First Steps to ESG Integration in Europe

First Steps to ESG Integration

More than a decade from a very hard financial crisis, largely created as we know it by exclusive short-term focus on earnings and profits, we are now witnessing a radical paradigm shift in the world of investing. Starting with the asset owners at the top of the investment chain, there is unanimous consensus that certain long-term risks and considerations can no longer be ignored on the understanding that consideration of these additional risks will prevent future economic and financial crisis. An increasing number of managers are turning to a different vision for their investment approach accordingly, geared towards long-term value creation and return generation, to meet the demands of asset owners.

In this article we look at the first steps involved in ESG integration and how managers should successfully navigate this generational change in investing.

 

The Right Mindset

There is pressure exerted from the top of the investment chain by asset owners. Their renewed concerns on sustainability and need for integration of long-term considerations in their investment portfolios became increasingly intertwined with the perception of correctly discharging their fiduciary obligations. Whilst there always existed a niche of managers historically taken into consideration long-term risks and factors in their investment approach, an increasing number of managers are these days busy at solving the puzzle of ESG integration.

What differentiates the approach of those new to ESG integration when compared to the ones which historically had ESG integration within their strategies is the mindset. A mindset based on a different awareness, enabling for the understanding first and then the evaluation of all opportunities and risks within investment opportunities. So far, a short-term approach represented the only dimension within which to consider investment opportunities and their risks. ESG integration, with the inclusion of environmental, social and governance material factors and risks in the investment decision process, allows for the creation of a new dimension for investing. Asset owners are of the view that the mis-acknowledgement of material environmental, social and governance factors and risks in the investing process can lead to severe economic and financial repercussions, to the point that ESG integration could well be considered as integration of additional financial data in the investment process, rather than the inclusion of data which is non-financial in nature.

The Materiality of Sustainability Issues 

Once acknowledged that a new dimension of investing does exist and, within that, different considerations and risk factors to account for, the next natural step for ESG integration lies in identifying sufficiently material and significant risks to drive investment decisions. The challenge here is not only to define material and significant, but also to be able to measure and quantify the additional risks factors. Of course, different managers will have different views on what is material, depending on the vision and the beliefs of each individual company and the audience of investors. At the same time, similar sustainability risks factors, for instance, might have a different weight in the view of different investors.

With ESG integration and with the evolution of a market in sustainable finance products comes also the reduction – to the maximum extent possible – of elements of subjectivity within the definition of materiality used in the assessment of environmental, social and governance risks. This is where the recent regulatory endeavours unfolding in Europe, for instance, will make the difference for the growth of a market in sustainable finance products. In fact, amongst the various aims of the EU Sustainable Finance Disclosure Regulation, for instance, there is the codification of indicators allowing for the measurability of the adverse impact of investment strategies and products. The codified indicators will allow financial market participants, on the one hand, to report correctly on issues that are unanimously referred to as material for an investment decision. On the other, the codified indicators will ensure that investors can make investment decisions based on the sustainability issues they deem the most important and they are concerned about the most.

Reporting

Investors engage with investment managers for different reasons. So far, investment decisions were mainly adopted on the basis of appetite for a specific strategy as well as the overall historical performance. As the pressure for sustainability on asset owners increases, performance on ESG is set to become one of the major driving forces behind investments decisions. In order to rank successfully, investment managers will have to be able to demonstrate ESG integration also ex post. In simple terms, the role of reporting on ESG integration will become central in attracting investors, because it will allow for an evidence of how ESG integration within a strategy has determined certain financial returns.

The aspect of reporting is still at its embryonal phase nowadays, especially in Europe. In fact, if we take a look again at the Sustainable Finance Disclosure Regulation, we see that the obligation to report on sustainability related obligations is imposed only as of 2022.

Of course, one of the most significant steps for the evolution of a market on sustainable finance will be the availability of data to report on ESG performance. As also discussed elsewhere in other articles, the reporting made by an investment manager will be as good as the reporting and the data made available by investee companies and economic activities. Also, to add the to complexity, the overall scenario on reporting of non-financial data in Europe is currently wired to impose reporting only on large public interest entities with exclusion of the obligation for small and medium enterprises.

Final Conclusions

The call for investment managers on ESG integration becomes more compelling the more a market on sustainable finance products evolves to become a mainstream phenomenon more than it could have possibly ever been conceivable in the recent past.

In order to be successful at ESG integration, firms will have to be able to articulate their vision on sustainability and make sure that is evident in the investment process, so as to be able to attract investors whose sustainability concerns are aligned with the one of the firm.