Growth of sustainable investing
The US sustainable investing landscape has continued to grow as more investment managers embrace environmental, social and governance (ESG) analysis within their decision-making process. Asset owners are also becoming more sophisticated in their understanding and demands around ESG and sustainable investing options. With this growing market, we have also seen regulatory bodies, such as the Securities and Exchange Commission (SEC), take more notice of sustainable investing practices, with a number of related proposals pushed forward in 2022. But the greater attention also led to greater scrutiny. The year was marred by claims of ‘greenwashing’, which were directed at corporations and investment managers – several of which faced hefty fines, as a result.
Politicization of ESG
In 2022, sustainable investing was, and continues to be, pulled into political debates within the US. This has resulted in a political division over the past year. Certain US states have taken steps to prohibit state investment funds from doing business with investment managers that use ‘ESG considerations’ within their investment process. For investment managers, this has created a polarization of views among clients and created increased risks around how investment managers communicate their sustainability efforts.
Source: Ropes & Gray LLP, March 2023
Regardless of political persuasion or geography, the past year has highlighted the key issue with sustainable investing – its definition. For a concept that has been around for decades, it is puzzling to witness debates that are based on a lack of consensus over the definition of sustainable investing. All too often, sustainable investing is lumped together with other terms, such as ESG, impact investing, or thematic investing to name a few. In reality, the term encompasses a wide range of different investing principles.
Breaking down barriers
The simplest way to break down and explain sustainable investing is to crudely split it in two: ESG as an input to the investment process, and ESG as an outcome driver. In its most basic form, ESG as an input – or ESG integration – is what all good investment managers and investors should be doing anyway. Part of being a good fiduciary is integrating all material financial risks and opportunities into its investment research process. By neglecting to consider a material factor in an investment decision, an investment manager would be failing to invest in the best possible way for clients. In a perfect world, we would remove the term ESG integration all together, as it would just be a standard part of financial analysis.
ESG integration doesn’t automatically mean investing with ‘values’ or allocating capital towards more sustainability-orientated outcomes. It simply means using all the available information to make the most informed investment decision. Unfortunately, many incorrectly assume that ESG integration means investing based on values – hence the surprise when funds hold oil and gas companies, for example. ESG integration is about understanding what those relevant and material ESG risks are and weighing those risks with the opportunities to come up with a reasoned investment decision.
When ESG is used to allocate capital towards more sustainability-oriented outcomes, then politics and emotions become important. In this case, ESG is used not only as a tool to manage risk and maximize opportunities, but also as a driver to achieve a particular sustainability-related outcome. For investment managers, ESG as an outcome is typically in response to managing a client’s stated sustainability objectives and so commonly drives products. Examples might include an impact strategy, such as investing in companies that have a measurable impact on addressing a UN Sustainable Development Goal). The client may also want thematic strategies, such as investing in companies that are focused on renewable energy and associated infrastructure. These outcome-driven strategies typically have a narrower investible universe and often include some form of negative and/or positive screen.
* Examples of sustainable-focused strategies, based on abrdn’s sustainability and product framework
Active ownership commonly plays a part in both ESG-integrated and sustainable-outcome strategies. Through active engagement, investors can gain better insight into how a company is managing its ESG-related risks and opportunities. Engagement can also encourage action to help improve financial resilience and long-term value. In addition, investors normally vote at annual general meetings to encourage positive change.
The rapid growth of products that are focused on sustainable-driven outcomes, combined with a lack of regulation, has led to the rise of external ESG-rating agencies. The varied interpretations and definitions around sustainability have also started to be addressed by regulatory bodies globally. Europe and the UK have taken the lead, with the EU rolling out its Sustainable Finance Disclosure Regulations (SFDR) and the UK’s Sustainability Disclosure Requirements (SDR) is shortly to be finalized. The US has followed closely, with the SEC finalizing a climate-related disclosure rule and a fund names rule later this year.
Over the last year, sustainable investing in the US appears to have weathered a triple storm of increased regulatory pressures, heightened risks around greenwashing, and a divisive political environment. Regardless of where regulations or politics takes us in 2023 and beyond, the key learnings are:
1. Definition matters. Lumping ESG integration together with sustainable-focused outcomes (such as thematic, impact and screening), and labelling it all as ‘ESG’ or ‘sustainable investing’ is incorrect and misleading. Misunderstanding is the root cause of the vast majority of the planets’ conflicts and until this definition dilemma is addressed once and for all, the debates will continue.
2. Sustainable investing and fiduciary duty go hand in hand. At abrdn, sustainable investing is centered around our clients and the fiduciary duty that we strive to deliver. That means integrating material ESG factors when building portfolios, in an effort to deliver the best returns we can for our clients. It also means responding to our clients’ needs through developing sustainable-focused solutions to address their objectives. Investment managers should continue to work with investors to help find solutions to address their sustainable-related goals.
3. Transparency is key. Investment managers need to focus on the priorities at hand – their clients. This means being transparent about what ESG and sustainable investing means to them and being clear in their related communications. In line with this, asset owners should continue to push investment managers to clarify their sustainable-investing processes and products. As regulations continue to develop, scrutiny placed on investment managers will only continue to heighten.
Applying ESG and sustainability criteria in the investment process may result in the exclusion of securities within the universe of potential investments. The interpretation of ESG and sustainability criteria is subjective meaning that products may invest in companies which similar products do not (and thus perform differently) and which do not align with the personal views of any individual investor. Furthermore, the lack of common or harmonized definitions and labels regarding ESG and sustainability criteria may result in different approaches by managers when integrating ESG and sustainability criteria into investment decisions. This means that it may be difficult to compare strategies within ostensibly similar objectives and that these strategies will employ different security selection and exclusion criteria. Consequently, the performance profile of otherwise similar vehicles may deviate more substantially than might otherwise be expected. Additionally, in the absence of common or harmonized definitions and labels, a degree of subjectivity is required and this will mean that a product may invest in a security that another manager or an investor would not.