As presented in Part 1: Introduction to Sustainable Finance and responsible investing, in order to fulfill its commitment to social, economic and environmental issues, the European Commission has undertaken two actions: the release of the “Shareholder Rights Directive II” in June 2017 and the appointment of a “High Level Expert Group” (HLEG).
Both initiatives share 3 common objectives and purposes:
Illustration 5 – Overlaps between HLEG action plan and SRD 2
What does it mean for financial institutions and investors?
In this section, requirements described regard asset managers, investee companies and institutional investors such as reinsurers, life insurers and pension funds.
- Enhancing transparency and long-termism through heavy non-financial disclosures
Both directives and regulations are leading financial institutions to provide maximum transparency including the integration of non-financial factors. Today’s financial disclosures are focused on a 3-year horizon making it difficult for users and investors to evaluate a more long-term performance. Also, most of the required financial disclosures are quantitative and do not take into account non-financial factors. In addition, these factors are disclosed separately and under a qualitative approach. The new regulations aim at promoting and enhancing disclosures on long-term performances and quantifying non-financial elements.
Financial institutions and investors should expect the following changes in their annual disclosures:
- Report on the integration of non-financial factors such as environmental, social and economic in their investment strategies.
- Report on how mid to long term risks are measured and taken into account.
- Report on how non-financial (ESG) risks are taken into account such as governance, climate change etc.
- Report on their engagement policy and how it has been implemented giving concrete examples on voting practices, dialogues with companies etc.
- Report on how investments are followed-up and monitored not only from a financial point of view but also from ESG perspectives.
The regulations do not only focus on the importance of disclosures of financial institutions and investors, but also of investee companies, who should communicate on their sustainability initiatives in order to foster internal debates, ensure proper governance and help promote dialogues between the management and the other stakeholders. Two of the most important disclosure requirements for listed companies are the responsible investor report that includes all sustainability actions and the remuneration report that includes the top management’s remuneration as it has been voted by shareholders in General Meetings.
- Including non-financial criteria in investment strategies and decision process
ESG concept started to emerge a decade ago but was not a widely spread investment strategy as financial institutions and investors were mostly driven by high performance and returns. Following the financial crisis and the many environmental and social initiatives led by the United Nations, investors, consumers and pension schemes providers started to ask for more transparency regarding what their money is funding. Many asset managers have thus started to propose ESG based products to fulfill this rising demand. Several studies and beliefs also state how investments in high ESG-rated companies lead to higher investment return at a lower risk on the long run. In a matter of fact, studies show that these companies have higher profitability, higher dividend yield and lower business-specific tail risks.
The United Nations suggested to asset owners and investment managers 4 ways to integrate ESG in investment strategies and analysis:
- Fundamental strategies: consisting of adjusting the forecasted financials such as revenues, costs, capital expenditure and the valuation models such as DCF, NPV etc. to include ESG factors like impact of labor standards on revenues, environmental impacts on project costs etc.
- Quantitative strategies: in which quantitative models integrate ESG factors in addition to other traditional factors. For example, some asset managers have linked ESG rating to volatility and others have shaped their portfolio with an ESG materiality profile.
- Smart Beta strategies: in which ESG factors are included in portfolio construction to take these criteria into account in the risk profile of the investment. This will lead to an excess risk adjusted return and to a reduced downside risk or enhanced risk profile. This strategy is achieved by constructing a smart environmental index and/or including governance insights into beta strategies.
- Enhanced passive strategies: consisting of tracking an index that has already integrated ESG factors in its selection of securities.
The integration of ESG criteria in investment strategies also has an impact on the investment process as it involves many operational changes, review of teams’ organizations etc. 4 steps have to be followed by financial institutions in order to have an integrated ESG team:
- Create an ESG team and implement cross-team meetings
- Ensure an active ownership in ESG shared resources
- Setup portfolio reviews and build risk monitoring tools that can be used to identify portfolio holdings with high ESG risks
- Have strong engagement through voting and dialogues between investment managers, ESG teams and company boards and senior management
ESG teams and specifically research teams will play a major role in the integration of ESG factors in investment strategies as they generate investment ideas and integrate ESG topics in their recommendations, analysis and financial models.
Many asset managers and financial institutions have created ESG products such as green bonds, ESG funds etc. But as of today, ESG factors need to be integrated in all types of investments and types of products.
- Including ESG risks in the material risks assessments
Although this will become a common practice in the next few years, up until now, ESG was only analyzed from a qualitative point of view. Financial analysts’ usual practices were: screening of companies’ sustainability tocks, using ESG scorecards established by third-parties or performing benchmarks among peers.
The new directives and the upcoming taxonomy will lead to a clearer definition of ESG risks and to more standardized practices. In Europe, the “Shareholder Rights Directive II” will require financial institutions to include non-financial factors in their risk assessment. More long-term factors should also be considered and the risk forecast should be superior to 3 years.
One of the most important factors to be incorporated in the risk models is the climate change risk that was as of today covered by Basel II in the Risks Category 5 (damage of physical assets) that includes notions associated to natural disasters.
A second type of factor to be included in the risk assessment is investee companies’ governance risk to which financial institutions and investors are exposed to through their investments. The main impact is the risk linked to the company’s behavior. As investors, lenders and shareholders, financial institutions and investors can play an important role in corporate governance in order to control this type of risk.
Incorporating ESG factors in risk assessment would certainly have an important operational impact, but also a positive one on the volatility of the stocks. Studies indeed show that companies with higher ESG rating have a lower volatility in their stock performance when compared to comparable companies from the same industry (the level of impact varying from one industry to another).
Financial institutions should also be aware of three types of risks that can arise from ESG:
- Financial risks due to the inability to make repayments because of environmental or social costs and a lower assets’ valuation due to contamination or non-compliance.
- Legal risks due to potential liability for a financial institution through the control of a company or holding of assets. For example: pay for clean-up due to a spilling caused by the client.
- Damage to reputation through association with companies generating high level of pollution or having an “unethical” activity.
Even though regulations on ESG integration are relatively new for financial institutions, some asset managers have already worked on this topic and implemented responsible investments actions. See Part 3: Lead asset managers in ESG integration for best practices and best in class on these topics.