Regulation adds complexity to strategy and reporting
Environmental, social and governance (ESG) topics are often at the forefront of discussions across the asset management industry — both in the U.S. and on a broader, global scale.
Investors play a prominent role in driving ESG initiatives forward. In Grant Thornton LLP’s CFO survey for the first quarter of 2023, 37% of respondents said investors are motivating them to enhance the maturity of ESG programs for their organizations. It’s safe to say that many of those same investors have an interest in investing in ESG-friendly funds.
A Stanford University survey conducted last year showed that even if it means decreasing the value of their investment, significant majorities of millennial and Gen Z investors said firms investing on their behalf should use their size and power to influence the environmental practices (85%), social policies (80%) and governance policies (80%) of the companies in which they invest.
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Seeking the right ESG approach
Regulation, pushback create complexity
Investors’ desires have some leaders in the asset management industry working to develop offerings that meet certain ESG parameters while still pursuing desired financial returns. Others in the industry who work closely with customers are devoting themselves to finding the best ESG-friendly options for consumers who wish to invest in such funds.
Meanwhile, asset managers who are subject to SEC regulation are awaiting new rules related to climate disclosures as well as ESG fund disclosures and marketing. Finally, many leaders in the various subsectors of asset management are asking:
- What ESG pressures are they facing and what do their investors expect?
- What ESG issues are important to the organization and how should the firm define its ESG ambitions?
- Should the organization have firm personnel dedicated to ESG?
- How to report ESG activities and performance metrics to stakeholders?
“ESG continues to evolve, grow and change in terms of what it means to asset managers and asset owners,” said Mark Zavodnyik, Director, ESG & Sustainability for Grant Thornton. “It’s important for asset managers to build a strong foundation when developing ESG programs anchored around issues truly relevant to their investments. This foundation-building allows the firm to adapt to developing market, investor and regulatory requirements as ESG continues to evolve.”
Along with all the progress related to ESG in the asset management sector, there has been pushback from stakeholders who believe that the consideration of ESG factors is an impediment to maximizing returns. Numerous states have proposed or passed legislation restricting state pension funds from investing with asset managers who consider ESG issues in their investment decision-making process.
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“Companies are reporting on how they're addressing ESG commitment in the environment, workplace and other areas,” said Michael Patanella, National Managing Partner for Asset Management for Grant Thornton. “But in recent months, there’s also been some back and forth in the political system as it relates to ESG.”
This swinging pendulum makes decisions related to ESG especially difficult in the asset management sector. Amid all these complexities, asset management leaders have the best chances to succeed related to ESG when they:
- Focus on ESG topics that matter. Asset managers should take the time to understand what ESG issues are material to the industries in which they invest.
- Understand investor expectations. Learn what investors prioritize related to ESG and provide investment offerings and reporting to meet their needs and those of their own stakeholders.
- Manage the regulatory puzzle. Understand the implications related to the SEC’s proposals regarding ESG fund classifications and greenhouse gas (GHG) metrics. And for managers with a global presence, understand to what degree those pending U.S. requirements align with existing regulations in Europe.
As noted above, the SEC has proposed rules for registered investment funds (e.g., investment companies, business development companies, registered invested advisers, and certain unregistered advisers) aimed at standardizing disclosures and preventing misleading ESG claims. These proposals seek to classify ESG funds into three distinct categories and restrict the way terms such as “ESG” are used in the names of funds. A similar Sustainable Finance Disclosure Regulation has been issued in the EU and applies more broadly to all market participants.
Through it all, the specter of possibly being accused of “greenwashing” — promoting an investment as ESG friendly when it’s not necessarily so — can be haunting for fund managers and firm leaders.
“If you end up in a greenwashing inquiry, it could be very negative for your business,” Patanella said. “Investors won’t invest anymore. You lose some level of integrity with your investors. You need to make sure you have the right policy and that procedures are properly completed and at times verified by outside trusted organizations.”
2:27 | Transcript
Map your ESG considerations
Leading asset management firms are navigating pending regulations by mapping out how ESG is being considered in the investment processes and what categories of proposed or existing regulations apply to those investments. The mapping process allows firms to correctly align the process to the category to meet regulatory requirements.
A path forward
Provide clarity and dig deep for information
Because requirements are inconsistent across jurisdictions related to how a fund can be labeled and marketed, fund managers and investment professionals have to be careful in how offerings are marketed.
Zavodnyik recommends that investment offerings should not be tailored to meet all potential regulatory requirements in all jurisdictions. Instead, he advocates taking the time to clearly document how ESG is considered in the investment process and then evaluate the regulatory implications on a regime-by-regime basis. To remain in compliance, asset management professionals can:
- Identify the fund category. Consider how funds that incorporate ESG factors would be categorized under the proposed regulatory categories and how the required disclosures associated with those categories would be reported.
- Review fund names: Reconcile the actual makeup of a fund’s assets before using “ESG” terminology in the name of the fund.
- Evaluate investment practices. Throughout the investment life cycle, evaluate funds to make sure they are aligned with public disclosures. In particular, focus on how key ESG information and data is identified, tracked and reported.
It may be necessary to engage a third party with expertise in ESG integration to assist with many of these evaluations and initiatives. Third-party ESG experts may be especially helpful when considering PE investments in private companies. Information on ESG factors is likely to be somewhat readily available for public companies, but these details may be much more difficult to track down for private company investments.
“It becomes more cumbersome when you're doing diligence on not just how a private company makes money or what their bottom line is, but on how its products are produced and from what suppliers they are purchasing their materials,” Patanella said. “You’re performing different types of diligence on a company in areas that you haven't looked at before.” Adding ESG due diligence to the pre-investment decision-making process provides PE firms with a wider lens from which they can evaluate the potential investment.
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Narrow your fund’s focus
It’s almost impossible to reverse engineer an ESG superfund that will meet all ESG requirements in all jurisdictions and will remain compliant as the rules are modified. Instead, construct a fund that meets a narrow range of requirements and market it accordingly.
Getting started
ESG is not one-size-fits-all
A vital issue for asset management firms getting started in ESG is to understand that not all issues and topics affect all businesses equally. Each business has different material topics that are relevant to its operations and industry, but very few issues have implications across all organizations.
As an example, a software company is less likely to focus on an environmental issue such as biodiversity because its operations have a relatively small physical footprint with limited impact on the surrounding ecosystem, compared with a shoe company with multiple manufacturing facilities around the country. Alternatively, given that software company’s reliance on highly educated, top-performing talent, ensuring that it has strong employee development programs such as training, mentorship and job shadowing, is critical to talent retention. In other words, ESG is not a one-size-fits-all exercise for all organizations.
To be effective related to ESG in asset management, leaders need to ask:
- Who are our key stakeholders (e.g., investors, employees, board members, customers, regulators), and what do they want?
- What ESG-related pressures are we facing?
- What industries are we investing in and what are their most relevant ESG topics?
- What are our ambitions in terms of advancing our firm’s performance in these topics?
“You may need a hybrid approach [for ESG staffing], where you have an internal ESG champion who can work with the outside provider.”
Knowing stakeholders’ desires and industry-specific topics is foundational to building a sound ESG program. Many leaders in asset management are finding it necessary to bring in dedicated personnel to navigate how the organization develops internal processes and manages external expectations and regulatory requirements.
Dedicated ESG personnel can help navigate the cross-functional reality of an organization’s ESG program and be the firm’s face of ESG as it communicates its efforts and achievements to investors, regulators and community members.
Depending on the firm’s needs, the proper skill sets may be acquired through in-house hiring or outsourcing.
“You may need a hybrid approach, where you have an internal ESG champion who can work with the outside provider,” Patanella said. “Regardless of how you do it, it’s important to have that experience and set things up correctly from the beginning. Trying to retrofit an ESG program after you make certain commitments or investments is very difficult and potentially risky.
Get the full picture
Don’t forget the ‘S’ and the ‘G’
For several reasons, the environmental aspect of ESG often gets more attention than social and governance.
Climate disclosure requirements that are expected to be issued soon by the SEC have placed environmental topics at the forefront of ESG efforts. Growing awareness of the impacts of climate change (such as weather-related disasters) places environmental topics in the public consciousness. And the measurable nature of environmental elements such as GHG emissions and use of water and energy make it easy to set targets and report on progress.
But there are opportunities for asset management firms to make progress on social and governance topics as well. As organizations become more sophisticated in their approaches to the workforce, they are analyzing a growing amount of data related to social topics such as employee engagement; diversity, equity and inclusion; and community engagement. Meanwhile, governance topics such as risk management, internal controls, board oversight and cybersecurity are fundamental components of sustainable businesses.
“Investors are going to be continually interested in what’s going on regarding climate risk; the energy transition; employee engagement and retention; and corporate governance.”
It’s a lot to keep track of, and it’s especially important for asset managers because much of the impetus behind ESG is created by the desires of investors who are the lifeblood of the industry. Although ESG is vitally important for long-term growth, Zavodnyik said much of asset managers’ focus in the near term will be on interest rates, inflation, recession concerns and sudden questions about the stability of the banking sector.
At the same time, though, he said many asset managers believe that long-term consideration of issues such as climate risk and the transition to a low-carbon economy are fundamentally important and can drive value creation in the industry. The winners in this space will be the ones who use ESG considerations to more consistently deliver strong financial returns.
“Over the long run, investors are going to be continually interested in what’s going on regarding climate risk; the energy transition; employee engagement and retention; and corporate governance,” Zavodnyik said. “These topics will be of fundamental importance to investors.”
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