With remarkable divergences in ESG adoption across regions and by asset class, three leading experts discuss both the “push” and “pull” factors driving institutional ESG investing today. Pensions & Investments spoke with Nalini Feuilloley, director of the responsible investment team at BMO Global Asset Management; JJ Wilczewski, managing director, head of institutional client group, Americas, and global head of consultant relations at DWS Group; and Rakhi Kumar, senior managing director and head of ESG investments and asset stewardship at State Street Global Advisors.
P&I: What are your conversations about ESG with clients focused on these days?
Nalini Feuilloley: We’re definitely hearing a lot around climate change, questions around TCFD [Task Force on Climate-related Financial Disclosures] and new standards that are coming into the market. Impact investing is the other area that is really taking flight in client interactions. This includes reporting on investments mapped to the Sustainable Development Goals and outcomes from company engagement. Clients are also interested in how to measure ESG outside of traditional financial performance.
Rakhi Kumar: I agree that climate strategies are probably top of mind for many clients globally. In addition, we’re having a lot of conversations on data quality and financial materiality of ESG data, which are leading to conversations on integrating this information into an investment process, what’s right for different strategies, etc. And the last bit is reporting and getting our clients information on what the ESG profile of their portfolio looks like.
JJ Wilczewski: I would add one comment and say that, particularly in the U.S., views are inconsistent and disparate client-by-client. The most pressing thing we hear is, “Educate me. Help me understand the regulatory dynamics in Europe and the U.S. and how to think about ESG versus [socially responsible] investing versus impact investing. Help me understand if indeed there is a material impact on my portfolio from a risk-reduction or return-enhancement perspective.”
P&I: How have those conversations changed over the last five years?
Wilczewski: If you go back five years, there was little to no ESG conversation versus today. If you go back even three years, less than 20% of the RFPs [requests for proposals] that we received had any language around ESG. Today, over 80% of the RFPs we receive ask for our ESG process.
Kumar: I agree about the change in RFPs. Five years ago, in the U.S., ESG requests were coming from a compliance perspective. Now it’s more, “How are you doing it from an investment perspective?” That’s a big perspective change. Though clients want more education, they’re also more informed and aware of the questions they need to ask. Conversations have become deeper. Clients are also open to more complex conversations around strategies and construction of strategies. Also, the review process goes beyond just financial performance to include ESG performance and the ESG objectives of a fund.
Feuilloley: My experience is somewhat different from my colleagues on this roundtable. Five years ago, clients were looking at ESG factors through a risk-based lens, asking: “How can we mitigate risk by looking at these nontraditional factors?” We’re finding that the conversation today has moved along significantly and that people are also now looking at the opportunity side of sustainability challenges: “How can we take advantage of the growth opportunities in sustainability, such as addressing huge concerns like climate? What companies are cutting edge in their thinking and tackling the more pressing issues? Also we want to be able to measure the impact that we’re having by being invested in this strategy.”
P&I: What is your area of ESG focus? How has that evolved over the years?
Kumar: We’ve been doing this for 38 years, originally as implementers. Over the past three to five years, we’ve become active in developing perspectives around ESG as a manager, and educating ourselves internally. That has resulted in a lot of training of existing portfolio managers and researchers, hiring of teams, etc.
The biggest change is that we approach ESG from a value-driver perspective, focused on financial materiality. We educate our clients about what we as asset managers see as data challenges. We have responded to that by creating our own scoring mechanism that is transparent in its methodology and integrating it into our stewardship program. Stewardship is very much a front-and-center part of our ESG strategy, as it is for all our other strategies.
Wilczewski: We’ve been involved in this topic for over 20 years. We have crystallized our thinking of how we’re going to add value to our clients, focusing on three themes: integration, partnerships and corporate activity.
We are moving to full ESG integration across our investment platform.
We have built an ESG engine that takes eight different ESG data providers and aggregates that data. It gives our portfolio managers and ultimately our clients the ability to see an aggregated ESG rating score for every security they’re considering and across their portfolio.
We also launched the first ESG money market fund last year in partnership with one of our large corporate clients. We’ve launched a clean energy solution with another corporate client to help their supply chain become greener. And finally, we’ve launched an African clean energy fund and another micro-finance solution.
For our corporate activity, we’re very active in the proxy voting space. We have voted 95% of the time in favor of climate-related resolutions. If we espouse ESG sustainability values for investors, we certainly have to live those ourselves.
There’s a much greater push by us on societal impact. We’re finding ways to engage in local communities to have an impact, such as supporting and helping with the cultivation of the garden of an inner-city school in Chicago. Again, for us, it’s not just being investors, but being positive contributors to society.
Feuilloley: We’re managing our assets in a responsible way, but we’re also taking responsibility to be advocates from a policy perspective. We think policy is going to drive this industry forward, and we’re engaging with regulators around the world.
The pillar that’s definitely evolved at the center of our program has been around active ownership, which refers to both engagement and proxy voting activities. In the past, we were focused a lot more on how information was disclosed [about] our holding companies. Now, we’re talking to the board and to very senior management about the core business priorities, and the strategic plans of companies, in regard to their business practices and how [these tie] back into sustainability. We have quite a track record in terms of how we vote on our proxies when it comes to ESG issues. In 2017, for example, over 25% of the time we voted against management. We’re taking our position as stewards of capital to affect change really seriously.
P&I: Climate change has already been mentioned as a common talking point with clients, and indeed, it seems to be the biggest ESG issue at the moment — or grabbing the most headlines. What do you think of this issue from an investment management perspective?
Kumar: We have identified climate change as one of the biggest risks facing companies. In terms of how we use our voice, as the third-largest investor in the world, we’re actively educating both companies and investors.
We have conferences for clients and are developing innovative solutions. We are able to tell clients “Look, it’s no longer just a risk, it’s also an opportunity, and you need to start investing in more sustainable companies.” In addition, we evaluate company disclosures around climate change using the TCFD framework. We keep improving disclosure as well as getting companies to incorporate and consider climate as a risk in their strategy.
We’ve played a key role in talking about data challenges. A client of ours once said, “I’ve just got my carbon emissions of my portfolio down by 50%.” And we asked, “How did you do that?” and they replied, “Well, we just changed the data providers.” Understanding the data challenges, especially as an investment manager that is advising clients, is vital to addressing this issue responsibly, and from a fiduciary perspective.
Feuilloley: We agree that climate change is front and center. We’re looking at it from a risk-management perspective. We’re thinking about the assets that we’re managing on behalf of our clients and the timelines that we’re all facing in terms the effects of climate change being irreversible.
The U.N. has made a lot of calls to action around year 2030, and so with that timeline looming, we’re starting to think through the impacts on our portfolios. The [U.N. Principles for Responsible Investing have] been championing the concept that if countries and sectors and companies don’t mobilize around this timeline, we’re going to see an “inevitable policy response.” What does that mean from an investor perspective in terms of the future value of our holdings? What we’re doing about climate change is critical. (“Inevitable policy response,” or IPR, predicts a rapid and forceful international policy reaction to climate change with widespread financial implications. The IPR project forecasts a response by 2025 that will be forceful, abrupt, and disorderly because of the delay.)
P&I: What areas of institutional investing do you think are trailing in the use or adoption of ESG? Put another way, what are the limitations to institutional investing with an ESG focus?
Feuilloley: There are different types of institutional investors. Our experience is that corporate pension plans are trailing — in terms of the use of ESG — the progress made by the larger public pension plans or foundations/endowments that are more mission-driven.
Limiting the investible universe is another challenge. A lot of people, especially on our side of the pond in North America, don’t think of divestment as one of the leading approaches to responsible investment. I think opening mindsets to divestment as a solution for driving sustainability is another area that institutional investors are trailing.
Wilczewski: One interesting dynamic that we see occurring in the U.S. institutional market is a bit of a red state/blue state dynamic, where pension plans in the historical blue states are a little more forward leaning when it comes to ESG. And then we find other plans that are more reticent to embrace ESG and are using the fiduciary rule as a defense because of the assumption there’s a trade-off between ESG and risk-return.
While it’s very clear to me that the folks on this roundtable are on the leading edge and can clearly articulate how we think about ESG, the asset management industry as a whole is not as far along. Every asset manager that says something different in terms of how, or even if, they think about ESG, creates confusion and a headwind. Now you have CIOs or even boards just completely confused.
P&I: Is the confusion about the constantly changing definitions of ESG or is it about the data inconsistencies?
Wilczewski: Data inconsistencies, nomenclature inconsistencies and material impact inconsistencies. We’ve probably all been on panels where one asset manager will say that ESG does not have a material impact, therefore as a fiduciary you shouldn’t worry. There are others who say ESG is simply a set of risk factors that we’ve always considered and why all the noise around ESG as a differentiated approach? These different schools of thought and differences in nomenclature, data and definitions, unfortunately, has hurt the rate of adoption in the U.S.
Kumar: I agree, but to add, we did a survey of 300 institutional clients, which we released last November. We found that ESG adoption within real assets, like infrastructure, real estate and private equity, is very low in contrast to equities. Fixed income, which used to be a laggard, is now catching up.
For example, among all our respondents, 1% said that they were integrating ESG in the infrastructure space, 2% in real estate and 5% in private equity, compared to 92% in fixed income and 100% in equities. What’s really limiting a further embracing of ESG is really the lack of standardization, data quality and internal expertise. There are not enough people out there who have enough experience and understand ESG investing.
P&I: Why do U.S. institutional investors trail their European counterparts in ESG investing?
Kumar: In our survey we found that Europe is leading and the biggest driver is regulation, while in the U.S., they’re coming to ESG slowly but they are coming from a fiduciary perspective. The buy-in from senior management is high.
Feuilloley: There are fundamental cultural differences between North America and Europe. I’m not saying that these differences cannot evolve, but it’s just that values versus value [moral values versus the traditional value-based objective] is not at the core of what we’re hearing in North America. Whereas in Europe, they’re not shy to say that this is the right thing to do and it’s their responsibility.
In North America, a lot of the narrative around buying into ESG has been that it is material, it’s a risk that needs to be considered, which is why there is a smaller uptake. Ten years ago, Americans might not have thought of climate change as an investible issue, and today they do. So I’m very hopeful for the next decade that the U.S. will catch up. It’s just a matter of time.
Wilczewski: Nalini, what you said is right on. There’s clearly a societal difference and societal embrace of sustainability throughout Europe, even broadly internationally. Here in the U.S., it’s been slower to take hold. A lot of it has to do with regulation. The one thing I’m optimistic about is on the political side.
I was talking to our head of governmental affairs, who said that there’s a real bubbling up within Congress around climate. It’s not highly publicized because it’s a polarizing issue. He pointed to the Climate Caucus, which is made up of Republican and Democratic legislators. It’s matching the intersection of commercial viability with better environmental awareness and business practice, and all things with respect to ESG. It could really be a great motivator to create legislative change.
So that, coupled with how important these issues are to millennials, will help us catch up to Europe and hopefully ultimately take a leadership position.
P&I: How important is regulation and initiatives like the UNPRI and its 17 sustainable development goals for driving change?
Kumar: Regulation does result in action. An area that is being discussed in the U.S. is the Securities and Exchange Commission conversation around human capital disclosure. The U.S. will lead from a disclosure perspective because in the U.S., what’s disclosed gets measured and what gets measured gets managed.
I would say that we may start seeing some push for more ESG disclosure or at least no barriers to ESG disclosure.
Feuilloley: In terms of regulatory development, we’re in this really important phase where the [European Union] taxonomy for sustainable development has recently been voted into law. I think it’s a huge step forward that’s going to affect [not] only European firms, but [also] organizations around the globe.
In Canada, a similar taxonomy is being developed. Canada is a resource-heavy economy, and so these taxonomies need to be developed delicately, and similarly in Australia. In the U.S., there’s been a lot of great progress made on a state-by-state basis. So I’m very hopeful.
The PRI [is] an independent non-for-profit member-driven association. [It’s] not responsible for writing or drafting legislation or policy, but [pushes its] collective members to lobby different governments to do more in this space.
P&I: What do you see as the biggest challenges to continued growth of ESG/sustainable investing? Do you think these challenges can be overcome in the immediate future?
Wilczewski: I’ll go back to what I said before, and that over 80% of the RFPs we’re seeing today have asked for ESG information. In nearly all institutional team meetings, ESG comes up. There’s an appetite amongst financial advisers and institutional investors to gain more information.
This societal change, driven by millennials and the global regulatory framework that’s being led out of Europe and slowly advanced in the U.S., will continue to push the demand for ESG solutions.
It’s up to leading asset managers like us to help frame the narrative the right way and to provide the data, research and analytics to help investors make good decisions.
Feuilloley: I don’t necessarily see massive challenges in the continued growth of the space; the momentum is there. There is definitely going to be a need for consolidation of data providers, just like what we have on the credit side for rating agencies. In terms of demand, from what we’re seeing in generational wealth transfer and from millennials, this area is going to continue to grow and permeate the mainstream. I’m really optimistic about the future of the space. There is a lot coming together.
Kumar: While we also expect to see continued growth, data coverage and issues around standardization are going to be challenges to overcome. In our survey, when we asked the question “What’s keeping investors away from ESG?” answers suggested that data remains a concern, particularly around consistency and coverage. Coverage is important because if you want ESG to go mainstream, it has to go across the portfolio, and the data quality in different markets, especially emerging markets, is patchy and the coverage for real assets is challenging.
In addition, the human factors, the lack of ESG expertise, requires some overcoming before we can really move forward at a fast pace.
P&I: Can you give us a real-world example of an impact your firm had?
Kumar: I hold up “Fearless Girl,” our initiative around the lack of gender diversity and bringing increased attention to the issue.
We started that campaign in 2017. We’ve had significant impact, in that now close to 50% of the Russell 3000 companies we identified as not having a woman on their board added a female director or committed to doing so. Now all S&P 500 companies have at least one woman on the board, whereas [in 2012, one in eight S&P 500 boards was all-male]. It’s been a big change.
We write a lot of thought leadership, too, on issues such as corporate culture. The best compliment we got on this work came when we put out a paper on climate change and our expectations around reporting from oil and gas utility and mining companies. A corporate board member said, “You know, we took your paper and each director read it. We discussed it and it influenced how we are going to approach reporting.”
Wilczewski: Two things stick out. With our ESG data engine we are able to help our clients understand the ESG exposure embedded in their portfolios. Once they’re aware of it, they can report to their boards and determine if they want to change their mandate to have a more ESG-friendly portfolio. That’s been a game changer. There’s typically a wow factor when we tell an investor, “Here’s your portfolio and here’s its ESG impact.”
One of the areas that we’re seeing activity is on the corporate balance sheet side. We do a lot of work with corporate treasurers. They’re now saying that their board, CEO and CFO are asking everyone in the organization to explain how they’re thinking about their job through an ESG or sustainable-investing lens.
With one large corporate client, one of the largest technology companies in the world, we are building an investment solution that’s helping to make their supply chain greener through renewable energy, better governance policies and procedures, and better efficiency. That to me is an investment solution, but it’s also a societal solution. It’s truly creating a win-win.
Feuilloley: Engagement drives impact. I’m going to talk about an Indonesian bank that we started engaging with a number of years ago that was involved in lending to the country’s palm oil industries. We had numerous conversations with their CEO to take a more strategic approach to the risks around lending to these controversial industries. We’re happy to say that as recently as August of last year, the bank published new sustainable finance action plans with palm oil. We’re super-encouraged that this commitment has been made by top management of the firm. They’re clearly considering palm oil as a real risk and looking to mitigate it through the execution of this strategic plan.
P&I: What’s missing from ESG investing right now? Is it active or passive solutions? New investment classes? What’s needed?
Wilczewski: Rakhi brought up earlier that the industry is not seeing a lot of adoption on the real asset side. We have been a leader in this space since 2009 when we co-founded the Greenprint Center at ULI [Urban Land Institute], an industry organization committed to reducing carbon emissions in buildings. It’s an area of strength for our organization, in real estate and real assets broadly.
In terms of our process, we are focused on implementing programming that enhances building value by reducing expenses and creating high quality, healthy spaces for tenants. We benchmark a majority of our portfolio for energy and water to ensure we're using resources in the most efficient way. We then prioritized and implemented efficiency measures — better LED lighting, smart irrigation, better energy management, things that we do in all of our buildings that create massive energy efficiency and therein, massive savings.
As a recent example, in a building of ours in Chicago, we invested in several energy efficiency measures, and as a result we have reduced energy consumption by more than 20%, saving the building more than $170,000 annually in operating expenses. Within the real estate sector in particular, we’ve seen tremendous investment return along with energy efficiency, reduction of carbon footprint and better resource utilization.
Kumar: Eventually, everybody expects ESG to go mainstream, and by that I mean a world where ESG investing is the only way to go. For that to happen, we need total portfolio solutions across all asset classes. What investors and consumers of ESG need to understand is that ESG will manifest itself in different asset classes in different ways. It will require investor sophistication to understand the risk-return profile of their portfolio and clarify what their ESG objectives are. And just as any investor looks at his or her portfolio and expects different risk-return profiles from different parts, from an ESG objective you will use different investment strategies or styles for different impact results.
Feuilloley: We are operating in a world where ESG has permeated both active and passive, and all asset classes. There are obviously asset classes that are further developed from an ESG perspective, like listed equity or maybe fixed income. But I would argue that on the real asset side, or [with] some alternatives, the nature of these asset classes is actually more conducive to ESG. If you think about the long-term nature of those asset classes, such as private equity, infrastructure and real estate, not looking at ESG issues could result in material risk.
And because of the generational shift that we’re seeing in terms of interest from millennials and values-based investing, I think people are hungry to have more thematic strategies. So whether it’s climate change or water scarcity issues facing certain regions of the world, people want to be able solve these problems through investment. ■