Companies that embrace the need for tougher climate and environmental, social and governance regulations will outperform their peers
While some asset managers are just getting to grips with integrating environmental, social and governance (ESG) practices into investment processes, tougher reporting regulations coming into effect mean they are under huge pressure to assess climate impact and business resilience in much greater detail. However, far from being a big risk, this can be a strong source of value creation, as James Hilburn, director of financial services at Carbon Intelligence, explains.
“ESG factors are no longer just nice to have elements of compliance, but fundamental drivers of business value, and companies that understand and have embraced this are outperforming their peers,” he says. “This is a crucial area for asset managers. When allocating capital, they need sight of how companies are responding to ESG pressures, how their practices compare to their peers’ and the key performance indicators. Here, ESG reporting disclosures have come to the fore by shining a light on those elements of a business that were previously rather unknown.”
The two new mandatory reporting areas coming into effect this year include the Task Force on Climate-related Financial Disclosures (TCFD), with 2021 a reporting year for UK banks, insurers, large pension schemes, and premium listed companies, and the Sustainable Finance Disclosure Regulation (SFDR) for entities operating in the EU.The TCFD, set up in 2015 as a business response to the Paris Agreement, manages climate risk by focusing on the impact of changing climate on the company.
“An asset manager needs to understand how a company has planned for different climate scenarios and the potential impact on its business,” says Hilburn. “Do they have the right governance structures in terms of decision-making? Are they measuring the right metrics and reporting on those?
“With this insight into the stability of the business and its cash flows, asset managers can make better informed decisions, ultimately leading to better pricing of the assets.”
The SFDR, also known as the anti-greenwashing regulation, is part of the European Union’s sustainable finance package of legislation and is specifically aimed at financial firms and their performance across a broader range of ESG practices; the elements that effectively grant a company a license to operate with its stakeholders.
“There are a growing number of ‘green’ or ESG-friendly financial products on offer currently,” says Hilburn. “SFDR requires the firms selling these products to prove their green credentials by demonstrating what they do that has a positive impact and doesn't have a negative impact elsewhere.
“Transparent reporting on key metrics can demonstrate what you say you are doing and what you do are aligned. Firms that fail to do this effectively could see a significant customer and regulator backlash.”
There are two levels to SFDR. The first is effective from March with the initial investment-manager and fund-level disclosures. From next year it is expected there will be the additional requirement to measure specific ESG performance of the underlying assets. This could be onerous for asset managers and investors as it will require disclosing granular detail, which the asset managers often don’t have a great deal of insight into or control over.
Hilburn says: “For investment firms, there are multiple benefits from having companies within your portfolio that perform strongly in ESG. These include the improved ability to attract new capital for a sustainability and ESG focus, and the fact these companies tend to have a stronger brand, more loyal customers, better knowledge of and relationships with their supply chain, and their ability to use resources more efficiently and provide a better cost position. These levers will drive higher valuations and portfolio returns.
“The next decade will see a disruptive wave of climate and ESG scrutiny that will impact the asset management world. As Blackrock CEO Larry Fink recently said, ‘We know that climate risk is investment risk, but we also believe the climate transition presents an historic investment opportunity’. The winners will be the ones that embrace that force, make climate-resilient ESG performance a board-level priority and harness it to create lasting value and competitive advantage.” For more information please visit www.carbon.ci.
This article originally appeared on the February 2021 Sustainable Investing publication by Raconteur
