European investors look to align sec lending programs with ESG

Investors in Europe are adapting their securities lending programs in response to challenges in incorporating environmental, social and governance objectives.

While investors like to put certain securities out for loan in order to earn extra profit, they are at the same time being pushed by European regulators to take ESG factors into account across their portfolios. That means paying more attention to how their securities lending activities align with their responsible investment objectives.

By offering their stock out for other investors to borrow, asset owners can earn between 0.5 and 5 basis points of return on assets on loan per year depending on the portfolio, sources said.

But despite these benefits, as investors are being pushed by European regulators to move assets to ESG strategies, they are starting to pay more attention to how their securities lending activities align with their responsible investment objectives.

Having been mandated by regulators to implement new ESG policies for their investments over the past year or so, investors in Europe and the U.K. are now extending such policies to cover their securities lending programs. Changes include excluding certain sectors such as tobacco and fossil-fuel companies from the collateral investors will accept in return for stock out on loan, restricting the loaning of shares that investors want to vote on, and, in some cases, reducing the amount of shares to lend out.

Securities lending is one of the topics that investors are rethinking or readjusting when it comes to their sustainability efforts, said Adam Gillett, director and head of sustainable investments at Willis Towers Watson PLC in London. Asset owners are "asking fund managers about their approach and challenging their asset managers. It's not something that was done much before," Mr. Gillett said, referring to the changes that investors have been making in the recent years.

One of the key issues that investors and their managers are taking action on is refining requirements around eligible collateral, in order to align with fund objectives. If that is not done in line with ESG principles, investors risk ending up getting stocks they would otherwise exclude from their investments.

"The issue does arise when you take equities as collateral because then you might take in equities that you have restrictions on," said Roelof van der Struik, investment manager at PGGM who manages the securities lending program of the €238 billion ($290.2 billion) Pensioenfonds Zorg en Welzijn, Zeist, Netherlands, in a telephone interview.

For this reason, when in early June PFZW approved accepting equities as collateral in PGGM's securities lending program, which will start in the summer, its exclusion list was applied to its collateral requirements. The decision to accept equities was based partially on risk considerations, but also because it makes sense in terms of matching the type of collateral it receives with the securities it has put out on loan, Mr. Van der Struik said.

Collateral requirements are also under review by some managers to ensure they comply with ESG and responsible investment policies when it comes to their ESG and responsible investment strategies.

"We started to look at the type of collateral that we are receiving against (our) ESG criteria," said Matthew Chessum, investment director at Aberdeen Standard Investments Ltd. in London, in a telephone interview. "The reason we do that is because we firmly believe that the investment strategy should be followed throughout all (of the fund's) activities."

Mr. Chessum said that the firm recently adopted an MSCI ESG screen index overlay on top of its existing collateral requirements, which means Aberdeen now excludes tobacco and fossil-fuel companies from the equities it accepts as collateral.

"We are trying to ensure that we are not financing (non-ESG) assets through the acceptance of collateral," Mr. Chessum said, referring to the ESG mandates.

But sources added that aligning collateral with their ESG objectives hasn't been an easy task because custodians and tri-party agents, which act on behalf of lenders are also having to adapt their processes before they can apply individual investors' ESG policies effectively.

"It's important that everybody adheres to some basic governance rules to make (securities lending) ESG (compliant). Securities lending is a good product, but it is at its infancy in terms of ESG. As an industry, we have to step up and improve that," Mr. Van der Struik said.

Mr. Van der Struik, who doesn't have in-house resources to evaluate collateral on his own and outsources it to PGGM's custodian Citigroup Inc., said custodians tend to comply with requirements given by beneficial owners, but they struggle to apply exclusions swiftly. For example, a pension fund that is actively engaging with portfolio companies may want to alter its exclusion list regularly to reflect ongoing engagement efforts. "They are fine if you ... don't change (the exclusion list) but if I want to change (it) regularly, they can't do that," he said, referring to custodians. "They need investment" in systems, he said.

Mr. Van der Struik added that tri-party agents don't always insist on receiving ESG-friendly collateral. "Either tri-party agents have to become more flexible to change their guidelines or come up with a standard list assuming which companies should be excluded," he said.

Aberdeen's Mr. Chessum also noted that the firm has its own challenges when it comes to applying ESG requirements to all of its equity securities lending activity. For example, he said, Aberdeen is not able to take emerging markets equity as collateral in lending transactions from its emerging markets climate fund due to existing policies around the suitability of such assets as collateral. "We can't remain aligned because we wouldn't take (these equities) on a normal fund," he said.

Investors are also taking action to ensure they can execute their votes at company annual general meetings by restricting the stocks managers can loan or making sure those stocks can be recalled as needed.

For example, for its pooled funds, the £17 billion ($24.1 billion) National Employment Savings Trust, London, either expects managers to be able to recall shares that are loaned out or expects managers to restrict the lending of shares of companies that will be voted on or are being engaged with, Fezhaan Yousaf, fund administration manager at NEST, said in an emailed comment. NEST also enhanced its scrutiny of managers who are required to have a clear securities lending policy and update NEST about any changes to the policies, he said.

Noting that the 2020 version of the U.K. Stewardship Code specifically highlighted the implications of securities lending for good stewardship, WTW's Mr. Gillett added that a vast majority of asset owners expect that shares are recalled for key votes.

But while managers have the ability to recall securities quite often it is not happening in practice.

WTW's research showed that managers might state in their securities lending programs that stocks can be recalled but are rarely providing specific examples of action that was taken, Mr. Gillett said. "Often a manager will have a policy that they can recall ... but feels (a recall) won't make a difference on (most) votes." Other sources added that managers may in some cases assess whether they can win votes before recalling shares.

NEST also reduced some of its securities lending activity following a move to segregated accounts from some pooled funds under its new climate policy launched in July. About 70% of its default fund assets are now in segregated mandates.

Although securities lending is subject to increased regulation and transparency requirements in Europe, it still carries risks, Mr. Yousaf said. "These include counterparty, collateral and operational risk. Managing these risks in a segregated fund is likely to be more resource intensive and likely outweigh the financial benefits."

NEST said in its 2020/2021 responsible investment report that as a lender it can't exercise its voting rights on its shares unless they are recalled in time for voting, which could reduce the plan's influence through engagement activity because its shareholding would be diminished. NEST is also concerned about the limited transparency of borrowers.

Following concerns that were raised by investors, industry bodies The Risk Management Association and Pan Asia Securities Lending Association jointly launched an ESG framework on May 27 to give guidance to market players. The recommendations included developing a policy for recalling loaned securities based on ESG considerations, applying the same ESG standards to the non-cash collateral that lenders are prepared to accept when they lend securities, applying an ESG lens when selecting direct counterparties and identifying potential conflicts between borrowers' market and lenders' corporate ESG commitments.

Paul Solway, PASLA's director and communications officer, said in a telephone interview that recalling shares when market timing isn't right can have an impact on investors' earnings as well as unintended consequences on the market depending on how big the recall is. But he said that these risks can be managed if investors state that they want to recall in advance.