Investors taking hard look to ensure firms will be following rules

Institutional investors in Europe have been increasing manager monitoring to ensure they are getting the best environment, social and governance results.

Investors are up against a March deadline to show how they have incorporated ESG factors into their portfolios under the European Union's Sustainable Finance Disclosure Regulation. First agreed to in 2019 by European institutions, the regulation puts an obligation on both investors and managers to show how their portfolios influence the environment, climate change and biodiversity. Investors and managers also need to show how they align with the EU taxonomy of environmentally sustainable activities.

And investors say they will not work with managers that are not demonstrating robust ESG integration and are not scoring high on investors' own ESG criteria.

Investors appear to be moving more decisively toward complying with the new rules than their money managers. A survey of 300 institutional investors in Europe published on Oct. 19 by PricewaterhouseCoopers Luxembourg showed that 77% will stop buying funds that do not demonstrate high levels of compliance with the new ESG requirements in 2022. The same report showed that only 14% of 200 surveyed managers will stop selling non-ESG strategies after that year.

While investors say they are not immediately going to terminate managers with an offering that isn't meeting their ESG requirements, they are making their manager selection and monitoring processes stricter. Sources said that managers that fall below investors' expectations will not be extended when their contracts are due to be renewed.

Meanwhile, managers said they are facing challenges with repurposing their traditional strategies into an ESG version and some believe not all of their strategies could be converted. Under the SFDR rules all financial market participants, including money managers, must integrate ESG risks into their investment processes and products. By 2022, the regulation will be reinforced with amendments requiring similar integration to those mandated under other EU financial services directives, such as the Alternative Investment Fund Managers Directive and Markets in Financial Instruments Directive II. Sources said mixed requirements from investors when it comes to exclusions, for example, could lead to assets being moved into segregated accounts or managers being forced to launch brand new strategies.

"Some of the managers haven't really integrated ESG into their thinking and their due diligence and we have been trying to push them in the right" direction, said Mikael Bek, head of ESG at PenSam, the 152 billion Danish kroner ($23.9 billion) multiemployer plan for elder care, technical service and education workers based in Farum, Denmark.

PenSam uses an ESG scoring system that influences hiring decisions. Managers must obtain at least 30 out of 60 points in areas such as policy, ESG integration and active ownership. PenSam's managers also must be signatories of the Principles for Responsible Investment. Mr. Bek said two managers that run an illiquid credit strategy and a fund-of-funds strategy, respectively, are currently scoring below the fund's threshold. Although he did not name the managers, Mr. Bek said that after consideration of the strategies these contracts will not be extended when they expire.

The managers that are the most challenged are illiquid credit managers, he said, "because they are new" to ESG integration. Conversely, managers can improve under the fund's direction, Mr. Bek said, noting three of PenSam's equity managers had improved scores and were retained.

National Employment Savings Trust, London, a defined contribution multiemployer plan in the U.K., has taken similar steps. Since July, the £13 billion ($16.8 billion) fund has required its managers to align the portfolio with efforts to limit global temperature increases to 1.5 degrees Celsius and has given them three years to show alignment. NEST's current managers, which will be assessed annually, will also be expected to exercise voting rights and engage to positively influence portfolio companies. Managers that cannot demonstrate their commitment to meeting these expectations will not be selected or reselected.

Despite the U.K. leaving the European Union and not falling under EU regulations, the upcoming U.K. Pensions Schemes Bill will require that multiemployer plans and large pension funds report on the climate impact of their portfolios against guidelines under the Task Force on Climate-related Financial Disclosures standards. The U.K. Financial Conduct Authority is also working to align money managers with the requirements under its own rules, with an obligation to follow TCFD recommendations, to be effective in 2022.

Separately, all U.K. plan trustees are already reporting on ESG integration and implementation due to a requirement introduced Oct. 1.

Tim Manuel, U.K. head of responsible investment at Aon PLC in London, said trustees are forced to scrutinize managers — and the firms' seriousness on ESG integration varies.

"One scheme is in the process of sacking (its) manager because trustees were not satisfied with how the manager conducted engagement activities," he said. Mr. Manuel said the plan, which he did not name, concluded that the manager did not justify its action on gender pay gap with a non-European portfolio company. "They voted against the company (having to produce) a gender pay gap report."

Many managers are not moving toward ESG integration at the same speed as investors, sources said, adding that managers could face terminations when mandates come up for renewal.

"In Europe, you are starting to see (that) a lot of buyers on (the) bank network level as well as on the institutional investor level are saying, 'we won't buy any assets unless you explain how your active investment process complies with any ESG principles, let alone ours,'" said Benjamin F. Phillips, principal and lead investment management strategist at Casey Quirk, a practice of Deloitte Consulting LLP, in New York.

Mr. Phillips said it will be difficult for managers to sustain offering both ESG and non-ESG strategies. "It will be hard for buyers to say they want the non-ESG component unless it is returning dramatically more. But I don't think anybody has the data to show that," he said.

Money managers say they could come up against operational, commercial and compliance challenges even if they plan to change their offering to integrate ESG factors. Some managers moved to launch new products rather than repurpose traditional offerings because of these challenges, sources said.

"Investors will have different views with how far they are ready to go, and they have different appetite for exclusions," said Luba Nikulina, global head of research at Willis Towers Watson PLC in London. "You have a range of views from investors to what degree fossil fuels should be excluded. That's why it is difficult for managers to come up with a standard product. That's a big constraint," she said.

But the spirit of the regulation was to apply it to all investment portfolios, Ms. Nikulina said. "This raises a question(of) why managers are raising ESG funds as separate products," she said. For traditional funds, it could potentially be very cumbersome to achieve a conversion because managers would have to get all of their investors in agreement, she added.

Under the EU's regulation, managers can opt out of incorporating ESG into traditional investment products as long as they communicate it to investors in fund prospectuses. Speaking about the transition, Carlo Funk, Europe, Middle East and Africa head of ESG investment strategy at State Street Global Advisors Ltd. in London, said communication with investors is becoming more important to manage the transition and investors' expectations.

"We will only do this (ESG conversion) if we see positive value or if (we) definitely won't see a value decline. Otherwise we would never do it. Because ... that would be a violation of your fiduciary duty," he said.

Mr. Funk added that in the short term there will not be a 100% conversion in the market. In 2022, "I would think there will still be demand for non-ESG products. It will take some time. The market will not shift so quickly," he said.

Mr. Funk also noted that certain strategies could be more difficult to convert than others. Managers need to check if integrating an additional dimension such as ESG into a sophisticated model doesn't harm an existing product, he added.

Managers are also facing challenges with regulatory clarity when repurposing funds in Europe, added Emily Chew, global head of sustainability for investment management at Morgan Stanley in Boston. Ms. Chew said individual European countries such as France and Germany are launching their own fund classifications that are often not consistent with those envisaged by the EU's disclosure regulation.

The EU disclosure regulation is intended to line up with the EU taxonomy — a separate regulation that sets out criteria for determining whether an economic activity is environmentally sustainable — that has not yet been finalized.

"We are also having to set objectives in a way that is trying to anticipate where we think the EU taxonomy is likely to go, because the EU disclosure regulation is intended to line up with the EU taxonomy regulation," Ms. Chew said. "That is an awkward position to put the asset management community in."