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Responsible returns: How ESG integration is transforming the institutional investment landscape…

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Whether due to increasing demand from investors, or new regulation from the EU, sustainable investing is currently one of the dominant trends in Europe’s institutional investment industry. And as Jan Wagner finds out, ESG integration can benefit everything from returns to reputation…

According to the Principles for Responsible Investment (PRI) a London-based NGO, almost 1,000 asset managers have signed up to its pledge to invests sustainably, or to put it in technical jargon, “integrate ESG” in investment strategies. 

That group of PRI signatories includes every major asset manager doing business in Europe, which is no surprise given that even before the EU announced its “Sustainable Finance Action Plan” in 2018, asset managers faced growing demand for sustainable investment competence from institutional clients. With the EU’s action plan, sustainable investing or ESG integration will arguably become the norm in Europe. The plan basically requires asset managers and institutions like pension funds to incorporate ESG at some level. The EU’s reasoning is that the financial industry can make a big contribution in helping the bloc meet its climate goals.

But setting politics aside, what exactly does ESG integration mean and what are its more tangible (ie economic) benefits for an asset manager? 

ESG stands for the environmental, social and governance criteria that an ethically-minded investor sets and that listed companies must meet to be considered investable. The principle then is straightforward enough, but things get more problematic when it comes to defining ESG criteria. While the PRI provides a list based on guidelines from the United Nations, acceptable application can vary depending on the cultural and/or political background of the investor. For example, a pension fund from Germany, a country committed to phasing out nuclear power, is likely to have a very different view of investing in the sector than a fund from say France, where nuclear power remains a mainstay of the country’s energy generation strategy.

And things become even more complicated when it comes to the use of ESG criteria. For many religious institutions, companies that do business connected with gambling, alcohol or firearms, for example, might simply be excluded, while more ‘pragmatic’ investors may adopt a ‘best-in-class’ approach, underweighting or overweighting companies according to the level of adherence to ESG criteria. 

The third approach is to take an ‘activist’ approach by seeking frequent dialogue with a company to improve adherence to or application of ESG criteria and actively participate through shareholder ESG proposals at annual general meetings. If engagement fails to produce the desired outcome, the investor can always divest. 

Union Investment (Union), an asset manager for German cooperative banks (AUM: EUR350 billion) and PRI signatory, says its ESG integration involves the use of all three approaches. For Union’s retail funds, which make up around half of its AUM, makers of weapons such as cluster bombs and coal companies are excluded. The funds also do not invest in derivatives tied to crop production. 

The next step is the best-in-class approach, which naturally applies to Union’s sustainable funds (volume: EUR48 billion) and which is used in combination with further exclusions (eg gambling, tobacco, alcohol). 

Considering ESG scores for companies is then applied to the entire portfolio. 

“For virtually all of our retail and institutional funds, varying degrees of ESG scoring of companies are taken into consideration. That means all portfolio managers rely on the ESG data that my team of 12 analysts supplies in making their investment decisions,” says Henrik Pontzen, who joined Union earlier this year as head of its sustainable investment team. 

Union also heavily relies on engagement as a technique. In 2018, it held around 4,000 discussions with investees – 525 of which had to do with the issue of sustainability. It voted at annual meetings and spoke to investors about good governance at the meetings of 15 leading German companies. 

Has any of this benefited its investments? Pontzen says that ESG integration has enhanced Union’s overall portfolio by reducing risk. He also cites the interesting example of the firm’s sustainable version of the “UniRak” balanced fund, which has outperformed the conventional variety since 2015. 

“I don’t want to say ESG integration leads to better performance. We just don’t have the final data on that. But it certainly has not hindered performance,” he adds. 

Pontzen’s sentiment is shared by Daniel Sailer, who co-heads the sustainable investment office at Metzler Asset Management, another Frankfurt-based firm. 

Since signing the PRI in 2012, Metzler has taken a consequential approach to ESG integration and currently applies it to more than half of total AUM (volume: EUR28 billion). 

“With the approach, we can aim for an improvement of the risk-adjusted performance of the portfolios in the long run and, at the same time, have a positive influence on society and the environment,” says Sailer, who believes that the positive results for companies that adhere to ESG are lower costs due to, for example, greater energy efficiency and a positive reputation. 

The latter can make the company more attractive to the next generation of investor and Sailer adds that the upshot of all this is less volatility in the company’s share price, and hence a more robust portfolio.

ESG integration is by no means perfect. If an ethically-minded investor relies too heavily on exclusion of sectors, this can shrink the portfolio to the extent that opportunities for return are missed. Indeed, this is why the likes of Union and Metzler – which also avoids manufacturers of controversial weapons – keep those exclusions to a minimum and instead rely on best-in-class and engagement. 

As Georg Thurnes, Chairman of German corporate pension lobby aba, and Aon Germany’s Chief Actuary,  puts it: “I can tell you that your risk-adjusted return will not improve but at best remain constant when strict exclusions are made.” 

Thurnes, a supporter of sustainable investing, hopes that the EU, as part of its action plan, will not define strict criteria for ESG integration among pension funds, but instead continue to grant them maximum flexibility.

Exactly what the EU’s action plan will bring is still somewhat unclear however,German asset management sources believe two new regulations will definitely emerge. 

The first is that financial advisors must ask clients if they want to invest sustainably and then come up with the relevant fund offering. The second is that the EU regulator will require pension funds to consider ESG risks when investing. 

These measures will help ensure that ESG integration becomes the norm in Europe.

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