ESG Investing is the consideration of environmental, social and governance (ESG) factors in the investment decision making process. It is estimated that between a quarter and a third of the current global assets under management are in some way influenced by ESG considerations in varying capacities.*

The environmental component of ESG analysis centers on assessing a company's impact on the environment including factors such as energy use or pollution output. The social component evaluates the company's relationship with people and society, encompassing areas such as diversity and inclusion, human rights, health and safety. Finally, the governance component examines how the company is governed, taking into account transparency and reporting, ethical standards, compliance, and board composition.

The origins of ESG investing can be traced back to the 1960s, when it emerged as 'socially responsible investing'. Initially, investors focused on excluding stocks or entire industries from their portfolios based on objectionable business activities such as tobacco production, gambling or weapons. In its present form, ESG investing seeks to better align investors' interests with societal needs and has been evolving over the years incorporating a wide and complex set of issues, primarily driven by consumer preferences, the influence of younger generations and overall investor demand for more socially engaged and purposeful corporations.

DECODING ESG FOCUSED FUNDS

An ESG Investment Fund is a broad term used to describe any investment fund for which the fund manager uses ESG criteria to determine its portfolio composition and allocation strategy.  The fund's prospectus should provide clear disclosure regarding its approach to incorporating ESG factors and the methodology used to weigh and assess these factors.

ESG fund managers have the flexibility to use or combine various ESG strategies, including:

• Negative Screens: The exclusion of certain companies or industries with undesirable characteristics like weapons, gambling, tobacco, nuclear energy, fossil fuel. This is probably still the most dominant type of ESG investing.
• Best In Class: Selecting companies with the exemplary best ESG practices only (those with best practices in areas such as CO2 emissions, water use, waste, social factors).
• Sustainable Investing: Seeks to achieve long term resilience in sectors with sustainable challenges (renewable energy, water, mobility, agriculture).
• ESG Integration: Traditional financial management that take ESG aspects into account with a view of seeking an advantage from the integration of ESG indicators.
• Impact Investing: Generate social and environmental impact with a financial return (for example by reducing CO2 emissions, saving water, improving access to housing or education).
• Engagement/Voting: The use of shareholder power to influence corporate behavior.

Today, more than 5,000 investors (including asset managers, pension funds, insurers, sovereign wealth funds, endowments and foundations) representing a staggering US$121 trillion of assets under management have become signatories to the UN Principles for Responsible Investment (PRI). These principles are built on six core pillars, mainly focused on committing to integrating ESG issues into their practices and advocating for adequate disclosures from the entities in which they invest.

UNVEILING THE LANDSCAPE OF ESG INVESTING - ASSET CLASSES AND PERFORMANCE

ESG investing exhibits distinct characteristics that vary depending on the type of asset class. Listed Equities have the longest track record, exhibit a higher level of sophistication, and offer a wealth of available data.  The integration of ESG factors into listed equity analysis is becoming more common among asset managers. Additionally, exclusions and engagement strategies are primarily employed when it comes to this particular asset class.

As Private Equity becomes a major force in the global economy, it is also becoming a powerful change agent for driving progress on ESG, climate and sustainability and there is an increasing trend of ESG integration and conviction, with Private Equity firms having the ability to consistently influence their portfolio companies on relevant ESG matters. The long-term horizon of Private Equity investments also facilitates a focus on ESG.

When it comes to debt instruments, more innovative ESG related products such as Green Bonds and Social Impact Bonds have hit the market and are becoming more popular.  Traditional fixed income initially lagged behind but recently there has been an increased focus in areas such as the sustainability of government debt issuers and the view that the governance factor ("G") can play a material role when it comes to financial performance of government and corporate bonds. Current trends suggest that incorporating ESG into fixed income investing should be part of the overall credit risk analysis and should contribute to more stable financial returns.

Due to its nature, responsible investing is more challenging for commodity related investments. Excluding certain types of commodities is a possibility, as well as investing in commodity related companies with good ESG practices. When analyzing commodity related investments from an ESG lens, it is crucial to prioritize several key factors. These include evaluating the sourcing risks associated with the physical origin and location, supply chain related ESG risks, usage in products and services and carbon foot printing over the life cycle of the commodity.

A natural question around ESG investing is whether there is a downside to it, from a risk or performance perspective. According to a study that measured how ESG funds performed relative to funds in the same Morningstar category over a 10 year period**, the overall conclusion appears to be that ESG funds have tended to perform very similarly and with very similar levels of risk to non-ESG focused funds. Therefore, there is not yet convincing evidence that ESG funds may be reliably better than non-ESG funds or that choosing ESG funds would put investors at any kind of disadvantage in terms of risk or performance.

ESG REGULATORY AND REPORTING FRAMEWORK

Europe is at the forefront of the ESG regulatory framework. The Corporate Sustainability Reporting Directive (CSRD) entered into force in 2023 (with reporting requirements starting in 2024) and has expanded the requirements of the previous Non-Financial Reporting Directive (NFRD) and will require nearly 50,000 companies to enhance their reporting around sustainability. Companies will have to publish information related to matters such as environmental protections, greenhouse gas emissions targets, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, diversity on company boards and due diligence processes in relation to sustainability.

In addition, the EU Disclosures Regulation applies to all financial market participants, including AIFMs, and requires them to publish their policies on integration and impact of sustainability risks into their investment program. ESG specific products (known as "article 9") require even further additional disclosures.

In March 2022, the SEC proposed climate-risk disclosure requirements for public companies and SEC filings will be required to discuss financially material, climate-related risks and the company's climate risk management processes.

In recent years, the Securities and Exchange Commission (SEC) has penalized certain investment advisors for making material ESG related misstatements, where the advisors were not able to prove that some investments had undergone an ESG quality review as previously disclosed to investors.  The SEC has advised that they are examining registrants for consistency and adequacy of disclosures concerning ESG investment strategies, and is also closely monitoring voting practices, internal controls and compliance programs.

In the Cayman Islands, an ESG framework for Cayman Islands Investment Funds has been proposed that will mostly target greenwashing (more on this later in the article) in the investment funds industry. The initial focus will be on the name of the fund, its marketing, failure to adhere to sustainable development goals, lack of disclosure and possible misleading claims.

In terms of global reporting, numerous international institutions such as the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI) and the Task Force on Climate-related Financial Disclosure (TCFD) have been working to form standards and define materiality to facilitate the incorporation of ESG factors into the investment process.

ESG AND FUND GOVERNANCE

As part of their oversight role, fund directors need to be aware of the efforts by fund managers to withstand ESG scrutiny by investors, the public and regulators. Fund Directors must gain comfort as to how the programs and processes of fund managers and advisers can address and manage ESG investment risks.  

As part of their ongoing fiduciary duties, fund directors need to make sure that the Fund disclosures accurately reflect and not overstate the fund's ESG investing activities and that it has appropriate controls, policies and procedures in place around ESG investing.

Naturally, the expected level of oversight intensifies for investment funds marketed as ESG Funds or those with prominent ESG elements in their marketing materials, in contrast to Funds with minimal or no ESG components.

Fund directors should focus on how ESG is defined, operationalized and monitored by a Fund that uses ESG factors as part of its investment process, and make sure the Fund builds ESG into the due diligence for investments. They should also receive adequate and regular information and reporting on the Fund's ESG strategy, performance and proxy-voting record. If the fund manager engages sub-advisers, fund directors need to understand how sub-advisers use ESG factors and if they have a compliance program in place.

The metrics used to measure a holding's ESG factors must be applied consistently across investment products. Fund directors should discuss with fund managers if investment professionals are using an appropriate level of judgement and healthy skepticism when using ESG data from third parties.

Fund directors also need to understand and regularly discuss how the fund manager considers the interplay between ESG investing and performance for investors.

Fund directors must be aware that as their funds vote their shares as fiduciaries on a growing set of issues, there is an increase in reputational risk if the proxy issues are not supported by a deliberate and transparent voting policy that aligns with the Fund's broader ESG policies.  

As part of their fiduciary duty to a fund, fund directors must oversee the fund's compliance function, proxy voting disclosures, investment performance and risk management and be familiar with the fund's ESG related investments, disclosures and practices.

With the ESG regulatory landscape evolving every year, Fund directors must receive frequent updates on regulatory trends and changes and confirm with fund managers that the Fund's practices remain in compliance with the latest applicable laws and regulations.

ESG IMPLEMENTATION AND ITS CHALLENGES AND CONTROVERSIES

ESG implementation does not come without a number of challenges and controversies. The following are key hot topics surrounding ESG investing:

• Greenwashing is perhaps one of the biggest challenges, and it is defined as the act of exaggerating the extent to which investment products and services take into account environmental and sustainability factors in a manner that makes it difficult for investors to distinguish if a fund is truly using environmental and sustainability strategies. This forces investors to do their homework with real care to ensure that they choose an ESG Fund that matches their needs and expectations.
• Lack of generally accepted reporting standards, consistency and terminology is also a significant challenge. It is difficult for peers to compare their ESG efforts without common metrics and highlights the subjective elements of ESG scoring. In addition, the data underlying ESG ratings are mostly unaudited, often incomplete and dated. For the foreseeable future, ESG investors will not likely have access to comparable accurate measures.  
• ESG vs Fiduciary duties: A group of investors believe that certain fund managers are using their proxy powers to push a political agenda and should instead be focusing on investment assets that yield the most returns.
• Small businesses may not be receiving funding in an equitable manner due to stringent ESG requirements they are unable to comply with, raising discrimination concerns.
• Do the investment horizon of companies and investors match with the timescale of collective problems we face as a society and that sustainable investing is trying to fix?
• Some funds that consider ESG may have higher expense ratios than other funds that do not consider ESG factors.  

The surge of an anti-ESG movement has been noted in many locations, particularly in the United States where governors from 19 US states have pledged to resist ESG investing over antitrust consumer protection and discrimination concerns (dropping some of the largest fund managers who promote ESG and penalize the US fossil fuel industry from pension and state-owned investment funds).

CONCLUSION

ESG Investing is still evolving and, despite the challenges noted above, a significant number of pension funds, sophisticated and institutional investors will continue to expect investments to follow and comply with certain ESG criteria.  Unsurprisingly, greater attention and efforts are needed to improve transparency, international consistency and comparability.

According to the study we noted above, an ESG investing approach does not necessarily mean lower returns or a higher level of risk.  It is also important to note that ESG and sustainable investing is applied differently depending on the asset class and that the level and intensity of ESG analysis may also vary for each portfolio company depending on the sector and the nature of its activities.

From a fund governance perspective, fund directors need to stay up to date on ESG matters and the applicable regulatory framework and pay particular attention to ESG fund disclosures and the fund's actual ESG procedures to ensure consistency and no gaps or misstatements between the disclosures and the final product offered to investors. A proxy voting policy aligned with the Fund's ESG framework is also important.

Fund directors should engage in regular discussions regarding the fund managers' long term ESG strategy to retain and attract investors. These discussions are crucial to instilling confidence that an effective strategy is in place to maintain competitiveness and visibility in the market. To this end, it is important that fund managers define their corporate ESG and sustainability framework and articulate how it aligns with their overall business strategy and purpose.

AUTHOR: Martin Laufer