ESG: Understanding and Implementing Effectively

ESG is a topic that is of increased importance for investors and increased regulatory focus not just from SFDR, but also other regulators around the world that are starting to crack down on people not doing what they say they are doing with regards to their ESG programs. EY and the Institute of International Finance surveyed bank risk managers on the most important risk over the next five years. Chief Risk officers placed “climate” risk as to the most important, at Laven we see this shift that has occurred over the last few years as a crucial tipping point for ESG.

Furthermore, Laven recently surveyed our Linkedin page on what were the most pressing themes currently on the minds of compliance officers. The winner with 37% of the vote was “Firm Culture (ESG, SM&CR, CSR)” which evidences the ever-increasing presence of these topics.

What does ESG stand for?

Environmental Social Governance (“ESG”) are the three pillars an Investment Firm or Fund is measured against in terms of its sustainability and ethical impact on the business or company. They are the core fundamentals to think about when creating an ESG program. They are:

• Environmental: Climate change, resource depletion, use of fossil fuels and destruction of nature.
• Social: Working Conditions, diversity and inclusion.
• Governance: Balancing the interests of stakeholders, senior management, customers, suppliers and the wider community.

However, applying ESG principles to corporate and investment processes is about doing more. It is changing one’s behaviour and moving beyond the ‘minimum required’, and  “one size fits all” approach, which can be difficult because:

• Evaluating ESG controls is difficult. Strategies vary, philosophies vary, commitments to UNPRI, UN Global Impact, SASB vary. 
• Effective ESG implementation into firm culture is difficult.

What doesn’t vary between firms however is the commitment that a fund manager needs to take when they truly promote ESG. This requires real behavioural changes and the need to develop a strong program.

How to Implement an ESG Program

The core tenants of an ESG Program are no different than any other program, initiative or change in behaviour:

1. Governance and Oversight
2. Policy and Procedure
3. Evaluate, Monitor and Update
4. Adoption Through Corporate Initiatives
5. Investor Reporting

Step 1: Governance and Oversight

UNPRI has a minimum requirement that there is senior-level oversight of “Responsible Investments” and that there are internal or external staff responsible for implementation.

Best Practice Recommendations:

• Fund Manager: Nominate an ESG Officer and/or ESG Committee that regularly meets to oversee ESG initiatives.  Small managers can review at Executive Committee meetings, but dedicated ESG time should be reserved
• Fund Board/LPAC: A fund board should monitor and supervise the execution of the ESG activity. The board should have sufficient topic expertise and knowledge.  Review meeting minutes to determine whether ESG topics are regularly discussed.
• KPIs: can be introduced to align the manager and board (although this is not required).

Step 2: Policies and Procedures

Any firm promoting ESG should spend time defining its policy and procedures. UNPRI requires its signatories to develop a Responsible Investment Policy.

Best Practice Reccomendations: 

• Define the individual(s) / committee responsible for the policy.
• Define the overall approach or guidelines for the firm’s E, S or G factors.  This should include screening practices and/or allowed/not allowable investments.
• Identify the assets under management that the policy applies to.
• Specify E, S, or G commitments, targets or goals that are (ideally) backed up by specific quantitative or qualitative targets.
• Address ESG training requirements.
• Address ESG investor reporting requirements.

Step 3 Evaluate, Monitor and Update

Evaluating, monitoring and updating ESG criteria especially for investments is dependent upon the product (SRI vs. non-SRI) and strategy (long-short vs. private equity)

Best Practice Recommendations – Liquid Funds

• Identify the data collection processes or data points used as criteria.
• Firms should develop a rating system or methodology to evaluate the ESG worthiness of an investment opportunity. 
• Identify ratings/standards or software utilised for screening/ranking (e.g. SASB standards or Sustainalytics or RepRisk software).
• Understand if ESG factors alone can veto an investment opportunity.
• Determine how the rating system and allowable investment universe are reviewed at least annually.

Best Practice Recommendations – Private Equity/Real Estate/FoF

• Identify if an ESG team member (or leader) is a voting member of the Investment Committee.
• Identify how the ESG team is involved in the investment research and recommendation process:
  • – Does ESG have an independent voice?
  • – Are materials prepared or reviewed by the ESG Team?
  • – Is an ESG review part of the investment memo.
• Define how the ESG team is involved in portfolio company monitoring:
  • – For majority investments (or board seat members) determine if ESG projects are developed and/or part of any 100-day plan.
• Determine if there are regular reviews from the ESG Team on current initiatives and at least an annual ESG progress report.

Step 4: Adoption Through Corporate Initiatives and Employee Training

ESG initiatives should be reflected throughout a fund manager’s organization.  If you believe that E, S or G improves company performance then a firm should adopt the same practices.

Best Practice Recommendations: 

• Managers should apply many of the E, S or G criteria or metrics that they define in the Responsible Investing policy to themselves.
• Managers should (ideally) establish KPIs to measure their progress.
• Managers should report (internally and externally) on their ESG initiatives and metrics at least annually.

Step 5: Investor Reporting

Investor Reporting is a key component of any ESG program.  Investors should receive a regular progress report on the ESG investments and ESG initiatives at the fund manager.

Best Practice Recommendations: 

• KPIs should be identified and reported upon.
• Investors should receive reporting on how ESG issues are integrated into the investment practices
• Proxy voting records should be reported so that investors can understand a manager’s voting record related to ESG 
• Reporting and disclosure of corporate engagements and active ownership activities for portfolio companies (private equity)

Looking Forward: Where is ESG going next?

The European Commission has recently adopted several new measures to regulate sustainable finance. This includes new standards for financing tools such as ‘Green Bonds’, which are fixed return products intended to support environmental projects such as sustainable building, wind farms etc.

There are currently around $1.2 billion green bonds in issuance. The EU has recently issued its own Green Bond Standard requirements, intended to be a ‘gold standard’ for Green Bonds, and intended to prevent ‘Green Washing’.  Although voluntary, currently proposals will require any EU Bonds to be labelled as ‘Green Bonds’, they must meet EUs taxonomy requirements.

The European Commission has also introduced its new ‘Sustainable Finance Strategy’ which outlines the EU’s transition towards a sustainable economy. It aims to tackle environmental challenges while increasing investment with a focus on SMEs.

A new global market-led task force has also been formed to target biodiversity risks – ‘Taskforce on Nature Disclosure’. It is a voluntary framework for identifying a firm’s risk profile concerning the natural world. It aims to shift financial services impact from ‘nature negative’ to ‘nature positive’ by 2023 and provide financial institutions and corporates with a complete picture of their environmental risks and opportunities.