From sustainability risk to sustainable investment strategy there is no right or wrong answer, but transparency is key.
Private equity asset managers are generally dealing with educated professional investors that have very strong views on what considered as sustainability or ESG [environmental, social and governance] investments should be. However, not all investors are DFIs [development finance institutions] and if asset managers want to expand their investor base, they must not only convince investors that the returns would be equivalent or better, but also help them understand what their strategy ESG is.
Whenever one mentions advising asset management firms on the sustainability investment processes, these views are received at best with a blank stare, and at worst with some scorn. For the general public, asset management and sustainability seem to be two irreconcilable terms, and recent headlines in the news about ‘rainbow washing’ and ‘greenwashing’ revelation are not helping.
Firstly, asset managers in general, and specifically in the alternative sector, have always had to manage sustainability risks. ‘Sustainability risk’ is to be understood as risk that has a financially material impact to the expected return on investment. The financial impact may be on the investment or the target company itself, arising from environmental, social, and governance considerations. Extreme weather, loss of the social license to operate, scandals linked to corruption or bad governance practice etc.
Although not always to referred to as such, long-term investments have always incorporated risk management, taking into account environmental, social, and governance risks, as they may affect the value of the investments. Would this however be enough to claim that asset managers have turned their funds into sustainable products, i.e. with a sustainability objective? Here, one should proceed with reasonable caution. Taking sustainability risks into consideration is clearly a distinctly different process from simply using sustainable investment strategies.
So what is a sustainable investment? There are many definitions but if only one were to be selected, it would be the following:
Investments in an economic activity that contribute to (i) an environmental objective, which can be measured by key resource efficiency indicators (use of energy, renewable energy, raw materials, water and land, production of waste, greenhouse gas emissions, impact on biodiversity and circular economy); and/or (ii) a social objective (tackling inequality, fostering social cohesion, social integration and labour relations, investments in human capital, or economically or socially disadvantaged communities), provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff, and tax compliance.
Many would argue that the above definition is rather ambitious and sustainable investment strategies may be construed otherwise and they would be right. Investment strategies range from negative and positive screening to investors engagement, ESG integration and sustainability-themed investment (depending on the asset types) and the asset manager’s ambition when it comes to sustainability investments. This is not an issue per se but it can be confusing for investors who are not well acquainted with such a variety of strategies. ESG investing is attracting a huge amount of interest and asset managers are starting to rebrand their funds to include ESG components. They can choose from the various strategies above, as long as they are fully transparent with investors about the methodology they use. The key components for success are:
- Drafting an ESG policy, which will clarify where you stand with sustainable investment and how much you want to achieve;
- Reviewing existing investment policies , integrating ESG factors and data points to produce reporting; and
- Disclosures in a PPM [private placement memorandum].
Asset managers have been relatively free to build their methodology and their reporting to investors without regulatory constraints, but this may change in the near future. In particular, European Commission proposals for regulation on disclosures relating to sustainable investments and sustainability risks are poised to put in place harmonised rules on the disclosure of how sustainability targets are achieved and define what sustainability-related impact of products or services can be marketed as sustainable. This should act as an additional driving force to establish these measures.
By Stéphane Badey, partner at Arendt Regulatory Consulting (ARC)
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