What’s the future for ESG broker research?

SRI team cuts and the merger of EAI and PRI demand clear future research incentives.

Fears that dedicated SRI research could become a victim of the credit crisis are proving prescient as banks look to tighten belts. News last week that Deutsche Bank had discontinued its corporate governance research service for clients added to the ending of dedicated ESG research coverage at JP Morgan and Citigroup’s decision to cut back staff at its in-house SRI research team. This is not yet a deluge. Some of the previously specific SRI research will be folded into existing equity and bond research and many brokers are retaining specialist SRI teams. It is, however, a worrying development for those concerned that ESG research, still a relatively new and growing discipline, could become ‘mainstreamed’ for cost rather than content reasons. The irony is that the credit crisis and the latest Madoff Ponzi scheme allegations have underscored a need for better, more probing research on governance and the link between social and investment issues such as sub-prime mortgages/credit cards and banking remuneration. However, major questions remain over how to broaden ESG research, how to mainstream it convincingly, and, of course, how to pay for it?At a meeting earlier this month in Paris, broker, investor and fund manager members of the Enhanced Analytics Initiative (EAI), sat down to close one chapter – the ending of the EAI – and the opening of another: the merger with the United Nations Principles for Responsible Investment (UNPRI). Prior to the recent alliance, the EAI, which numbered 30 pension funds, asset managers and brokerage arms of investment banks, carried out a bi-annual evaluation of investment research providers. This identified a recommended shortlist of those producing high-quality extra-financial research to which buy-side members could direct a portion of their research commissions. Under the merger, the PRI will effectively adopt the EAI as its platform for promoting the first of its six principles: to incorporate ESG issues into investment analysis and decisions.
In his parting comments as incumbent chairman of the EAI, Peter Scales, former chief executive of the London Pension Fund Authority, said broader coverage of extra financial issues should have alerted investors to poor governance, dislocated incentive structures and bad capital management: “That is not to say that better

research would have averted these crises – other remedies are required to resolve those problems – but investors would have been better prepared to deal with the implications over a longer-term horizon.” One of the EAI’s major drivers was that it put hard money at the heart of its push for better ESG research. Investors promised a 5% cut of commissions to recommended brokers. This was an important signal to management at investment banks that SRI research was worth backing. Indeed, according to a report put together by OnValues, the Zurich based research firm on behalf of the EAI, members of the initiative actually paid 11% of commissions for ESG research as of June 2008. Marcel Jeucken, head of responsible investment at PGGM Investments, a founder member of the EAI, said that incentive signal had now officially ended with the dissolution of EAI. Encouragingly, a number of asset managers present gave clear support for continuing to pay commissions as before. In its place, the PRI hopes to open research to a much broader base of potential clients with the creation of a research database of ESG reports produced by brokers and fund managers. The PRI said the database, which will be free to signatories, is expected to be fully operational in spring 2009 following a test period by investors. It said the database would “incentivise” banks to produce so-called extra-financial analysis via the lure of archiving it for promotion to the PRI’s membership, which now represents assets of about $18 trillion. An independent working group will moderate the content from research providers to ensure it is specifically ‘material’ to investors and eligible for posting. While the PRI database is still very much work in progress, brokers have yet to warm to the idea.At the EAI Paris meeting, Stéphane Voisin, head of sustainable and responsible investment for Crédit Agricole Cheuvreux, said it was unlikely that brokers would upload relevant research because it would flout their sales model. He said brokers would prefer to target their research to certain clients and not others and that most knew their potential client base already. Valéry Lucas-Leclin, co-head of SRI research at Société Générale, raised concerns about the database becoming a ‘dumping ground’ for information that could, as a result, devalue good ESG research. Eric Borremans, head of sustainable and responsible investments at BNP Paribas Asset Management, said in response that it was accepted that much of the broker research would be a ‘shop window’ rather than actual product. Nonetheless, he said he believed the database held great potential for SRI research to reach a much broader audience. Other brokers told Responsible Investor they thought the initiative badly timed, coming at a moment when the value of SRI teams was potentially high on management cost-cutting agendas. These concerns are important and will be tricky to resolve. When measured against some of the other interesting findings of the OnValues report, they suggest investors could be at a crossroads regarding what they want to see from their research providers. The report noted that environmental issues had seen the greatest proliferation of research since the launch of the EAI in 2004, particularly in more quantifiable areas such as emissions trading. However, notable gaps in coverage, it said, included governance research, which despite progressing in quantity and quality was still “greatly under-covered relative to its importance.” In addition, coverage of social issues was
found to be scant, despite repeated appeals from EAI members to cover issues such as company stewardship of human capital. In terms of sector coverage, the report said heavy industry with serious exposure to environmental risk was well covered, while other industries including banks/insurers, pharma and IT telecoms were under researched, despite strong drivers related to governance and human capital. The findings suggest that ESG research is, perhaps understandably, still focused on low-hanging fruit that can be more easily sold to clients. Worryingly, the credit crisis has demonstrated that investors can lose a lot more money more rapidly on governance and socially related issues than anywhere else. These issues may be harder to detect, but there are warning signs such as opaque accounting practices and off-balance sheet investment vehicles that should be a red flag to investors about long-term corporate strategy. To this end, good broker research needs to be fresh, forward-looking and incisive rather than just reactive to industry trends. It also needs to be funded properly if investors believe it is important, as we believe they should.Now is the time to make those points more forcefully. If the experiment that was the EAI is going to be truly mainstreamed, the UNPRI could do well to come up with ‘incentives’ that ensure its new database acts a signal to banks that ESG research is fundamental to investors doing business with them. A first step could be for the PRI to make a clear statement from members, notably pension fund trustees, supporting long-term investment initiatives as the Marathon Club and pledging to make the use of both material and exploratory ESG research conditional to the lengthening of that time horizon. Asset owners could for example, use the research as a tool to challenge the ESG investment credentials of their fund managers. Then, perhaps the quid-pro-quo for a serious research shopping window and genuinely larger client base should be that the PRI demands evidence from brokers that they are properly funding ESG research and incorporating it. What better encouragement than to say that PRI members could only end up dealing across the board with those that do so?