Updated with correction
Asset owners are significant, powerful investors and can play a leading role in the integration of environmental, social and governance factors and the move toward a longer-term horizon.
That significance means much is expected of them. Asset owners are the cornerstone of our capitalist system and have the ability to put a stop to many of our environmentally and financially destructive practices. The rate of adoption of responsible investment is, however, not as high as it could or should be. In fact, although it appears as if investors have become more socially and environmentally responsible, organizational reality begs to differ.
To find what influences the rate of adoption on the asset owner level, I interviewed 10 major players in the United Kingdom, the Netherlands and Germany, focusing specifically on those that outsource at least part of their listed equity portfolio, to capture potential agency issues.
The findings were analyzed in the context of Innovation Diffusion Theory, explaining how, over time, an idea gains momentum and spreads through a specific population. Such an analysis sheds light on the way asset owners perceive ESG and how they translate it into their investment strategies.
I started by looking at the perceived attributes of an innovation, which in this case is responsible investment. It appears asset owners are not (yet) fully convinced of the business case of ESG. Responsible investment is also not something you can easily try out, given that pension assets are at stake and switching asset managers is costly. Still, what is striking is that fiduciary duty is not seen to be an issue anymore; it was not mentioned even once during interviews as an obstacle. This is connected to another finding that none of the respondents believe responsible investment destroys value. However, they also do not all believe it increases returns. This lack of belief in the business case might very well be the reason not everyone translates their claimed preference for ESG integration into action.
I also found there is room for improvement in communication among asset owners and asset managers and that there is a lack of effort by asset owners to influence their asset managers. Communication, is a central element in the diffusion of an innovation. Exposing members of a social system to continuous ESG discourse helps in making it the dominant paradigm. Especially given the complexity of responsible investment, dialogue is important, as this is a more effective communication channel than written communication or having rules in place regarding ESG but not talking about them. However, the findings show there is currently insufficient dialogue between asset owners and asset managers when it comes to ESG. It is not just the complexity of ESG that makes dialogue more difficult, but also the outsourcing of the investment function and the cooperation with, in some cases, (too) many asset managers. Noteworthy here, are Dutch asset owners. They work with fewer asset managers and thus have closer relationships. Their monitoring process is thus less complex and can be more intensive.
Additionally, I found that the extent to which asset owners are pushing their asset managers to integrate ESG by setting hard standards or by tying ESG to compensation is not sufficient. Asset owners' due diligence in determining a manager's incorporation of ESG mandates is there in 60% of the cases, but some still merely ask their potential managers if they are a signatory to the U.N. Principles for Responsible Investment.
To really understand the way a money manager integrates ESG, one must lift the veil. Asset owners should ask managers about the quality of information and its impact on investors, what strategy they think is best, how this is implemented, etc.
In addition, not many of the respondents asset owners interviewed have a thorough monitoring and review process. Very few interviewees have ESG requirements or targets in their mandates.
The asset owners interviewed are anchored in different countries, which might have a substantial impact on the extent to which they have integrated ESG. Overall, there is too much uncertainty around how to capture ESG. Nevertheless, many of the Dutch asset owners have managed to translate their words into action.
The U.K. respondents are working hard on doing the same, although they are hampered by the number of manager relationships they have. The asset pooling by the Local Government Pension Scheme will make the space more competitive for asset managers and could improve the adoption rate of responsible investment as well. After all, smaller pension schemes will be pooled with larger ones that likely have more ESG expertise, given that size is often a proxy for resources.
Germany is a laggard in this sample, as asset owners there do not appear to challenge their managers much when it comes to responsible investment. However, it must be noted that not only is the German pension system less developed than the U.K. or Netherlands or , but also their equity exposure is much lower. They do not have as much weight to pull as asset owners in the U.K. and Netherlands.
Asset owners must believe ESG integration enhances returns, for it to really become mainstream. If it does not become part of the mindset, ESG is unlikely to ever truly become integrated.
Stephanie Mooij is a doctoral researcher at the Smith School of Enterprise and the Environment, Oxford University, Oxford, England. Her full paper can be found here. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.