Fund managers are looking increasingly to integrate environmental, social and governance (ESG) considerations into their strategy and operations. This entails a shift for many managers who need to consider the ESG risks and opportunities for their businesses and the outcomes they want to achieve. ESG integration is difficult because ESG is a broad theme, but it matters – and its application needs to be tailored to each specific context.
Why integration matters
Value and risk: the value of investments may increase if they are shown to have a positive impact on ESG outcomes. Conversely, a negative impact can destroy value through reputational harm. ESG analysis needs to be integrated into the appraisal, monitoring and exit of investments.
Fundraising: institutional investors are increasingly taking into account a manager's ability to meet ESG standards when making manager selections. These investors not only care about ESG but also have their own regulations with which to comply – for example, pension scheme trustees face new rules on climate change disclosures.
Regulation: ESG regulation has come into force and more is on the way. The EU's Sustainable Finance Disclosure Regulation (SFDR) came into effect in March 2021. It will affect EU alternative investment fund managers (AIFMs) and UK AIFMs that market their funds into the EU. In the coming months, the UK government is expected to consult on domestic legislation regulating ESG disclosures in the funds industry.
Six practical steps
What areas should fund managers consider as part of the ESG integration process? Here are six practical steps (these are iterative and not necessarily in chronological order). Some will likely need to be revisited as the landscape changes in the coming months (for example, due to regulation). But they should give managers a steer on how to apply ESG both when investing externally as well as internally as a firm.
1. Senior leadership: ESG integration involves a firm reflecting on and potentially changing its core strategy and operations so as to embed ESG factors. This will not be possible without the backing of senior leadership. The process must begin with the board or C-suite making a commitment to this change. The day-to-day design and delivery of the project can be managed by an executive. But this executive must (regularly) report to the senior leadership team as the sponsor of the project.
Actions: prepare a strategic positioning or board paper and a project delivery plan.
2. ESG materiality: ESG is context specific: a manufacturing firm may place more focus on health and safety, whereas a professional services firm may place more focus on human capital management. You need to determine which are the most material ESG issues for your business. As part of this process stakeholder engagement is crucial: speak to investors, employees, suppliers, management of investee companies, industry bodies and peers. This will help in framing your ESG approach from the perspectives of both an investment manager and as a firm.
Actions: undertake internal research, engage with stakeholders, produce a stakeholder impact map and an ESG materiality matrix.
3. Focus on outcomes: with the materiality assessment done, you can consider the ESG outcomes your business aims to impact and how you will measure performance against those outcomes. For example, you could select a sub-set of the UN Sustainable Development Goals (UN SDGs).
Actions: determine the long-term goals/UN SDGs you intend to impact, consider joining the UN Principles for Responsible Investment; consider how you will measure performance.
4. Processes: work out what business processes need to shift as a result of the above. It is likely that your investment process will need to change. Does your due diligence process need to change so that there is a focus on material ESG risks and opportunities? Is ESG considered in the business plans of underlying investments, and do you need to implement regular ESG reviews for underlying investments?
Actions: update policies (including due diligence policy), update investment strategies (if applicable), update investee entity business plans and engage with management at investee entities.
5. Governance and reporting: think about whether you have the right structures in place as a firm. Do you have the right boards and committees in place and are the right people appointed to these? You may wish to consider the remuneration of some of your staff so that it is linked to sustainability outcomes.
What enhanced reporting do you need to provide to your investors and how does this need to be updated in line with ESG regulation? How are you going to collect data from underlying investments to meet your reporting obligations?
Actions: review governance structures and policies, review remuneration policies, review applicable ESG regulation, update template reports and commit to an annual ESG impact report for stakeholders.
6. Horizon scanning: ESG is an evolving theme so it is important to keep abreast of current events, market practice and changes in regulation. In terms of regulation, it is worth understanding the main features of the SFDR and how it applies (the SFDR has been tipped as the gold or "green" standard of ESG regulation so you may wish to adopt some of its standards even if they do not directly apply).
Actions: improve understanding of emerging regulation and subscribe to OC's ESG updates.
See our Funds Focus briefing for an update on the latest developments on the SFDR and ESG.