Key Takeaways:

• Investor flows in Europe indicate that funds with the best ESG credentials are winning market share and are focusing on corporate performance metrics beyond traditional fundamentals like P&L and balance sheet strength.
• Given fragmentation around ESG rules, standards and data metrics, managers should articulate their ESG strategy better and back it up with tangible, credible data. In short, they need to get their internal ESG policies and procedures in shape and their external messaging should match reality rather than be aspirational.
• In many instances, asset managers are overwhelmed by the sheer volume of ESG data. So, to articulate a fund’s ESG strategy, it is critical that firms also have the people who understand what the data means and the metrics behind it.

Communicating a compelling environmental, social and governance (ESG) narrative to attract and retain investors is now arguably just as important for asset managers as evidencing strong performance and complying with regulatory and risk management requirements. That narrative should include how the asset manager’s people, policies and procedures all support their ESG principles.

The problem, however, is that the rules, standards and data metrics around ESG are highly fragmented, creating complexities for fund managers, their boards and end investors. Speaking during our latest webinar, industry experts from RepRisk, FE fundinfo, and BBH shared their insights into the current state of the ESG market, together with some of the challenges facing it and how managers can adapt their internal processes to capture the opportunities ESG may bring.

The ESG Market – No Slowing Down

The momentum behind investor inflows into ESG funds is expected to grow. According to PwC’s Asset and Wealth Management Revolution 2022 report, global ESG-related assets under management (AUM) are expected to skyrocket from $18.4 trillion in 2021 to $33.9 trillion by 2026, corresponding to a projected compound annual growth rate (CAGR) of 12.9%.¹ “ESG, or SRI (socially responsible investing), has been a feature in the funds industry for over 15 years, so it is not a new topic, but it has certainly accelerated over the last 18 months,” noted Killian Lonergan, Head of Distribution Intelligence at BBH.

Investor flows in Europe indicate that funds with the highest ESG credentials are winning market share. Under the March 2021-enacted Sustainable Finance Disclosure Regulation (SFDR), asset managers are required to label their funds as being either one of Article 6, Article 8, or Article 9, depending on their ESG objectives. Lonergan said Article 9 funds – namely those with the highest ESG classification – attracted €12.6 billion in net inflows in Q3 2022, while Article 8 funds – which simply claim to promote ESG characteristics – shed €28.7 billion.² Meanwhile, he added that Article 6 funds – which purport to have no ESG characteristics whatsoever – suffered outflows totaling €62.1 billion in Q3.³

“Customers clearly want to buy ESG investment products, and this is reflected in wider societal shifts, with a growing focus by people on issues like climate change, workers’ rights and combating modern slavery together with diversity and inclusion (D&I),” explained Adrian Whelan, Global Head of Market Intelligence at BBH. As a result, more asset managers are focusing on metrics beyond just traditional fundamentals like P&L and balance sheet strength when investing into companies, and are instead paying closer attention to workers’ rights, carbon emissions and D&I.

A Market Riddled with Acronyms and Uncertainty

Despite the market’s meteoric growth, there are a number of impediments hampering ESG investing. One of the problems facing ESG investing is not so much the lack of regulation but rather the abundance of it, together with the absence of harmonization across different markets. Within the EU, there are three main ESG regulations, including the SFDR, the EU Taxonomy Regulation – creating an ESG classification system for economic activities – and the Corporate Sustainability Reporting Directive (CSRD), which is a recently enacted provision that applies to large and/or listed companies. Amid the “alphabet soup” of regulations, gaining comfort in the ESG space is becoming trickier.

“A reason we are facing so many difficulties around ESG in the EU is because of the staging and sequencing of the rules,” said Whelan. By this, he means that the EU ESG rollout might have been better served with issuer-led data transparency via the CSRD, followed by classification through the Taxonomy and then disclosure with SFDR, rather than the other way around.

Compounding matters further is that various markets – including the U.K., U.S. and those in the Asia-Pacific region – are adopting their own bespoke approaches towards ESG regulation, classification and reporting, creating added complications for cross-border investment firms. For instance, a U.K. based asset manager distributing into the EU will be expected to comply with both the EU’s regulations on ESG and the U.K.’s Sustainability Disclosure Regime (SDR), the contents of which are more closely aligned with the Financial Stability Board’s (FSB) Task Force on Climate Related Financial Disclosures (TCFD). Despite this fragmentation, there is evidence that global rules are beginning to coalesce around International Sustainability Standards Board and Task Force on Climate-Related Financial Disclosures (TCFD) standards, and managers who can deal with the EU ESG rules can also deal with most forms of subsequent ESG rulemaking.

Getting it Right: How Asset Managers Can Improve Their ESG Processes

Amid this regulatory uncertainty, some firms have been accused of greenwashing or mis-labelling. Consequently, there have been a number of high-profile ESG rating downgrades, with attention drawn to those funds downgrading from Article 9 to 8 designations. “This year has been quite a year for greenwashing, and regulators – including the U.S. Securities and Exchange Commission (SEC) – are taking action. Many of the fines being issued against managers relate to deficiencies around their policies and procedures, as well as firms making false or misleading statements around sustainability,” said Maryse Gordon, Sustainable Finance, Partnerships and Business Development Manager at RepRisk.

Investors are also scrutinizing if firms are walking the ESG talk. Firms therefore need to consider ESG in a holistic sense: in addition to performance, investors may expect an "outside-in" view of their firm and being able to talk about their own culture. “It’s not about making external ESG declarations – you have to look at the bigger picture and demonstrate responsible business conduct,” said Gordon.

Despite what has been published, in the trade press, about the frequency of occurrences of greenwashing in the asset management industry, Whelan expressed skepticism: “I do not think asset managers are intentionally greenwashing or mis-selling, but rather they need to articulate their ESG story better and back it up with tangible, credible data. In short, they need to get their internal ESG policies and procedures in shape if this sort of thing is to be avoided,” he said.

Access to accurate and quantifiable data is another barrier impeding the development of the ESG market. In many instances, asset managers are being overwhelmed by the sheer volume of ESG data, much of which may be contradictory or non-standardized. Aggregating and collating this disparate information into digestible reports for retail and institutional audiences is therefore a challenging undertaking in itself, a point made by Matthias Breier, Head of ESG Product at FE fundinfo.

“The ESG market has exploded over the last few years, but with that comes a lack of the people who can interpret these data points and turn them into understandable reports for investors. Often, we see investment firms creating ESG reports which are 40 to 50 pages long. We spend a lot of time convincing managers that people will not read these lengthy documents. While there are hundreds of underlying ESG data points, it is critical managers focus on the core measurables,” explained Breier.

Breier added: “Many fund managers are missing the qualitative aspects or underlying understanding of the data of risk metrics for environmental change.” This will ultimately require firms to hire the right people who are well-versed in ESG matters, so that they can convey the right data to clients in a manageable format.

In summary, fund managers can improve their ESG governance starting with three steps:

1. Ensuring their people who are talking about ESG are well educated about what it means so that they can explain it to their clients and investors.
2. Having a holistic view of what ESG performance looks like – it’s not just the data that’s self-reported but an “outside-in” view of what an organization is saying so that they demonstrate removal of certain types of biases.
3. Consider what true credibility looks like, e.g. working with partners, omitting potential greenwashing. That involves having policies, procedures, controls and access to accurate, reliable, non-biased data that helps with the culture of ESG and measuring performance.

Building for the Future

ESG is a rapidly expanding market, one that asset managers are looking to capitalize on. However, issues around arbitraging regulations and uncertainty around data are causing concerns for the industry. By developing better ESG governance and employing more people who understand the nuances around sustainability, investment firms will be able to navigate some of these teething problems.

For more information, contact your BBH representative or follow BBH Market Insights on LinkedIn where we will be sharing further insights on ESG in the coming months.    

The views and opinions expressed are for informational purposes only and do not constitute investment, advice and are not intended as an offer to sell, or a solicitation to buy investment products or services.  Views and opinions are current as of the date of the publication and may be subject to change.

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