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The Institutional Investor’s Guide to ESG INVESTING P&I Content Solutions in partnership with

CONTENTS

This Guide is a resource for asset owners on best practices and current trends in environmental, social and governance (ESG) investing — an evolving field that continues to see advances across asset classes, data availability, benchmarking and engagement.

Each section offers guidance on the approaches that investors are taking to engage with asset managers, corporates, issuers, and wider industry groups in order to promote and expand the ESG footprint across investment portfolios.

The Guide has been updated to reflect evolving investment approaches and top ESG and sustainability themes for 2023.

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DEFINING ESG TODAY

Historically, we’ve focused on the risks, like the transition and physical risks of climate change or social risks like human rights and data privacy. But increasingly, we think [of sustainability] in terms of opportunities. For example, companies that address environmental issues can have a very attractive growth and investment potential.
Xavier Chollet
Senior Investment Manager, Thematic Equities, Pictet AM

ESG investing has gained momentum among institutional investors, and it continues to evolve across asset classes and types of investment strategies. The broad dialogue among the investment community, corporations, sovereigns and regulators has shifted from an initial phase of evaluating ESG factors to an ongoing phase of practical implementation across the investment universe. Many market participants have established sustainability goals and pursue ESG themes. ESG investing today reflects both risk mitigation and return potential from evolving opportunities in sustainability.

By adopting sustainability as the foundation of any investment thesis, investors seek to address the financial materiality of ESG issues, particularly climate change. They are closely tracking progress by corporations and governments toward the transition to a net-zero economy — to reduce greenhouse gas emissions to zero by 2050. In addition, diversity, equity and inclusion, along with other social issues, have become a key part of the overall sustainability discourse.

Examples of ESG Risks

A long-term focus on sustainability lies at the heart of ESG investing. This updated Institutional Investors’ Guide to ESG, sponsored by Pictet Asset Management (Pictet AM), provides current insights and best practices as well as a road map for ESG investing. It covers ESG by asset class, data and disclosure issues, benchmarking, regulation, industry initiatives and more.

As the concept of sustainability has become widely understood, asset allocators have incorporated the material impacts of ESG factors as part of their fiduciary oversight of investment portfolios. Fiduciary duty has always meant taking a long-term view to protect and grow investment capital.

By deploying capital with this long-term lens to support and accelerate the transition toward a more resilient and responsible economy, asset allocators are looking to achieve both financially material performance and ESG objectives.

The way that investors approach ESG has evolved away from simple exclusion and best-in-class integration to, more recently, targeted ESG strategies with attractive growth opportunities. As asset allocators have become more ESG savvy, they are working with their asset managers to seek greater transparency, encourage more disclosure from companies and source higher quality data on sustainability.

While investor belief in the long-term performance of companies that are ESG aware and forward thinking in sustainability has grown, there are ongoing concerns — and persistent challenges — around greater accountability, regulatory scrutiny, standardized data and corporate disclosure. Addressing accountability requires informed perspective and experience in ESG investing by both allocators and asset managers.

A pension fund cannot have a substantive long-term view on the risks and opportunities they face in managing a long-duration investment portfolio without taking into account how climate change and other environmental and social challenges impact the assets they are invested in.
Eric Borremans
Head of ESG, Pictet AM

Spectrum of ESG Approaches

Asset owners can utilize several different approaches to ESG investing. Broadly, Pictet AM defines these as three types of strategies: ESG integrated, ESG focused and positive impact, based on the European Union’s Sustainable Financial Disclosure Regulation (SFDR).

ESG Integrated: In an integrated approach, the asset manager takes ESG factors into account in the analysis of a stock or bond to enhance their risk-return profile. Those considerations can have a material impact on the company’s performance and are weighted alongside other financial factors that inform an investment decision. Portfolios may invest in securities with high sustainability risks. However, the investor is not promoting an environmental or social outcome. ESG integrated is equivalent to an article 6 SFDR*.

Global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total AUM, according to Bloomberg Intelligence.

ESG Focused: An ESG focused approach is when the investor promotes environmental and/or social characteristics and may partly target sustainable investments, provided that the companies in which the investments are made follow good governance practices. ESG focused is equivalent to an article 8 SFDR*.

Positive Impact: With an impact strategy, the investments are intended to target economic activities that are environmentally and/or socially sustainable, provided that the companies in which the investments are made follow good governance practices. Investors often employ an impact approach through a thematic strategy that targets a specific challenge, such as clean water or clean energy. Positive impact is equivalent to an article 8 or 9 SFDR*.

*Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector (SFDR).

Types of ESG Approaches

The Role of Regulation

Government policy worldwide has moved toward mandating ESG disclosures and requirements by corporations. Many regulators also require asset managers to identify and define their ESG approaches and methodologies in more specific terms. In response to the need for more specific metrics on sustainability, asset managers are investing in proprietary tools that, in turn, need more disclosure from issuers, creating more transparency in ESG metrics across the investing universe.

Regulation is accelerating worldwide as governments address some of the challenges in ESG-related data and metrics, as definitions and disclosure requirements can differ by sector within an economy and across global economies. The European Union (EU) has led with the Sustainable Finance Disclosure Regulation (SFDR), EU taxonomy for sustainable activities and the proposed Corporate Sustainability Reporting Directive (CSRD). In the U.S., the Securities and Exchange Commission has proposed rules to enhance and standardize corporate disclosures regarding CO2 emissions. In Asia, China is working with the EU on taxonomy classifications, while Hong Kong regulators have increased their focus on climate reporting standards and Association of Southeast Asian Nations (ASEAN) taxonomy is in development.

An important European regulatory development in ESG pertains to the EU taxonomy and SFDR classifications. They require EU-based asset managers to account for how ESG is embedded in their investment processes, portfolios, risk metrics and outcomes. These have provided a significant guidepost to the standardization of industry criteria. Asset managers, including Pictet AM, have incorporated many of these guidelines and monitor regulatory developments closely.

Global Initiatives on ESG Investing

Global challenges, such as climate change and social inequality, are too big for a single investor or a single country to address significantly without widespread support. Therefore, a number of global and regional entities and initiatives have helped set ESG standards and guidelines that continue to drive progress. Here are some early proponents of ESG investing:

The Principles for Responsible Investment
The United Nations-supported PRI, one of the earliest ESG initiatives, launched in 2006 to establish a framework for responsible investing via ESG disclosure and metrics. It provides a standardized approach to ESG integration within the investment process and within an asset manager’s active ownership practices, including engagement and proxy voting.

ESG integration is about understanding the impact of ESG factors on the risk-return characteristics of your assets. That doesn’t necessarily mean that you are promoting specific environmental or social factors. That happens when you use a binding approach or, at the furthest end of the responsible investing spectrum, a positive impact strategy.
Eric Borremans
Head of ESG, Pictet AM

Pictet AM is one of more than 4,000 asset owners and asset managers that are PRI signatories. The signatories have moved to integrate the PRI principles into their investment process and broader ESG stewardship efforts. As part of their commitment, asset managers work to promote ESG principles across the investment industry and report on their own progress in implementing the principles.

UN Sustainable Development Goals
The sustainable development goals are a set of global social, environmental and economic goals agreed upon by the United Nations’ member countries in 2015, with a target to achieve them by 2030. Some SDGs are investible goals, such as clean water and climate action. Others are more the purview of governments, such as establishing peace and strong institutions.

Institutional investors can use the goals to determine how companies are exposed to these aspects and to help determine where to aim their investment strategy for impact. Asset managers often align with the SDGs through focused, thematic strategies. For example, Pictet AM has thematic strategies focused on environment, water, nutrition, timber and clean energy, among others.

Sustainable Development Goals

Sustainable Finance Disclosure Regulation
The European Union’s Sustainable Finance Disclosure Regulation (SFDR Level 1) was introduced in 2019 and came into effect in March 2021. The set of rules aims to make the sustainability profile of investment funds more transparent and comparable. Ultimately, the rules are designed to give asset owners more clarity about a strategy’s sustainability characteristics and to prevent “greenwashing,” a term used to describe how some firms make misleading claims about the ESG credentials of their strategies.

Starting in January 2023 with activation of SFDR Level 2, more detailed disclosures, based on technical standards, will apply. This level provides specific guidance and templates on exactly how and where disclosures should be made, including principal adverse impact (PAI) reporting, pre-contractual templates or periodic reports.

Task Force for Climate-Related Financial Disclosures
The Task Force for Climate-Related Financial Disclosures (TCFD) is a task force created by the Financial Stability Board, with the support of some G20 member countries, to develop and promote more effective climate-related financial disclosures from issuers. The initiative is important because ESG investors depend on the quality of disclosure by the issuers. Disclosures in a standardized manner are important for investors to determine how companies are transitioning to a net-zero economy over the coming decade.

Net Zero Asset Managers Initiative
The Net Zero Asset Managers initiative is an international group of asset managers committed to supporting the goal of net-zero greenhouse gas emissions by 2050 or sooner, in line with global efforts to limit planet warming to 1.5 degrees Celsius. The initiative was launched in December 2020. As of November 9, 2022 there were 291 signatories—Pictet AM being one of them—that represent a total of $66 trillion in assets under management.

Science Based Targets Initiative
SBTi is an initiative that defines and promotes private-sector best practices in emissions reductions and net-zero targets in line with climate science. Science-based targets show companies and financial institutions how much and how quickly they need to reduce their greenhouse gas emissions to prevent the worst effects of climate change. SBTi is a partnership among CDP Worldwide (Carbon Disclosure Project), the United Nations Global Compact, World Resources Institute and the World Wide Fund for Nature. Pictet Group, parent company of Pictet AM, is a member of SBTi.

Top 10 Societal Issues in Sustainable Investing Today

Based on the interests of institutional investors, asset managers are creating impact strategies that focus on addressing specific sustainable themes. For Pictet AM, a few priority themes include water risk, which is becoming an urgent issue in many countries, and regenerative agriculture, because intensive agriculture is ravaging farmland in many regions. On the governance side, a key priority is getting companies to create a long-term corporate culture that fosters talent and nurtures sustainable performance.

Key investible themes today:
  • Climate change
  • Diversity, equity and inclusion
  • Clean energy
  • Water management
  • Waste management
  • Sustainable agriculture practices
  • Sustainable forestry
  • Biodiversity
  • Nutrition
  • Smart city (grid infrastructure)

Read: Biodiversity: Why Investors Should Care

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ESG ACROSS ASSET CLASSES

While asset owners can now apply an ESG framework across their entire portfolios, there are unique considerations for different asset classes. Here are some key takeaways that an institutional investor needs to be aware of in equity and fixed income:

Equity

ESG approaches in equity investing are the most developed among all asset classes. Many institutional investors have applied, or are familiar with, methodologies such as negative or exclusionary screens and integration of sustainability factors in portfolios based on company-level ESG ratings or scores.

  • Exclusionary screens: Often, institutional investors will mandate the exclusion of companies or industries that do not align with their sustainable investing objectives. Typically, exclusionary screens are determined in partnership between the asset owner and asset manager. Pictet AM’s own responsible investment policy excludes companies that derive a substantial portion of revenue from fossil fuels and nuclear energy, weapons production, tobacco, adult entertainment, gambling, genetically modified agriculture and pesticides.
  • Scoring of companies: One of the biggest challenges to ESG investing is applying increasingly sophisticated data — which usually comes from disparate sources — in a way that informs an investment thesis for a specific issuer. As such, investors need to understand and be comfortable with their asset managers’ internal framework for scoring companies on ESG factors.

The ESG Scorecard
At Pictet AM, the scoring framework revolves around a proprietary ESG Scorecard that provides a focused view of the ESG risks and opportunities associated with an issuer, based on a curated set of the most material data points across four themes, or pillars.

  • Corporate governance: Considers factors such as board competence and independence, executive remuneration, audit and risk controls.
  • Products and services: Examines how the company is generating its revenue. For example, are its products or services addressing public health or environmental issues? Is the company offering “clean and safe” products and services?
  • Operational risks: Provides a gauge of a company’s operational issues, including the carbon intensity of its operations and whether it is exposed to extreme weather events or other climate risks. It also analyzes factors such as whether the company is managing the environmental and social impacts associated with its supply chain.
  • Controversies: Examines and includes any negative issues that a company has been involved with, such as bribery and corruption, market abuse or product recalls.
 
Four Pillars of the ESG Scorecard

The ESG Scorecard “red flags” areas of ESG concern, while areas seen as positive are indicated with “green flags.” Flags can stem from each individual data source and are summed up at both the pillar and scorecard level. Individual or multiple companies can then be compared uniformly, within and across sectors and locations, to identify ESG leaders as well as laggards.

Sample of ESG Scorecard

Impact Investing
As society has come to understand the magnitude and scope of the environmental and social problems it faces, enterprises are rising to the challenge of addressing them. The growing solution set that addresses climate and other environmental concerns — and the growing demand for such technologies — has made thematic impact strategies a strong area of interest for institutional investors. According to Pictet AM, these strategies invest in stocks whose returns are influenced by structural forces of change that evolve independently of the economic cycle.

Read: Adding thematic equities to diversified portfolios

Investors should be aware that positive impact strategies address a specific environmental or social issue. This makes the investment universe much narrower, which could lead to tracking error when making comparisons to a standard equity index. In addition, impact strategies tend to require a longer time horizon, as services and technologies for an environmental or social issue can take time to develop. A typical impact investment horizon is three or more years.

Examples of Thematic Environmental Strategies

Private Markets
Applying ESG to private markets introduces a different dynamic of influence than in public markets. For example, a general partner for a private equity fund typically has more control over the business strategies of its portfolio companies than an asset manager holding public equity. The opportunity to shape corporate direction in terms of ESG risks and opportunities may be attractive to private market investors, and they can incorporate an ESG impact strategy with a measurable social or environmental outcome. However, private equity funds typically own fewer companies than a public equity strategy, and the overall ESG impact is usually much smaller.

Read: Climate Change and Emerging Markets After COVID-19

Fixed Income

Many ESG considerations for fixed income are similar to those for equity. Asset owners can work with their fixed-income managers to establish exclusionary screens or develop criteria for integration. Asset owners also need to understand their managers’ scoring processes. For example, Pictet AM uses the same proprietary ESG scorecard to evaluate issuers of corporate debt as it does for stocks.

The introduction of SFDR in the EU in 2022 has encouraged fixed-income managers to provide more clarity around ESG strategies and methodologies.

The nature of fixed income and the enormous size of the asset class has provided a springboard for engagement. As debt issuance tends to get rolled over, Pictet AM maintains long-term engagements with governments, corporate issuers, investors and asset managers in order to build strong relationships. And since institutional investor interest in ESG has grown globally, many issuers — both sovereign and corporate — welcome the dialogue, as they understand that investors require them to take action and meet international standards on sustainability.

Rather than using ESG as an input and a blunt tool, let’s have a conversation about what outcomes we’re looking to achieve and how we can work as a financial community across the buy side and the sell side to actually come up with solutions that make sense for our
asset class.
Mary-Therese Barton
Head of Emerging Market
Fixed Income, Pictet AM

Green Bonds, Sustainability Bonds and Social Bonds
Green bonds — debt issues raised to finance specific projects related to the environment, a majority of which address climate change — are an area of sustainable fixed income that has seen robust growth. Green bonds can be a constructive means for governments or companies to finance climate-change initiatives. As such, Pictet AM has actively encouraged select countries to start a green-bond program to help achieve environmental targets.

Sustainability and social bonds are similar to green bonds, but they support a greater cross-section of projects, including education, sanitation and clean transportation. Many of the specific objectives that the proceeds of these bonds support are still evolving, and standards are still being put in place.

Investors need to be wary of greenwashing, as there have been many instances of green, sustainable and social bond proceeds being used for purposes other than their stated environmental objective, such as refinancing existing debt. Investors need to look past the green label to assess whether the financing has a measurable sustainable effect.

Sovereign Issuers
Evaluating sustainability factors for sovereign debt adds a layer of complexity and more robust evaluation process. There is not yet industry consensus on how best to rate ESG for a country, given the lack of common standards and a dearth of reliable data. Applying a blunt ESG score, based on absolute criteria, can create a bias toward wealthier economies while a poor score can reflect structural impediments within a country that may be working to improve its ESG profile.

Read: Why EM bond investors can no longer ignore ESG

Typically, each asset manager has its own proprietary methods to assess how a country contributes to climate change and other factors relative to other nations. Pictet AM’s approach is to consider a range of quantitative and qualitative criteria and apply thoughtful judgment in an engaged and responsible outlook with sovereign issuers.

Pictet AM has also improved its qualitative assessment by adding climate scientists to its board, consulting with nongovernmental organizations and participating in sustainability research and policymaking endeavors. For example, Pictet AM has worked with EMpower, a global philanthropic organization focused on youth in emerging economies, to provide a more complete picture of a sovereign’s long-term sustainable trajectory in human development.

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WORKING WITH YOUR ASSET MANAGER

Sustainable investing has become more widely accepted, and most global asset managers embrace ESG factors in their decision-making process. But the approaches, methodologies and level of commitment among them varies considerably. Asset owners need to do their due diligence to determine how — and how well — ESG principles are embedded into an asset manager’s investment process and the firm’s culture.

Over the past two years, we’ve seen a significant change in terms of what investors are asking. They’re looking for a lot more detail about what we can do to urge companies to improve, how many engagements we’ve made and the aspects of their
action plan.
Xavier Chollet
Senior Investment Manager, Thematic Equities, Pictet AM

Is ESG supported from the top?
When ESG is encouraged by the chief executive officer and other C-suite executives at an asset management firm, it can have a cascading effect through the company’s culture. The commitment from top executives is best demonstrated not just by what they say about ESG, but also by what they do. For example, Pictet AM’s Co-CEO and Group Managing Partner Laurent Ramsey, sits on the investment stewardship and sustainability board that is responsible for driving the firm’s ESG strategy and coordinating its ESG and stewardship initiatives.

Does the asset manager engage with the scientific community on climate and other environmental issues?
The body of knowledge surrounding climate science continues to evolve. As such, asset managers dedicated to addressing environmental issues must step outside the realm of finance and collaborate with the scientific community to inform investment analysis.

At Pictet AM, scientific collaboration takes many forms. The firm produces research and thought leadership on environmental issues in collaboration with universities. University professors who are leaders in climate science and ecology are also on the firm’s thematic strategy advisory boards.

Example of Scientific Partnership: Pictet AM has partnered with the Stockholm Resilience Centre (SRC), a renowned international research organization behind the Planetary Boundaries (PB). The PB framework, developed at the SRC in collaboration with scientists around the world, is groundbreaking because it identifies the nine most critical environmental dimensions — including carbon emissions, freshwater use, land use and biodiversity — that are essential to maintaining a stable biosphere. The framework promotes a broader approach to environmental investing, at a time when the main focus is still on global warming.

Integrating ESG means that you’re adopting considerations of sustainability in your product offerings, not just in terms of screening through an ESG lens, but [also by] building in sustainability through strategic tilts, methodological weightings and other directional approaches.
Ella Hoxha
Senior Investment Manager,
Global Bonds, Pictet AM

Working with the SRC, Pictet AM has adapted the PB model to an investment metric by quantifying the environmental impact for every $1 million in annual revenue that a business generates. It uses the PB model to help define its investible universe and determine which firms develop products and services that can make a real difference in reversing environmental degradation.

Pictet AM is also a founding member of the Finance to Revive Biodiversity (FinBio) research program, which will be overseen by the SRC. The four-year research initiative aims to help the financial industry develop strategies that protect natural capital and halt biodiversity loss.

Read: Global Environmental Opportunities: transforming sustainable investment

Planetary Boundaries

Does an ESG-specific team work alongside the investment team?
While portfolio managers and analysts play a critical role in considering ESG factors in the investment process, some asset managers also maintain an additional resource: a dedicated ESG-specific team that works alongside the investment teams.

At Pictet AM, the ESG-specific team coordinates implementation of their responsible investment policy, including ESG integration in investment processes, risk management, training on ESG-specific issues and reporting tools. In addition, it keeps the investment team up to date on how ESG third-party data is evolving, and it coordinates corporate and sovereign engagement across strategies with the same issuer so that the firm can put its full heft behind an initiative.

What is the asset manager’s history with ESG investing?
While the ESG lens has been more widely adopted across Europe, it is becoming more popular with U.S. institutional investors, leading to the introduction of several ESG-themed products by asset managers. Asset owners need to understand their asset manager’s journey in ESG investing — when it started and how they have moved forward. For some managers, ESG investing is still relatively new. Others have provided ESG-integrated strategies, or even impact strategies, for two decades.

Pictet AM’s first environment-focused strategy, which addressed water scarcity, was launched in 2000.

How robust is the analysis of companies based on ESG criteria?
With ESG ratings and data now widely available, asset managers can often find outside sources to inform their ESG analysis on an issuer. However, asset managers who are dedicated to ESG tend to have a robust proprietary process that connects data from multiple sources and that weighs relative data points appropriately for each holding.

Pictet AM’s proprietary ESG scorecard distills all the disparate data, sourced both externally and internally, into a comprehensive view of an issuer’s ESG risks and opportunities.

Some of the ESG tools that have been developed and applied over time are now being tested. It’s an opportunity to adapt them and make them more relevant and applicable to ensure they’re material, meaningful and fit
for purpose.
Mary-Therese Barton
Head of Emerging Market Fixed
Income, Pictet AM
What are some sustainable practices undertaken by the manager?
Some asset managers take on the responsibility to run their own businesses in the sustainable manner that they expect from the companies they invest in. At Pictet AM, internal sustainable practices include the following key achievements and initiatives:
  • The firm reduced its own CO2 emissions per employee by 73% between 2008 and 2020.
  • Its balance sheet has been de-fossilized by following defined thresholds.
  • Its balance sheet is invested in activities that help speed up the transition to a low-carbon economy.
  • By 2025, it aims to cut its direct greenhouse gas emissions by 60% versus 2019 levels, with residual emissions mitigated through an approach that includes removing carbon from the atmosphere.
  • Its commitment to gender pay equity is confirmed by EDGE Certification Level 2, which includes an annual gap analysis as well as subsequent actions to enable progress.
  • The Pictet Group Foundation was established to fund impact-driven solutions that build resilient communities and ecosystems in the areas of water and nutrition.
Pictet AM Internal ESG Commitments

Is the manager part of broader initiatives to promote ESG industrywide?
While each investor can make a difference by allocating dollars to sustainable investing, long-term transformational change in global environmental and social challenges is a larger, collective endeavor. Some asset managers who are committed to ESG are involved in broader industry collaborations that raise awareness, promote best practices or further the body of knowledge related to sustainable investing.

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MONITORING AND BENCHMARKING

Perhaps more so than in traditional investment management, ESG and impact investing requires a close partnership between asset owner and asset manager. Below are some best practices for monitoring your asset manager’s approach to ESG investing and benchmarking.

Investment Process Checklist
There are a number of ways to monitor how an asset manager implements an ESG-integration and impact-investment strategy. Those run the gamut from performance updates to directional shifts on ESG factors to progress on stewardship efforts. Below is a sampling of questions that often come up in the monitoring process.

  • Did the portfolio manager change a weighting or sell a position because of ESG factors?
      •   If so, what was the rationale?
  • Within the portfolio, did the sector or industry tilts change?
      •  If so, what was the reason?
  • In proxy voting, how often did the asset manager vote against management?
      •   What were the reasons for its position?
  • What is the dialogue process on specific engagement issues?
      •   Is there an outcome?
      •   If the outcome failed, did the asset manager divest?
  • Are there any relevant updates to the data sourced externally or internally?
      •   How has the process changed, or will it change?
      •   Has the manager asked for any specific changes?

ESG Benchmarking
Most institutional investors track the performance of their active ESG strategies against a traditional stock or bond index and add material ESG key performance indicators (KPIs) to benchmark the strategy. Those KPIs can vary based on each asset owner’s mandate and goals.

The challenge is in the latitude that active managers are given on an ESG-integrated strategy to move away from a traditional benchmark. For actively managed traditional strategies, institutional investors are accustomed to a small tracking error, generally in the range of 2% to 3%. Asset owners need to be able to account for a wider tracking error for ESG strategies, and this can be particularly true for impact strategies.

For instance, Pictet AM’s positive impact strategies, such as its global environmental opportunities strategy or clean energy strategy, are typically non-benchmarked products. Each strategy aims to beat a broad market index, such as the MSCI World, but does not try to align with it. The comparison with a broad market index can, instead, be more helpful in determining what the ESG strategy adds in value versus a traditional benchmark.

Developments to Watch
Major index providers already offer ESG-specific benchmarks for passive strategies that institutional investors can use for comparison on their active strategies.

Developments in benchmarking and adoption of new benchmarks continue to accelerate, particularly in areas such as climate transition. For instance, targeted benchmarks, such as the European Union’s Climate-Transition Benchmark and its Paris-Aligned Benchmark, could become increasingly relevant to institutional investors as they focus on the transition to net-zero carbon emissions by 2050.

Both benchmarks consider the carbon footprint of the underlying assets. The Climate-Transition Benchmark brings the resulting portfolio on a decarbonization trajectory, and the Paris-Aligned Benchmark puts the resulting benchmark portfolio’s carbon emissions in line with the Paris Climate Agreement to limit the rise in global temperature to 1.5 degrees Celsius above pre-industrial levels.

Looking ahead, we expect to move toward more standardization in the next few years. We also expect to see increasing differentiation in terms of methodologies and
[a divergence in the market] between those
who take sustainability seriously and those who don’t.
Ella Hoxha
Senior Investment Manager,
Global Bonds, Pictet AM
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ACTIVE ENGAGEMENT AND STEWARDSHIP

Many institutional investors approach ESG investing with a dual mandate. Their first goal is typically to direct capital to issuers that already demonstrate favorable ESG characteristics while avoiding companies that have a poor track record on environmental or social issues. Their second goal is to put issuers on a more sustainable path. This is where engagement comes in, taking diverse forms.

Direct Dialogue with Corporate Issuers
Asset managers can engage with companies through proxy voting or through consistent dialogue with a company’s management or board of directors to encourage change on a particular ESG issue. Active managers that interact frequently with issuers consider engagement as an integral part of their broader ESG strategy.

For example, in 2021 alone, Pictet AM led or supported engagements with 270 companies on more than 300 different ESG topics. By topic area, the engagements included 55 on environmental issues, 122 on social issues and 156 on governance issues. Pictet AM has detailed its engagement initiatives in its Responsible Investment Report.

Collaborative Engagement
In specific areas, it can be more effective for asset managers to act collectively rather than individually, particularly when the manager’s investment is relatively small in relation to the enterprise value of the company. Below is a sampling of key initiatives by asset managers:

  • Climate Action 100+
    This initiative, led by global asset managers and asset owners, engages with the largest global greenhouse gas emitters and with other companies that are driving the clean energy transition, to achieve the goals of the Paris Agreement. By October 2022, 700 investors, responsible for over $68 trillion in AUM, had joined Climate Action 100+ to engage companies on improving climate change governance, cutting emissions and strengthening climate-related financial disclosures.

  • Ceres
    Founded more than three decades ago, Ceres is a nonprofit organization that works with capital market leaders to solve the world’s greatest sustainability challenges. Through a global collaboration of investors, corporations and other nonprofits, it drives action and inspires equitable market-based and policy solutions in the global economy.

  • Access to Nutrition Initiative
    ATNI is an independent nonprofit organization that works with corporations and other stakeholders to address the world’s nutrition challenges. Through engagement, research, partnerships and a range of private-sector accountability tools, it encourages businesses to do more to achieve good health through more thoughtful diets and improved nutrition.

  • Investor Mining and Tailings Safety Initiative
    This is investor-led initiative, covering 983 extractive companies, was launched in the wake of Brazilian mining company Vale’s Brumadinho dam disaster in January 2019. Key objectives are to develop the first public global database of toxic mining waste storage facilities and to create a new, independent global standard in tailings safety.

  • Investor Initiative for Sustainable Forests
    This joint collaboration between PRI and Ceres was created to raise awareness of the material financial risks of deforestation for companies sourcing commodities. It aims to foster investor engagement with firms to eliminate deforestation from supply chains.

Broader Stewardship Efforts
Asset managers and asset owners also participate in industry collaborations that seek to raise awareness, promote ESG best practices and further the body of knowledge related to sustainable investing.


ESG-Related Organizations, Initiatives and Partnerships in the Investment Industry*

Access to Nutrition Initiative (ATNI)
Carbon Disclosure Project (CDP)
Ceres
Climate Action 100+
Climate Bond Initiative
Copenhagen Institute for Future Studies (CIFS)
European Fund and Asset Management Association (EFAMA)
Finance for Biodiversity Pledge
FNG (Sustainable Investment Fund label)
FTSE Environmental Markets
Institutional Investors Group on Climate Change (IIGCC)
International Corporate Governance Network (ICGN)
Investor Initiative for Sustainable Forests
Investor Mining and Tailings Safety Initiative
Italian Sustainable Investment Forum
Oxford University: Smith School for Enterprise and the Environment
JP Stewardship Code
Spanish Sustainable Investment Forum
Stockholm Resilience Centre (SRC)
Swiss Climate Foundation
Swiss Sustainable Finance (SSF)
Task Force on Climate-Related Financial Disclosures (TCFD)
UK Stewardship Code
Science Based Targets initiative (SBTi)
Net Zero Asset Managers Initiative
UN Principles for Responsible Investment (UN PRI)

Note: *List includes groups that Pictet AM has been involved with
 

Source: Pictet AM, October 2022
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LOOKING AHEAD

As ESG investing receives broad attention across the investment ecosystem, adoption by institutional investors is moving toward a critical mass. Both regulators and asset allocators are keeping pressure on issuers to become more transparent in their ESG disclosures, and on asset managers to be transparent about their ESG strategies while also providing verifiable ESG credentials.

Many corporations have taken sustainability more seriously by hiring dedicated staff, modeling exposures, increasing disclosures and pivoting to adopt new business opportunities in the transition to a renewable economy. In anticipation of mandated reporting requirements, more corporations are issuing corporate sustainability reports that cover scope 1 and scope 2 emissions — those from their own operations and those from related third parties. To take the next step and measure scope 3 emissions, which occur across a company’s complete global supply chain, will require an enormous amount of work, but awareness and efforts to meet this goal are building.

The lack of standardized ESG metrics and disclosures continues to be a challenge. Current ESG scores don’t always provide appropriate context or adequate perspective. The proliferation of data providers and complex methodologies in the market can bring contradictory results. While a global, standardized methodology is much needed, it must account for a wide range of applications, objectives, quality of data and, ultimately, interpretations across countries.

Upcoming regulatory developments to watch include the SEC’s proposed rules that affect public companies, funds and investment advisers. One would mandate extensive and prescriptive disclosure requirements in companies’ annual reports and registration statements about climate-related risks and greenhouse gas emissions. The agency has also proposed rule amendments seeking to categorize ESG strategies and to require funds and advisers to derail their ESG strategies. If adopted, these changes could go into effect in 2023.

In Europe, the European Commission adopted technical standards, in April 2022, to supplement SFDR and the EU taxonomy. Meanwhile, the European Financial Reporting Advisory Group is developing EU sustainability reporting standards (ESRS) that are expected to support the European Commission’s proposed Corporate Sustainability Reporting Directive (CSRD), which could take effect in early 2024.

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GLOSSARY

Active ownership
This refers to investors addressing the ESG policies of companies and other issuers. It includes proxy voting at shareholder meetings and engagement with issuers and third-party fund managers on priority themes (climate, water, nutrition, long-termism) and other material ESG issues.

Best-in-class
An investment approach based on a sustainability rating in which a company's or issuer's ESG performance is compared with that of its sector peers. All companies with a rating above a defined threshold are considered as investible.   

Engagement
Investor-led dialogue with companies and other issuers on ESG matters with a view to share potential concerns, seek additional information, enhance public disclosure and/or influence behavior.

ESG
ESG stands for environmental (for example, energy consumption, water usage), social (talent attraction, supply chain management) and governance (remuneration policies, board governance). ESG factors form the basis for the different sustainable investing or responsible investing approaches.

ESG factors
ESG factors are ESG data (indicating both risks and opportunities) including sustainability risks and principal adverse impacts.

ESG focused
Investments that integrate ESG factors in order to enhance their risk-return profile and promote environmental and/or social characteristics. Environmental and social promotion seeks to increase exposure to issuers with low risks/high opportunities while decreasing/avoiding exposure to issuers with high risks/low opportunities (where applicable). An exclusion framework applies, along with focus on issuers with good governance in place, and with active ownership carried out (where feasible). ESG focused is equivalent to an article 8 SFDR*. Also see ESG integration; ESG factors; exclusionary screening.

ESG integrated
Investments that integrate ESG factors in order to enhance their risk-return profile. ESG integration includes ESG data availability, a defined framework, ESG data usage in the investment process, monitoring and disclosure of the ESG role in the investment process. ESG integrated is equivalent to an article 6 SFDR* and may invest in securities with high sustainability risks.

Exclusionary screening
An investing approach that excludes companies, countries or other issuers based on activities considered not investible. Exclusion criteria (based on norms and values) can refer to product categories (for example, weapons, tobacco), activities (animal testing), or business practices (severe violation of human rights, corruption). Also called negative screening. Please refer to Pictet AM’s responsible investment policy for more detail.

EU taxonomy
A classification system created by the European Parliament & Council that establishes a list of environmentally sustainable economic activities.

Greenwashing
A term used to describe misleading claims by asset management firms about the ESG credentials of their investment strategies.

Impact investing
Investments intended to generate a measurable, beneficial social and environmental impact alongside a financial return.

Positive impact
An outcome-focused investment approach that integrates ESG factors in order to enhance its risk-return profile, promote environmental and/or social characteristics and target activities that are environmentally and/or socially sustainable. Examples of thematic strategies are clean water or clean energy. Positive impact is equivalent to an article 8 or 9 SFDR*. Also see ESG integration, ESG factors, ESG focused, exclusionary screening and sustainable investments.

Principal adverse impacts (PAIs)
Negative, material, or potentially material effects on sustainability factors that result from, worsen, or are directly related to investment choices or advice performed by a legal entity. Examples include greenhouse gas (GHG) emissions and carbon footprint.

Principles for Responsible Investment (PRI)
The United Nations’ supported investor network that promotes and supports ESG integration into the investment and ownership decision process. Since 2006, the 100 original signatories have grown to more than 4,000 worldwide.

Proxy voting
In the context of the shareholder’s right to vote on certain corporate matters, the option for the shareholder to cast a proxy vote without attending the company’s annual and special meetings to vote.

Responsible investment
Any investment approach that integrates environmental, social and governance criteria into the selection and management of investments. It takes many forms, such as best-in-class investments, ESG integration, exclusionary screening, thematic investing and impact investing.

Sustainable Finance Disclosure Regulation (SFDR*)
The European Union’s set of disclosure regulations, effective March 2021, that requires asset managers and other financial market participants to be transparent in reporting sustainability risks in their investment processes and potential adverse impacts of investment decisions on sustainability factors.

Sustainable investments
An investment in an economic activity that contributes to an environmental and/or social objective, which might be aligned with the EU taxonomy, a classification system created by the European Parliament and Council that establishes a list of environmentally sustainable economic activities. Usually measured by the percent of revenue contribution of the activity, given it abides by the do-no-significant-harm principle. Targeting means having sustainable investment as its main objective.

Task Force on Climate-Related Financial Disclosures (TCFD)
The Financial Stability Board released the TCFD framework in 2017 to help public companies and other organizations disclose climate-related risks and opportunities in a more effective, standardized manner in their reporting processes.

Thematic investing
Investment in businesses contributing to sustainable solutions in environmental and social topics. Environmentally related investments include renewable energy, energy efficiency, clean technology, low-carbon transportation infrastructure, water treatment and resource efficiency. Socially related investments include education, health systems, poverty reduction and solutions for an ageing society.

United Nations’ Sustainable Development Goals (SDGs)
The set of social, environmental and economic targets agreed to by the United Nations for its member countries (such as zero hunger, gender equality, clean water, climate action). The SDGs are used by businesses to report on their sustainability efforts and credentials, and by investors who want to know how companies are exposed to the SDGs.

*Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector (SFDR).

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Quiz

Test your knowledge of ESG investing based on the information provided in this Guide. It offers a brief recap of some key areas of information related to ESG investing.

 
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