The burning issue of ESG
15 October 2019
As the world battles with climate change-induced forest fires, floods, hurricanes and drought, that is causing wide-spread social unrest around the world, the securities lending industry looks at how it can do its part to adapt to the new ESG environment
Image: Shutterstock
This year so far has seen the Amazon rainforest afflicted by untameable fires, while global temperatures continue to rise and ocean ecosystems are being terminated. Elsewhere, the refugee crisis in the Middle East following the collapse of the terrorist group ISIS in Syria continues to worsen, and grassroots protests have sprung up in the US and across Europe against perceived political corruption, social injustice, and environmentally irresponsible business practices.
One of the most prominent mass protests occurred earlier this year in London when thousands of protesters took to the streets under the banner of a new environmental activist group called Extinction Rebellion to shut down large swathes of the city in a bid to force the then Prime Minister Theresa May to declare a 鈥渃limate emergency鈥�.
More recently, teenage climate change activist Greta Thunberg gave an impassioned speech at the United Nations鈥� Climate Action Summit, saying: 鈥淔or more than 30 years, the science has been crystal clear. How dare you continue to look away and come here saying that you鈥檙e doing enough when the politics and solutions are still nowhere in sight.鈥�
鈥淧eople are suffering. People are dying. Entire ecosystems are collapsing. We are at the beginning of a mass extinction, and all you can talk about is money and fairy tales of eternal economic growth. How dare you!鈥�
Without doubt, 2019 is the year that environment and social issues fully captured the world鈥檚 attention to such a degree that it has trickled down into niche areas of the financial markets, including the world of securities finance.
In fact, while Thunberg was berating world leaders in New York, securities finance market participants were meeting at IMN Beneficial Owners鈥� 网爆吃瓜 Finance and Collateral Management Conference in London, for a series of panel debates that repeatedly highlighted the growing trend of environmental, social and governance (ESG), also known as 鈥榮ustainable investing鈥�, in the lending market.
Talking to 网爆吃瓜 Lending Times earlier this year, Andrew Dyson, CEO of the International 网爆吃瓜 Lending Association, described ESG as an umbrella term for investments that seek positive returns and long-term impact on society, environment and the performance of the business.
鈥淪ustainable finance includes a strong green finance component that aims to support economic growth, while reducing pressures on the environment, addressing greenhouse gas emissions, tackling pollution, minimising waste and improving efficiency in the use of natural resources,鈥� Dyson explains.
鈥淚n light of the growing political and social focus on issues associated with climate change more broadly, investors are increasingly looking to align their investment strategies with these greener credentials,鈥� he added.
However, despite the virtuous overtones presented by many entities the inevitability of ESG integration in investment analysis, for both securities lending and borrowing, is a case of practicality over philanthropy, says Harry Merrison, investment manager, vice president at Kingswood Group, a wealth management business.
So what is driving this greener and more ethical way of doing business? Is it a latent moral awakening by the financial community or a shrewd investment move to capture the latest social trend?
The pull of the sell side
In its mission to affect a real change in the climate debate, Extinction Rebellion has found an unlikely ally in several of the largest pension funds and asset managers around the world.
Industry experts have indicated that the drive primarily stems from the sell side and that pension funds, in particular, are pushing for ESG investing to present a socially responsible face to their investors鈥攁nd they might be onto something.
鈥淭he latest research reinforces popular belief that millennials value ethical investing more than the previous generation,鈥� explains Merrison. 鈥淭he age of wealth distribution is imminent. Millennial investors are more and more discerning, thus increasing the likelihood that demand for ethically focused strategies will continue to swell.鈥�
One such example of the knock-on effect of this social shift was offered when the Amazon rainforest fires in Brazil and Bolivia first began to dominate media headlines. In response to the crisis, the California Public Employees鈥� Retirement System, one of the largest pension funds in the US with $16.2 trillion in assets, became one of 230 global investors to sign an open letter warning hundreds of unnamed companies to either meet their commodities supply-chain deforestation commitments or risk economic consequences.
Merrison highlights that, as well as becoming more vocally activist, pension funds are also putting their money where their mouth is. He says that in the UK alone, capital allocated to ESG funds now exceeds 拢1.2 trillion, with the majority held within pension funds.
Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting, which works with beneficial owners on their lending programmes, reinforces this point, explaining that pension schemes are increasingly focused on ESG and transparency for members is essential for those plans.
鈥淩etail funds, including exchange-traded funds, mutual funds and UCITS use the ESG tag as a way to capture inward investment in this trendy and timely area,鈥� he says.
Zimmerhansl says that he sees ESG being an increasingly important issue for institutional investors as part of their governance process and portfolio construction. He explains that inevitably this is having an impact on the securities lending market and the market intermediaries will be required to respond.
鈥淥ur discussions with beneficial owners focus on the full lifecycle of activity,鈥� he explains. 鈥淥bviously, agents can only lend securities in client portfolios, so the front-end composition is the responsibility of the portfolio managers. However, clients also own the collateral they receive from borrowers and so in our view, collateral needs to also satisfy the lender鈥檚 ESG guidelines. There is also ever-increasing scrutiny of actual voting practices by asset managers and this will also impact the business as we anticipate more active voting in future.鈥�
Speaking at the IMN conference, Matthew Chessum, investment manager at Aberdeen Standard Investments, said: 鈥淓SG is embedded across all of the investment processes that we [Aberdeen Standard Investments] run.鈥�
鈥淭he main driver behind ESG investing is to increase corporate standards which is becoming more important. Clients are very interested in understanding how our focus of ESG is embedded in our investment management process. The momentum behind this practice is definitely picking up and it is only going to become more important as time goes on,鈥� Chessum notes.
Dispelling the myths and tackling the issues
While there is an increasing demand for ESG investing options, some industry experts say that it is not on every investor鈥檚 agenda and more can be done to enhance engagement. One of the main reasons for behind some investor鈥檚 reservations is the belief that ESG investment processes can reduce a fund鈥檚 performance, especially when it comes to securities lending. The argument against ESG follows the well-trodden path that the equity as the collateral debate has taken in recent years. In essence, in the context of the buyers鈥� market that lenders operate in means, they cannot afford to make themselves any less attractive to borrowers by presenting potential suitors with a laundry list of collateral that goes against its ESG policy.
In tackling some of these issues, Merrison notes that while investors increasingly expect ESG factors to be integrated into investment processes, he sees reduced performance as often being cited as a reason for investing elsewhere. According to Merrison, this is simply not a valid argument and in the past five years, ethical indices have outperformed their non-ethical counterparts.
He adds: 鈥淎nother measure of success is non-monetary. Investors can map securities to the UN Sustainable Development Goals (SDG) to determine how their investment has a positive impact. Investor capital can be an important mechanism for change if responsibly deployed.鈥�
The relationship between ESG strategies and risk is also frequently questioned, but Merrison outlines that evidence suggests and performance demonstrates that companies which integrate ESG factors into their corporate fabric are better long term custodians for investor capital.
鈥淭he logic is irrefutable and many investors recognise that long-term stable and sustainable investment returns depend on well-governed social and environmental systems,鈥� he argues. 鈥淯ltimately investing in companies which apply ESG factors offers greater downside protection and yields better long-term risk-adjusted returns.鈥�
On the practical reality of the more complex collateral profile that ESG represents, Pierpoint鈥檚 Zimmerhansl says: 鈥淔rom a securities lending perspective, we expect to see more operational impact in terms of customised collateral profiles, more comprehensive governance and oversight and increased voting. More moving parts are a potential risk, but the industry infrastructure is more than capable of dealing with these rising demands.鈥�
Other forces for change
Additionally, Zimmerhansl notes that he has been involved in discussions with hedge funds that use ESG filters as triggers for potential short positions as there is some evidence that poor corporate ESG characteristics may lead to share price underperformance. The issue that they face at times is a lack of supply for mid-cap companies that are short candidates, he adds.
Moreover, regulators are also applying pressure on firms to consider ESG risk and the carbon impact of investments.
A series of governing rulesets, such as the United Nations Principles for Responsible Investments (UNPRI), have been formed in the past decade to offer financial institutions guidance and a framework with which to support their evolution to a more responsible way of doing business. Signatories of the UNPRI, for examples, are committed to incorporate ESG considerations in their investment decision making.
鈥淩egulatory changes are strongly contributing to the shift towards a low-carbon economy and the reorientation of private capital towards a more sustainable world,鈥� says Sergi Castell脿, managing director, head of asset liability management, treasury and funding at CaixaBank, which is a signatory of the UNPRI, 鈥淎t the European level, for instance, the publication of the new EU taxonomy provides a shared classification system to identify green assets that should be increasingly used by the investor community.鈥�
Castell脿 also cites the Paris Agreement as a driving force behind a great number of global economic stakeholders including sovereigns, corporate and institutional investors taking a stand on how they can contribute to climate change mitigation.
鈥淭he challenge is now to move beyond consciousness and towards concrete actions. Again, CaixaBank鈥榮 SDGs Framework is not only a response to increasing investor demand but also aimed at reinforcing awareness around the importance of ESG investing options,鈥� he says.
Looking to the future, we can expect environmental and social issues to remain in the spotlight and likely grow further in prominence on the world stage and in finance; and the securities lending industry will have to play its part.
One of the most prominent mass protests occurred earlier this year in London when thousands of protesters took to the streets under the banner of a new environmental activist group called Extinction Rebellion to shut down large swathes of the city in a bid to force the then Prime Minister Theresa May to declare a 鈥渃limate emergency鈥�.
More recently, teenage climate change activist Greta Thunberg gave an impassioned speech at the United Nations鈥� Climate Action Summit, saying: 鈥淔or more than 30 years, the science has been crystal clear. How dare you continue to look away and come here saying that you鈥檙e doing enough when the politics and solutions are still nowhere in sight.鈥�
鈥淧eople are suffering. People are dying. Entire ecosystems are collapsing. We are at the beginning of a mass extinction, and all you can talk about is money and fairy tales of eternal economic growth. How dare you!鈥�
Without doubt, 2019 is the year that environment and social issues fully captured the world鈥檚 attention to such a degree that it has trickled down into niche areas of the financial markets, including the world of securities finance.
In fact, while Thunberg was berating world leaders in New York, securities finance market participants were meeting at IMN Beneficial Owners鈥� 网爆吃瓜 Finance and Collateral Management Conference in London, for a series of panel debates that repeatedly highlighted the growing trend of environmental, social and governance (ESG), also known as 鈥榮ustainable investing鈥�, in the lending market.
Talking to 网爆吃瓜 Lending Times earlier this year, Andrew Dyson, CEO of the International 网爆吃瓜 Lending Association, described ESG as an umbrella term for investments that seek positive returns and long-term impact on society, environment and the performance of the business.
鈥淪ustainable finance includes a strong green finance component that aims to support economic growth, while reducing pressures on the environment, addressing greenhouse gas emissions, tackling pollution, minimising waste and improving efficiency in the use of natural resources,鈥� Dyson explains.
鈥淚n light of the growing political and social focus on issues associated with climate change more broadly, investors are increasingly looking to align their investment strategies with these greener credentials,鈥� he added.
However, despite the virtuous overtones presented by many entities the inevitability of ESG integration in investment analysis, for both securities lending and borrowing, is a case of practicality over philanthropy, says Harry Merrison, investment manager, vice president at Kingswood Group, a wealth management business.
So what is driving this greener and more ethical way of doing business? Is it a latent moral awakening by the financial community or a shrewd investment move to capture the latest social trend?
The pull of the sell side
In its mission to affect a real change in the climate debate, Extinction Rebellion has found an unlikely ally in several of the largest pension funds and asset managers around the world.
Industry experts have indicated that the drive primarily stems from the sell side and that pension funds, in particular, are pushing for ESG investing to present a socially responsible face to their investors鈥攁nd they might be onto something.
鈥淭he latest research reinforces popular belief that millennials value ethical investing more than the previous generation,鈥� explains Merrison. 鈥淭he age of wealth distribution is imminent. Millennial investors are more and more discerning, thus increasing the likelihood that demand for ethically focused strategies will continue to swell.鈥�
One such example of the knock-on effect of this social shift was offered when the Amazon rainforest fires in Brazil and Bolivia first began to dominate media headlines. In response to the crisis, the California Public Employees鈥� Retirement System, one of the largest pension funds in the US with $16.2 trillion in assets, became one of 230 global investors to sign an open letter warning hundreds of unnamed companies to either meet their commodities supply-chain deforestation commitments or risk economic consequences.
Merrison highlights that, as well as becoming more vocally activist, pension funds are also putting their money where their mouth is. He says that in the UK alone, capital allocated to ESG funds now exceeds 拢1.2 trillion, with the majority held within pension funds.
Roy Zimmerhansl, practice lead at Pierpoint Financial Consulting, which works with beneficial owners on their lending programmes, reinforces this point, explaining that pension schemes are increasingly focused on ESG and transparency for members is essential for those plans.
鈥淩etail funds, including exchange-traded funds, mutual funds and UCITS use the ESG tag as a way to capture inward investment in this trendy and timely area,鈥� he says.
Zimmerhansl says that he sees ESG being an increasingly important issue for institutional investors as part of their governance process and portfolio construction. He explains that inevitably this is having an impact on the securities lending market and the market intermediaries will be required to respond.
鈥淥ur discussions with beneficial owners focus on the full lifecycle of activity,鈥� he explains. 鈥淥bviously, agents can only lend securities in client portfolios, so the front-end composition is the responsibility of the portfolio managers. However, clients also own the collateral they receive from borrowers and so in our view, collateral needs to also satisfy the lender鈥檚 ESG guidelines. There is also ever-increasing scrutiny of actual voting practices by asset managers and this will also impact the business as we anticipate more active voting in future.鈥�
Speaking at the IMN conference, Matthew Chessum, investment manager at Aberdeen Standard Investments, said: 鈥淓SG is embedded across all of the investment processes that we [Aberdeen Standard Investments] run.鈥�
鈥淭he main driver behind ESG investing is to increase corporate standards which is becoming more important. Clients are very interested in understanding how our focus of ESG is embedded in our investment management process. The momentum behind this practice is definitely picking up and it is only going to become more important as time goes on,鈥� Chessum notes.
Dispelling the myths and tackling the issues
While there is an increasing demand for ESG investing options, some industry experts say that it is not on every investor鈥檚 agenda and more can be done to enhance engagement. One of the main reasons for behind some investor鈥檚 reservations is the belief that ESG investment processes can reduce a fund鈥檚 performance, especially when it comes to securities lending. The argument against ESG follows the well-trodden path that the equity as the collateral debate has taken in recent years. In essence, in the context of the buyers鈥� market that lenders operate in means, they cannot afford to make themselves any less attractive to borrowers by presenting potential suitors with a laundry list of collateral that goes against its ESG policy.
In tackling some of these issues, Merrison notes that while investors increasingly expect ESG factors to be integrated into investment processes, he sees reduced performance as often being cited as a reason for investing elsewhere. According to Merrison, this is simply not a valid argument and in the past five years, ethical indices have outperformed their non-ethical counterparts.
He adds: 鈥淎nother measure of success is non-monetary. Investors can map securities to the UN Sustainable Development Goals (SDG) to determine how their investment has a positive impact. Investor capital can be an important mechanism for change if responsibly deployed.鈥�
The relationship between ESG strategies and risk is also frequently questioned, but Merrison outlines that evidence suggests and performance demonstrates that companies which integrate ESG factors into their corporate fabric are better long term custodians for investor capital.
鈥淭he logic is irrefutable and many investors recognise that long-term stable and sustainable investment returns depend on well-governed social and environmental systems,鈥� he argues. 鈥淯ltimately investing in companies which apply ESG factors offers greater downside protection and yields better long-term risk-adjusted returns.鈥�
On the practical reality of the more complex collateral profile that ESG represents, Pierpoint鈥檚 Zimmerhansl says: 鈥淔rom a securities lending perspective, we expect to see more operational impact in terms of customised collateral profiles, more comprehensive governance and oversight and increased voting. More moving parts are a potential risk, but the industry infrastructure is more than capable of dealing with these rising demands.鈥�
Other forces for change
Additionally, Zimmerhansl notes that he has been involved in discussions with hedge funds that use ESG filters as triggers for potential short positions as there is some evidence that poor corporate ESG characteristics may lead to share price underperformance. The issue that they face at times is a lack of supply for mid-cap companies that are short candidates, he adds.
Moreover, regulators are also applying pressure on firms to consider ESG risk and the carbon impact of investments.
A series of governing rulesets, such as the United Nations Principles for Responsible Investments (UNPRI), have been formed in the past decade to offer financial institutions guidance and a framework with which to support their evolution to a more responsible way of doing business. Signatories of the UNPRI, for examples, are committed to incorporate ESG considerations in their investment decision making.
鈥淩egulatory changes are strongly contributing to the shift towards a low-carbon economy and the reorientation of private capital towards a more sustainable world,鈥� says Sergi Castell脿, managing director, head of asset liability management, treasury and funding at CaixaBank, which is a signatory of the UNPRI, 鈥淎t the European level, for instance, the publication of the new EU taxonomy provides a shared classification system to identify green assets that should be increasingly used by the investor community.鈥�
Castell脿 also cites the Paris Agreement as a driving force behind a great number of global economic stakeholders including sovereigns, corporate and institutional investors taking a stand on how they can contribute to climate change mitigation.
鈥淭he challenge is now to move beyond consciousness and towards concrete actions. Again, CaixaBank鈥榮 SDGs Framework is not only a response to increasing investor demand but also aimed at reinforcing awareness around the importance of ESG investing options,鈥� he says.
Looking to the future, we can expect environmental and social issues to remain in the spotlight and likely grow further in prominence on the world stage and in finance; and the securities lending industry will have to play its part.
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