoing dialogue — with both peers and providers — will be crucial to helping more investors to harness the potential of ESG.”  

The report was based on a study conducted between December 2016 and January 2017. The study surveyed senior executives with asset allocation responsibilities at 475 institutions globally. They included private and public pension funds, endowments, foundations and official institutions.