The ESG push and pull factors managers should be aware of in 2020

Summary key points

• There has been a sea change in the ESG space with investors, regulators, asset managers and owners realising both the risks and opportunities posed by ESG.
• Regulation is set to increase across the world as central banks and governments begin to require ESG disclosures.
• The public is increasingly anxious regarding the pace of government action on climate change. This has led to a wave of litigation against a range of defendants for their lack of action, including investment managers and corporations.
• Investors from a range of generations are preferring to invest in ESG focused financial instruments offering a big opportunity for asset managers.
• The rise in volatility expected from climate change is offering opportunities for smart hedge fund managers who have a high degree of strategy flexibility.

PRI in person: The push and pull behind ESG adoption

The PRI in Person conference, held in Paris in September, was the largest PRI conference in history, reflecting the demand and urgency from attendees wanting to see changes in the financial system.

The discussions covered a range of topics, including how the price of carbon is calculated, modelled results on which sectors would win under a climate transition and high-level discussions on the Task Force for Climate-related Financial Disclosure (TCFD), the Inevitable Policy Response (IPR) and the UN’s Sustainable Development Goals.

Across the four-day conference a number of push and pull mega trends emerged which will dominate in 2020. Whilst it was noted that a large number of funds still see ESG as a way to attract capital; the discussions at PRI in Person noted the shift in mindset of PRI signatories away from ESG as a unique selling point to the understanding of ESG as both a risk and opportunity. The old impediments to ESG integration, lower returns, transparency and greenwashing are being eroded by emerging push factors from regulators and pull factors such as performance.

ESG push factors: Regulation, Due Diligence Questionnaires (DDQs), Requests for Information (RFIs)

Regulation is beginning to affect investment portfolios from both directions. Issuers are increasingly being scrutinised by governments and international bodies, such as the TCFD, on their climate impact, whereas investors continue to demand greater transparency on ESG reporting from their managers. Policies such as the EU Taxonomy on Sustainable Finance, the EU’s manual on what is defined as a “green” investment, will be integral for managers and investors in determining which investments are sustainable. The announcement that Canada will be creating their own EU-style taxonomy for resource reliant economies is a positive sign that governments are working to create non-prescriptive guidance for managers, rather than top-down regulation. However, as the chart below shows, the direction of travel is clear; climate related regulations on investments are set to increase and become more onerous. A clear example is the Hong Kong¹ Stock Exchange’s announcement that they will be setting expectations for how managers should be assessing climate change and creating a database of ESG funds authorised for retail distribution in Hong Kong.

Policy interventions graph taken from the Grantham Institute Global trends in climate change litigation 2019 report – http://digital.shearman.com/i/1165056-2019-corporate-governance-executive-compensation-survey/15?

Further to this, there have been numerous examples of so called “survey fatigue” by both managers and issuers, as they are inundated with DDQ requests and RFIs. Often this takes up time with repetitive form filling as each institutional investor and pension fund attempts to differentiate themselves by asking more complex information. In a competitive marketplace, missing the deadline can mean the loss of a mandate which has led to bodies such as SASB (Sustainable Accounting Standard Board) and the GRI (Global Reporting Initiative) to help deal with the 20% rise in ESG-related DDQ requests. In larger organisations, these standards can be incorporated into the investment process. However, smaller managers are at risk of being screened out of managers all together if they do not meet the minimum ESG requirements.

Sustainability framework survey data taken from Shearman – http://digital.shearman.com/i/1165056-2019-corporate-governance-executive-compensation-survey/15?

Threat of policy ratchets

The Paris agreement, now five years old, is set to begin its first “policy ratchet” phase in 2023 when national carbon budgets for each country’s response to limit climate change are implemented. By November, the 195 Paris Agreement signatories are expected to begin draft decarbonisation plans, along the lines of the UN Secretary General’s, Antonio [need acute on first “o”] Guterres, four specific requests:

1. carbon neutrality plans for 2050;
2. ways to tackle fossil fuel subsidies;
3. taxing carbon; and
4. no new coal power beyond 2020.

The progression of these policy ratchets may start to increase the risk of stranded assets, as even though continued coal investment is incompatible with the transition to a low carbon economy the global installed coal power capacity is set to increase.

https://endcoal.org/tracker/

Investors now face the risk of holding assets which are unable to compete effectively against renewables, as the cost of generating renewable energy has declined and pricing is now competitive with traditional energy sectors in many countries. In 2017 the Minister of State for Power, Coal, New & Renewable Energy and Mines for India, Piyush Goyal, stated that the cost of solar power is now cheaper than coal. Quite a statement for a country which derives almost 60% of its energy needs from coal fired plants². Closer to home, the latest report on the cost of UK energy from the department for Business Energy and Industrial Strategy states that the cost of onshore wind power is the cheapest form of electricity.

ttps://www.parliament.uk/business/publications/written-questions-answers-statements/written-question/Commons/2018-04-26/138372/

It was once the case that renewables thrived and died on subsidies, however new technology, varying prices and increasing demand has led to this becoming an antiquated idea. Add to this the threat brought by regulatory knee jerks, what the PRI terms as the Inevitable Policy Response, the case behind moving away from certain industries for risk management purposes becomes clear. An example of this direction is shown in the latest report from the EU’s body for sustainable finance which recommends excluding investment in any company which derives over one per cent, 10% and 50% from coal, oil and natural gas respectively. Larry Fink’s recent letter laying out BlackRock’s commitment to divest from firms with over 25% of revenues from thermal coal suggests the industry is taking notice.

Growth in climate litigation

Climate-related litigation is emerging as a growth area for law firms, as plaintiffs look towards the courts as a way to move nations, corporations and investment funds towards a more sustainable future. Cases such as Urgenda v Kingdom of the Netherlands⁴, Lliuya v RWE AG⁵ and McVeigh v Retail Employees Superannuation Trust⁶ are part of a new wave of over 1,200 cases⁷, 75% of which have been filed in the USA, and have entered proceedings in numerous jurisdictions.

Although cases addressing climate change are not new, this latest wave of litigation reflects the innovations in Attribution Science⁸ which allows certain events to be attributed to climate change in a way which was not possible in the past. Such science has allowed the increase in intensity of certain weather events to be credited to anthropogenic (human-caused) climate change. For example, a 2017 paper⁹ stated that Hurricane Harvey, which made landfall in Texas and dropped the annual rainfall in four days leading to $125bn damages, was made 38% worse by climate change. Much of the litigation focuses on the Oil Majors, 20 of whom are responsible for 1/3rd of all emissions¹⁰ and knowingly supplied a commodity, petroleum, which damaged the planet while spreading misinformation about the product¹¹. The most interesting case against an oil major is Lliuya v RWE. Lliuya, a Peruvian farmer, alleges that RWE, having knowingly contributed to climate change by emitting substantial volumes of greenhouse gases, bore some measure of responsibility for the melting of mountain glaciers which threaten his town of Huaraz with a population of 120,000. Irrespective of the outcome, the court has already taken the significant step of recognising that a private company can be held responsible for their share of climate damages. This case is leading law firms, enticed by the potential for large damage settlements, to strengthen their knowledge on climate law.

A recent article by Michael Liebreich¹² suggests that estimated damages in Texas from Hurricane Harvey in 2017 reached $47.7bn. If somehow a case was brought alleging the Carbon Majors were liable for their share, they would immediately become insolvent, a risk Liebreich identifies as not implausible. However, no case has yet succeeded to bring a large carbon emitter to account. As outlined above the stakes for these companies are huge as giving ground on one case would cause a tidal wave of litigation, for this reason they will boldly defend their case.

Pull factors

Many countries and regulatory environments are making a concerted effort, through legislation such as the EU Taxonomy and partnerships such as the Network for Greening the Financial System, to direct capital flows towards industries with good sustainability credentials. These industries include infrastructure investments for charging stations, emerging carbon capture utilisation and renewable energy storage. These areas present opportunities for investors and fund managers.

Investors are taking notice

It has long been understood that socially conscious millennials are helping to drive ESG investing across markets; however, there is an increasing body of evidence suggesting that Generation X (Gen X) are also becoming a driving force. The Wall Street Journal highlights that despite their smaller population, Gen X has a much larger pool of capital compared to millennials and have an interest beyond exclusionary screening, preferring to invest in companies which can demonstrate a positive impact. This may be because Generation X have lived through environmental and social scandals such as the Exxon Valdez Spill, Nike Sweatshops and Foxconn employee suicides. All these were caused to some degree by poor governance oversight which is rarely viewed favourably by investors and often is seen as a warning sign. Whereas millennials, who are in the process of inheriting some $24trn¹³, are more interested than their parents in investing along the themes which abate climate change as well as bribery and corruption¹⁴. Further to this, there is an increasing body of evidence showing that sustainable investing does not sacrifice returns. A study from Morgan Stanley’s Institute for Sustainable Investing found that investing along sustainability themes meets and often exceeds the performance of comparable traditional investments¹⁵, both on an absolute and a risk-adjusted basis, across asset classes and over time.

Strategy innovations

Mark Carney, the outgoing Bank of England Governor’s warning regarding “companies that don’t adapt, including companies in the financial system, will go bankrupt without question” was very widely reported. Less reported was his suggestion some firms have the opportunity to make “great fortunes” if they handled a transition to a low carbon economy correctly. One interesting example can be found from the remains of PG&E, the Californian utilities provider which was found to be liable for starting the wildfire, made worse from climate change, which ravaged the city of Paradise in 2018. Due to a unique Californian law known as Inverse Condemnation, the utility can be found liable if their equipment is found at the spark site of a conflagration, regardless of whether or not they were negligent. This was the thinking behind Seth Klarman’s Baupost Group, which in November 2018 purchased $1bn in subrogation insurance claims.

Aftermath of the Californian wildfires

A subrogation claim, in the case of a fire, arises when an insurance company seeks reimbursement for the damage claims they paid to insured homeowners, when the utility is found to have caused the fire. In the case of the Paradise fire, Baupost Group purchased the rights to claim damages from an insurance firm at a discount (up to 35 cents on the dollar) and were recently rewarded from a $11bn settlement between the claimants and PG&E. This set a blueprint for a new way to hedge the risk of climate change as companies which fail to adapt or mitigate the risk can become an opportunity for hedge fund managers.

Conclusions

Climate change certainly poses an existential threat to how we currently live, and its effects are diverse, omnipresent and will not abate. The trends outlined here can, and in the eyes of many investors, do, pose an opportunity to attract new investors and create new investment strategies. THFJ

Footnotes:

1. https://www.hkex.com.hk/News/News-Release/2019/1905172news?sc_lang=en .
2. http://www.infraline.com/blogdetail.aspx?id=234&sid=1.
3. https://www.parliament.uk/business/publications/written-questions-answers-statements/written-question/Commons/2018-04-26/138372/.
4. http://www.lse.ac.uk/GranthamInstitute/litigation/urgenda-foundation-v-kingdom-of-the-netherlands-district-court-of-the-hague-2015/
5. http://www.lse.ac.uk/GranthamInstitute/litigation/lliuya-v-rwe/
6. https://www.judgments.fedcourt.gov.au/judgments/Judgments/fca/single/2019/2019fca0014
7. http://www.lse.ac.uk/GranthamInstitute/wp-content/uploads/2019/07/GRI_Global-trends-in-climate-change-litigation-2019-snapshot-2.pdf
8. https://www.scientificamerican.com/article/scientists-can-now-blame-individual-natural-disasters-on-climate-change/
9. https://agupubs.onlinelibrary.wiley.com/doi/abs/10.1002/2017GL075888
10. http://climateaccountability.org/pdf/CAI%20PressRelease%20Top20%20Oct19.pdf
11. https://www.theguardian.com/environment/climate-consensus-97-per-cent/2018/sep/19/shell-and-exxons-secret-1980s-climate-change-warnings
12. https://about.bnef.com/blog/liebreich-climate-lawsuits-existential-risk-fossil-fuel-firms/
13. https://www.refinitiv.com/perspectives/ai-digitalization/sustainable-investing-for-millennials/
14. https://www.schroders.com/en/sysglobalassets/digital/insights/2018/pdf/global-investor-study/sustainability/global_investor_study_2018_sustainable_investment_report_final.pdf
15. https://www.morganstanley.com/what-we-do/institute-for-sustainable-investing

With the increasing focus on environment, social and governance (ESG) factors within the investment industry, many managers are assessing how they can become Carbon Neutral within their organisations. In 2019, INDOS Financial went through this exercise and became a carbon neutral organisation. In this week’s blog, we provide a high-level summary of the steps that firms need to take.

What becoming Carbon Neutral means

Becoming carbon neutral requires the measurement of an organisation’s carbon footprint through the direct and indirect emissions of greenhouse gasses and taking action to offset and reduce those emissions.  Offsetting involves removing the equivalent amount of carbon from the air from sequestering or preventing that emission from another place such as providing more efficient cook stoves in developing countries.

Step One: Decide on your carbon footprint certifier

The carbon footprint certifier will audit the information you provide and will also generally offer offsetting services. For financial services firms it will depend on what parts of the company you want to offset, this is either the company’s operations or the portfolio or both. Many investors now like to see their fund manager itself as carbon neutral and it shows commitment beyond a paper policy.

Step Two: Measure your greenhouse gas impact

Your greenhouse gas impact is split into ‘Scopes 1, 2 & 3’. Scope 1 is a company’s direct emission into the atmosphere, think of an iron smelter or a factory emitting Sulphur dioxide. Scope 1 is therefore not relevant for most financial service companies. Scope 2 covers indirect emissions from a company’s use of electricity, and Scope 3 relates to work related travel.

Information needs to be collected for each Scope category. This includes utility bills, receipts for travel and expense claims for vehicle use. You should make reasonable assumptions for what cannot be easily accounted for.

Step Three: Subject the data to audit / review

Having collected the information the verification partner will audit the data and assumptions, a process which takes about a month, coming back with queries. These queries will generally focus on where the information was sourced from, such as utility bills and flight receipts, as well as more technical questions if travel includes private jets and so on.

Step Four: Offset your emissions

With the audit complete the final step is to offset the emissions using a Gold Standard carbon credit so that you are assured they are not being resold. Many firms will offset slightly more than they have measured, this is because there will likely be more indirect emissions from how their water and waste is processed.

Step Five: Obtain your certificate and continue work to reduce carbon footprint

Once you have offset your emissions the company is carbon neutral for 12 months. Over the next year, the company should work to further reduce their carbon footprint for example, through switching energy suppliers and increasing video conferencing to avoid travel etc.

The Cayman Islands government recently published a new registration regime for closed-ended investment funds. The move is one of a series of recent regulatory changes to strengthen the Cayman Islands’ reputation as a leading fund domicile and more closely align its rules with developing global governance practices.

While the Cayman Islands has long had a regulatory regime in place requiring open-ended funds such as (among other things) hedge funds to register with the Cayman Islands Monetary Authority (CIMA), closed-ended funds have traditionally been exempt.

The Private Funds Bill, 2020, published on 8 January, is expected to pass into law at the end of this month. It will introduce a number of changes for new and existing private equity, real estate,  infrastructure and other types of closed ended investment funds. A large number of funds, the majority of which are managed by US firms, will be impacted.

In addition to requiring existing and new private funds to register with CIMA, the rules state that managers will need to have their accounts audited annually by a CIMA recognised auditor. Furthermore, several other investor protections have been introduced, which borrow heavily from the EU depositary rules that were formalised by the AIFMD (Alternative Investment Fund Managers Directive) in 2014. It is notable that the EU as well as the OECD are understood to have been involved in the review of the new legislation prior to it being published.

The proposals require private funds to implement procedures around appropriate and consistent valuation which must be carried out at least annually; the safe keeping of fund assets including holding custodial assets in custody and verification of ownership and title for other assets such as private equity and real estate investments; and the monitoring of cash flows including the checking of cash accounts and receipt of investor contributions.

These duties may be carried out by the manager or operator of the private fund (subject to functional independence from the investment management role, plus management and disclosure of any conflicts), or a third party such as a depositary or fund administrator.

Managers are advised against implementing a ‘tick the box’ compliance model because the Cayman Islands is under international pressure to ensure its new regulations are being complied with.

No guidance notes have been published yet to clarify the scope of the new requirements. The valuation, asset safekeeping, verification and cash flow monitoring requirements may appear straightforward but, as always, the devil will be in the detail and may dictate the solutions available to managers.

For example, few fund administrators actually perform the valuation or verify ownership and title of private assets. Depositaries, on the other hand, are more suited to performing the functions given their existing remit under AIFMD and can also do so for managers that have not outsourced their fund administration function.

Some non-EU managers operating closed-ended Cayman funds will already be familiar with the depositary requirements if they market their funds in certain EU countries. These managers will attest that the depositary has been able to discharge its duties in a pragmatic and efficient way without significant impact on the manager itself. This is the case irrespective of whether the manager performs fund administration in-house or has outsourced the function.

Depositaries have an extensive track-record of carrying out oversight of fund valuation, cash-flow monitoring and asset verification under the AIFMD. Depositaries could leverage this expertise to support private funds with these incoming CIMA rules. The depositary may also be able to undertake the Cayman Islands’ fund AML (anti-money laundering) officer duties which were introduced in September 2018, in effect providing a one-stop compliance solution.

While depositary was initially viewed as an extra cost, many institutional investors are now very receptive to the model, welcoming the additional layer of oversight, transparency and protection which they deliver. Fund directors also value the reporting they receive from depositaries, as it helps them fulfil their board responsibilities.

While not mandated by the regulations, the decision by private funds to leverage the services of a depositary to help them comply with the new regulation could be an attractive option for managers. Moreover, it would enable managers to demonstrate that they are taking their regulatory obligations seriously.

In March 2019, the full INDOS Financial team from its three offices in London and Fareham (UK) and Enniscorthy (Ireland) gathered in Ireland for its first firm-wide offsite. Since the business took on its first client in June 2014, it has grown to a diverse group of 40 staff providing services to over 80 clients and 130 investment funds with more than $40 billion of underlying assets, spanning hedge fund, private equity, real estate and infrastructure funds.

We were particularly pleased with our team painting showing some of the strengths of the business which all combine to Protect Investors. We are extremely proud of what we have achieved to date and look forward to continued growth of the business and the team during 2019.

Regulatory efforts to encourage more financial institutions to incorporate climate change risk into their business models are accelerating. Mark Carney, governor of the Bank of England, warned in a recent speech in Amsterdam that climate change was a systemic risk that will seriously destabilise the financial system. He said these challenges comprised of physical risks caused by extreme weather conditions damaging property and trade; liability risks stemming from parties who have suffered losses seeking compensation; and transition risks, whereby markets undergo a disorderly readjustment to a low carbon economy.

Carney’s comments are evidently on the same wavelength as the European Commission (EC), who in March 2018, announced an Action Plan on Sustainable Finance, an initiative designed to strengthen institutional investment into sustainable causes and assets. Regulators now see the financial services industry including fund management as being a critical cog in the fight against climate change. INDOS Financial attended the Association of the Luxembourg Fund Industry’s (ALFI) European Asset Management Conference between March 5 and 6, where sustainable finance and the EC’s Action Plan were dominant themes.

The Controversial Taxonomy

While nearly all panellists at ALFI welcomed the EC’s initiative to stimulate sustainable investing, the taxonomy envisaged under the Action Plan continues to be divisive. Of the four Action Plans published so far by the EC, the taxonomy is at the least advanced stage, although its principles are currently being discussed at a technical working group level.  The taxonomy creates a dilemma for the industry. Firstly, data on sustainability is often cited as poor as it is not easily quantifiable meaning interpretations about ESG are quite loose and varied. Amid this uncertainty, some managers have advertised their products as ESG when they are not.

Such greenwashing on the part of a handful of managers is harmful to investors and risks undermining peoples’ faith in ESG investing, which is why regulators feel it is necessary to create a taxonomy to prevent the practice. A benchmark is crucial if investors are to accurately measure managers’ ESG, but experts at ALFI warned that the taxonomy could result in unintended consequences springing up, if classifications are either too generic – allowing for greenwashing to continue unchecked – or excessively rigid thereby stifling product development. As such, the taxonomy’s contents are likely to be scrutinised heavily.

Reporting to investors

The Action Plan’s ESG disclosure requirements are also contentious not because asset managers are reticent about reporting, but because there are concerns about sustainability data. One speaker said ESG reporting by companies – particularly in emerging markets – were variable, adding that  data providers giving opinions on ESG often had different methodologies, sowing further confusion. Unless the data quality issues are remedied through standardisation or internationally accepted classifications, managers are at risk of supplying misleading or inaccurate reports to end clients under the EC’s proposed rules.

Embedding ESG in asset management

One panellist acknowledged that ESG was going to become fully integrated into the activities at asset managers. He highlighted that just as risk management is an absolute prerequisite for managers in their investment and operational processes nowadays, in time so too will sustainability. While there is some nervousness about the direction of regulatory travel inside the EU about integrating  sustainability, very few asset managers and investors at ALFI would disagree that ESG is not going to affect their businesses moving forward. 

How independent oversight can help

INDOS Financial – with its proven track record of ensuring that managers running a wide range of strategies are complying with their investment mandates – is continuing to develop an independent ESG assurance solution. The service will enable managers to demonstrate to investors and other stakeholders that they are complying with their ESG policies and investment mandates.  Through careful ESG oversight and compliance monitoring, INDOS Financial aims to play an integral role in the evolution of ESG within the asset management industry.