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ESG Explainer: Engaging with Reality

Investor engagement with companies on climate change has come under the spotlight, with some warning of shortcomings with current processes.

The effectiveness of asset owner and manager actions in tackling greenwashing by companies is seen as critical to the low-carbon transition. But it is also being questioned due to concerns over scalability and rigour. As calls for more urgent measures on climate change grow, strengthening engagement processes is on the agenda.

This explainer looks at the actions asset owners and managers can take to ensure engagement is effective and not just lip service.

How should engagement work in principle?

Asset owners engage with companies on three levels, says the Principles for Responsible Investment (PRI): direct engagement, collaborative engagement (which may include asset owners and asset managers and is unlikely to be the sole method of engagement) and outsourced engagement, which is carried out by an investment manager (who in turn may subcontract to service providers) or a specialist service provider contacted by the asset owner directly.

Working on behalf of their asset owner clients, asset managers typically conduct corporate engagements and cast votes through their stewardship programmes. While asset owners set the boundaries and expectations of companies in their portfolio with asset managers, there is a risk that the latter may to pull their punches in engagement and voting because of a more complex relationship with the investee company. That said, some asset managers impose strict boundaries between stewardship teams and other company-facing staff, such as portfolio managers and analysts, also offering increasing transparency on processes through stewardship reports.

The first element of engagement is dialogue, where asset owners or managers speak with the investee companies about any concerns they have. If the outcome of engaging with companies fails to meet investors’ expectations, the engagement can be escalated, which includes expressing views publicly, proposing resolutions at the investee company’s annual general meeting, voting against directors at the AGM or requesting an extraordinary general meeting.

What are the shortcomings with engagement?

NGO Reclaim Finance’s 2022 climate Scorecard says asset managers’ engagement policies “fail to send clear signals to fossil fuel companies”. While some of the asset managers studied claim they are pushing companies to improve on climate-related issues, Reclaim Finance says the engagement work “has not led to palpable changes”. The NGO even suggests asset managers are “actively maintaining the status quo by backing fossil fuel companies’ management despite inadequate climate strategies and plans to develop new fossil fuel projects”.

Rickard Nilsson, Director, Strategy and Growth at ESG engagement tracking software developer Esgaia, says key structural challenges with engagement include the ‘free-rider problem’, a lack of transparency leading to many duplication efforts, and the oftentimes lack of effectiveness or success of engagements – the “actual impact”. Perhaps less spoken of, he adds, are the challenges within investor organisations as regards their engagement management and coordination efforts.

The UN-convened Net-Zero Asset Owner Alliance (NZAOA) says asset owners need to take a multi-pronged approach to climate engagement to ensure investee companies are decarbonising in line with their net zero portfolio targets. While engagement with companies on climate-related performance and commitments via dialogue and proxy voting is increasing in depth and frequency, members warn corporate engagement becomes less effective when the business case for requested action is “impractical, uneconomic, or uncertain”, which is more often the case for companies in hard-to-abate sectors.

How effective are engagement policies?

Effectiveness of engagement is hard to measure, individually and in aggregate. If a firm changes policy due to ‘behind-the-scenes’ dialogue with investors, the level of external influence is opaque, even though these efforts are increasingly reflected in managers’ stewardship reports. The lodging of a shareholder resolution by investors can change policy, even if it is withdrawn or defeated, but directors may still choose to cite other factors for any shift.

When it comes to climate-related engagement, the responses of large corporates to investor pressure have been fairly mixed so far, with even Climate Action 100+, an initiative dedicated to collaborative engagement on climate, has admitted much remains to be done.

Reclaim Finance notes a “growing trend” within the investor community to condemn exclusion and divestment from heavy emitters as both “unrealistic and ineffective” tools to decarbonise the economy. Increasingly, the NGO asserts, engagement policies are used as a justification for the absence of or lacking restrictions on fossil fuel companies. “Engagement activities, which consist mainly of dialoguing with investee companies and voting at their AGMs, are supposed to push companies’ efforts to decarbonise and transition their business model,” says Reclaim Finance. Pitting engagement and exclusion as diametrically opposing practices is “at best misguided and at worst a deliberate strategy to avoid exclusion”. Reclaim Finance argues that the most effective investors use the threat of future divestment as a cudgel to enhance their engagement efforts.

Colin Baines, Investment Engagement Manager at UK charity Friends Provident Foundation, says the idea that divestment is not an option is “nonsense”. ”Even if engagement is the preference, divestment cannot be taken off the table and should form part of the engagement escalation policy”. Engagement with high-risk sectors like fossil fuels should be reasonably forceful; “tea and biscuits” engagement has failed, he adds.

The effectiveness of proxy voting as an escalation technique is also questionable. Baines says resolutions relating to net zero transition at recent bank AGMs have not been supported by management or a majority of shareholders, even though they were fully aligned with the goals of Climate Action 100+, Net Zero Banking Alliance and Net Zero Asset Managers initiative (NZAM). “This is despite most of the banks in question and a great many asset managers being members of these coalitions.”

The fact that asset managers are not voting in favour of these resolutions makes a mockery of their climate commitments and claims to be integrating ESG, he adds.

How are investors responding to slow progress on climate engagement?

At COP26 last year, a group of UK asset owners including the Charities Responsible Investment Network and Students Organising for Sustainability launched the COP26 Declaration of Asset Owner Expectations, which set out eight principles covering issues including engagement, voting and escalation around climate.

The declaration states that investee companies “should be engaged with to set short and medium-term science based targets (e.g. 45% emissions reductions by 2030), and a net zero target for no later than 2050 that is not overly reliant on negative emissions technologies”. Engagement for distant targets and improved disclosure alone is insufficient, said the declaration, as is membership of third-party collaborative initiatives without evidenced proactive engagement.

Too many asset managers use membership of groups such as Climate Action 100+ and the NZAM as a “fig leaf”, says Baines. “They point to membership as evidence of their climate commitments, but it is meaningless as an indicator for asset owners. There is an extremely wide variance in the behaviour of the members of these groups – for example, some have good voting records on ESG while others support very few of the relevant resolutions that come to AGMs.”

The COP26 declaration states that engagement escalation policies should be developed and disclosed, including details on how and when engagements will be escalated. To improve transparency, voting records should be published as soon as possible after the AGM and include rationales on votes against management as well as votes on shareholder resolutions.

The Institutional Investors Group on Climate Change (IIGCC) recently developed a toolkit to help asset owners and managers enhance their stewardship practices when engaging with companies on their progress transitioning to net zero greenhouse gas (GHG) emissions. Created with UK pension scheme Railpen, the Net Zero Stewardship Toolkit consists of six key steps including setting net zero alignment criteria, developing an engagement strategy for priority companies, and introducing a baseline for engagement and voting across all portfolio companies.

What can asset owners and asset managers do to strengthen engagement?

The IIGCC said asset owners and asset managers should make sure their engagement priorities and objectives are aligned, adding that this will “reduce duplication and enhance impact by collaborating where valuable”.

Engagement is “anything but simple”, says Nilsson, pointing to a disconnect between the complexity of the task and that of the solutions currently being applied. “To ensure active ownership does not become an illusion, and to avoid greenwashing, we need to focus on quality and not quantity, with more honesty and realism about the deployed resources and communication of progress. This includes the why, how, and what of engagement objectives, resources and process, and outcomes/attribution.”

The severe sustainability issues facing society is a “market failure”, he adds. To address these, system-level change is required. “We need a step change in investment stewardship. The most effective way to set direction and achieve progress here is public policy. Industry participants need to increase policy advocacy, both in direct support of and through coordinated efforts. Additionally, we should collectively continue to develop mechanisms that lead to increased quality, efficiency, and collaboration, including, for example, initiatives that help pool investor resources, increase sector/value chain engagement, and so forth.”

How can asset owners assess the engagement credentials of managers?

Baines says asset owners must put pressure on asset managers to “walk the talk” on ESG. “Asset owners must send asset managers a strong market signal of their expectations and be very public about the standards they expect and will judge managers against.”

While increasing numbers of asset managers say they have integrated ESG into investment management, there can be a large disconnect between marketing claims and practice, he adds. “Asset owners must hold asset managers’ feet to the fire and get them to follow through on their public pronouncements.”

To date, asset owners have been reluctant to include engagement as a critical element of their manager selection processes, although the PRI has issued guidance on this matter. But their ability to assess managers on engagement is improving, with many managers publishing their voting records and other engagement metrics in stewardship reports. Minimum member standards for initiatives such as the NZAM should be introduced, argues Baines, to ensure that commitments are genuine and not greenwashing.

“To judge the green credentials of asset managers, asset owners should look at their holdings, voting record, and how they engage,” says Baines. “They should really dig into the engagement process of asset managers, looking for engagement escalation, including voting against management and co-filing resolutions when required, and identify who is greenwashing and who is doing meaningful engagement.”

Baines believes the potential to tackle climate change is “huge” if asset managers start to engage and vote in line with their commitments. “Resolutions would be passed and companies would be forced to change their behaviour and adopt meaningful transition plans,” he observes.

Friends Provident is a co-filer, with Market Forces, of a resolution at Standard Chartered’s AGM on 4 May that calls on the bank to align its fossil fuel financing with the International Energy Agency’s ‘Net Zero by 2050’ pathway.

“At the Standard Chartered AGM and others, asset managers have a clear choice – do they support their own climate commitments or do they go along with greenwashing?” says Baines.

Earlier, Friends Provident had co-filed a resolution, with a ShareAction-led coalition of investors for the HSBC AGM. The resolution was withdrawn as the filers considered the bank was making progress following engagement by the investor coalition. The bank has committed to strengthened policies and engagement will continue, adds Baines.

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