EXPLORED: ESG Implementation for Asset Owners

Posted on 04/22/2014


Implementing ESG (environmental, social and governance) standards into an asset owner’s allocation is a complex and costly endeavor, especially for smaller public funds. The massive asset owners like the Dutch pensions have been able to hire ESG personnel, fund ESG evangelist companies and promote the cause through various non-profit entities like the Investor Network on Climate Risk (INCR). APG even follows the Global Real Estate Sustainability Benchmark (GRESB) and screens its institutional real estate investments annually for environmental performance.

Thus active ownership is a means to accumulate gains to market performance.

Affecting Company Returns

A leading motivator for incorporating ESG into the investment process is to actively manage important factors that are believed to be prime drivers of risk and return. Under this context, ESG factors can be used to screen for better-managed companies that can alleviate risks and take advantage of fortunes stemming from key environment and social issues. For example, climate change can negatively affect a company’s financial performance in a number of ways. Carbon emission standards and regulations in various jurisdictions can impose costs, thus lowering the corporation’s profitability.

Picking External Managers

The adoption of ESG standards was slowed by the global financial crisis – generating high returns were of the utmost importance. In addition, taming investment operating costs were important, thus ESG-focused consultants and companies have provided the majority of ESG capabilities for asset owners.

Increasingly, investment consultants and companies have created ESG ratings, mostly toward equity managers and companies. There is no industry standard and investors are questioning the various methodologies and applications. When selecting external managers, a manager may have a highly-rated portfolio of ESG stocks, but fund performance may be lagging. On the other hand, a high performing manager may be able to add ESG to boost his or her fund’s performance. Also when investment consultants select managers for ESG-focused clients, if two receive equally high ratings, the fund with the higher ESG ratings will be preferred. To push for more external managers adopting ESG standards, asset owners can include such standards in their mandates and influence non-profit networks like the UNPRI.

Active Ownership Approach

In some circumstances, institutional investors may take an active approach in engaging with companies that are less enthused or interested in ESG principles. Asset owners like sovereign wealth funds and pensions have many tools at their disposal such as voting and management engagement. For example, the California Public Employees’ Retirement System (CalPERS) has a focus list that targets companies lagging in governance standards. Thus active ownership is a means to accumulate gains to market performance.

Keywords: California Public Employees Retirement System.