This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.
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The EU High Level Expert Group (HLEG) on sustainable finance has a clear goal and a unique opportunity; to set out concrete steps to create a financial system that supports sustainable investments – a priority action of the Capital Markets Union (CMU) Action Plan. This is an opportunity for Europe to lead in orientating its investors, companies and financial institutions, to deliver and benefit from the industrial transition to a sustainable and low carbon economy that is now underway. In the current UK negotiations with Europe this should also be a priority for both parties given the global expertise and thought leadership on sustainable finance that is currently located and headquartered in London.
When I joined FTSE 15 years ago integrating sustainability into investment strategies was a minority sport. Over this period the change has been dramatic. For many years there was gradual increased focus from institutional investors, but over the last two years the pace of change has accelerated to the point where most large institutional investors now aim to integrate sustainability into active and passive strategies as part of all new mandates. The changes on the passive side have been particularly intense over the last year: the majority of new institutional mandates by AUM are passive. The majority of these are smart beta index funds, and the majority of these are now incorporating climate and/or other sustainability parameters into the index design. This is very different to the previous dominant position that ESG in passive was only about voting and engagement – it’s now all about index design too. For new mandates, it is no longer a minority sport, but the market norm.
At the same time amongst issuers there are very different responses to these change. On one hand there is massive corporate change taking place, with a large proportion of listed companies now having a presence in industries that enable the green economy – we have identified around 3000 companies who now have ‘green revenues’ – i.e. whose products and services have a clear environmental utility across diverse sub-sectors including advanced battery technology, water desalination and waste treatment. On the other hand, most companies are blissfully unaware of the changes taking place among their investors. Many companies reference the fact that few questions refer to sustainability in their analyst meetings. However, the analysts represent one part of the investment chain and many of the world’s largest pension funds are simply changing their core mandates and investments; with investee companies completely unaware.
Without fanfare, large volumes of capital are being shifted into sustainable strategies that incorporate ESG considerations. Last November, for instance, HSBC announced that its corporate pension scheme had switched its default equity fund to a smart beta strategy with three climate change ‘tilts’, underweighting companies with high relative carbon emissions and fossil fuel assets, and with higher exposure towards those with revenues from green industries. Both the risk premia factors and the climate tilts have led to the fund’s historical out-performance against its benchmark.HSBC Pension Fund’s trustees did not make these changes to save polar bears or penguins. They did this for fiduciary reasons. They wanted to reduce the risks facing their beneficiaries from climate change. Where previously fiduciary duty prevented trustees from adopting sustainable strategies, managing ESG risks is now integral to fulfilling these duties.
These kinds of mandate are growing on an increasingly frequent basis especially with larger asset owners re-allocating multi-billion dollar funds. Just recently, Japan’s Government Pension Investment Fund – the world’s largest pension fund – announced it would shift $8.8bn into three new ESG indices. In an interview they stated that they also expected to increase this allocation three-fold within five years.
By allocating assets towards funds and strategies such as these, investors are sending an increasingly clear signal that they recognise ESG risks and opportunities, and that they are prepared to invest on this basis. However, investors need accurate and consistent ESG data upon which to build these indexes. Without it, investors must either create proxy measures, or assume the worst – penalising those companies that do not provide adequate disclosure.
Understanding the industrial output from the issuer of a bond should be as important as understanding how the finance will be used
Among other issues, HLEG is considering disclosure practices and how to build on the EU’s Non-Financial Reporting Directive, the TCFD recommendations, and the French Energy Transition law. HLEG is also considering the role of green taxonomies, labels and standards. One of the areas that until now has not been getting enough attention is encouraging more granular reporting of green revenues, where companies in their annual report and accounts break out revenue sub-segments associated with green products. The focus on green bonds is admirable, and these will play a growing role in green financing, but there is an opportunity to join up the work on green definitions around the use of proceeds with the field of green industrial definitions, which to-date has been more focused on equities than bonds. Understanding the industrial output (i.e. the breakdown of products) from the issuer of a bond should be as important as understanding how the finance will be used. A European drive on green taxonomies must focus on how to connect these two areas to provide investors with a more complete picture of risk and opportunity.
We are in a period of rapid industrial change as the transition to a sustainable and low-carbon economy gathers pace. Old industries will change shape, and new ones will emerge. Investors are directing growing volumes of capital to this transition; companies must ensure that they are doing so armed with the best possible information, and policy makers need to ensure they embrace and enable these changes to give their investors and industry the best chances of succeeding in the rapidly changing green global economy.
David Harris is Group Head of Sustainable Business at the London Stock Exchange Group
To give feedback on the group’s interim report, published in July, see here.