Fund Solutions

ISS ESG Calls for Funds to Align with Race to Zero Criteria

New report published with Herbert Smith Freehills outlines recommended approach to constructing and implementing net zero strategy for funds.

Building a net zero strategy for funds based on the United Nations Race to Zero campaign criteria is an “intuitive step” for asset managers to take, according to Viola Lutz, Head of Climate Solutions at ISS ESG, the responsible investment arm of the Institutional Shareholder Services (ISS).

Race to Zero is a global campaign providing clear guidance on what a high-quality and actionable net zero pledge should look like. It currently represents 708 cities, 23 regions, 2,162 businesses, 571 higher education institutions and 127 of the world’s biggest investors.

“Given the climate emergency, coordination between actors is key,” she told ESG Investor. By developing their net zero strategies in line with a global set of criteria, asset managers’ products will be more easily comparable and progress can be monitored by asset owners and regulators, she said.

Asset owners are putting more pressure on asset managers to align funds with net zero as they set their own decarbonisation targets. A recent survey by State Street Global Advisors (SSGA) noted that, while only 20% of global asset owners have set decarbonisation targets in line with the goals of the Paris Agreement, two-thirds plan to do so within the next three years.

They also expect asset managers to disclose and manage climate-related risks within funds. For example, UK-based asset owners in the education and charity sectors set out minimum expectations for asset managers’ climate policies. The declaration, which was published at COP26, covered strategy, asset allocation, active stewardship and transparency.

ISS ESG and law firm Herbert Smith Freehills (HSF) have published a report outlining how the Race to Zero recommendations as part of their efforts to provide clients with fund solutions that deliver zero greenhouse gas (GHG) emissions.

The report has outlined that fund managers should: set appropriate targets (pledge); design a net zero strategy based on the targets (plan); implement the strategy in the fund’s governance and daily administration (proceed); and disclose strategy progress (publish).

For the latter step, asset managers have a range of reporting requirements and voluntary disclosure frameworks to disclose against, such as the Task Force on Climate-related Financial Disclosures.

The four-step criteria can also be applied to any type of entity or sector, whether corporate or governmental, meaning that it will be far easier to compare progress across industries, according to Heike Schmitz, Corporate Partner at HSF.

Guidance on producing transition plans for their funds is particularly important as new regulations come into force.

For example, the UK’s Sustainability Disclosure Requirements (SDRs) will require disclosures on transition plans from companies and regulated investors including asset managers, according to the government’s ‘Roadmap to Sustainable Investing’ report. Under the SDRs, asset managers will also be required to disclose the environmental impact of the activities financed by their investment products, justifying any sustainability claims made.

This follows the EU’s Sustainable Finance Disclosure Regulation (SFDR), which asks Europe-based asset managers to categorise their ESG-labelled funds according to how ‘green’ they are. From July 2022, SFDR Level 2 will require asset managers to provide more comprehensive underlying evidence outlining the fund’s exposure to a series of environmental and social factors.

Not a perfect system

While the Race to Zero is the recommended place to start, it won’t be without its challenges, according to the report.

Defining a strategy to ensure that the fund is beginning to transition to net zero will be the “most challenging” of the criteria for asset managers, said Lutz.

“Decisions related to strategic asset allocation (SAA) are within the control of the individual fund manager, but activities relating to active ownership often necessitate coordination within the larger company and can also be resource intensive and result in more open outcomes,” she said.

Some asset managers, such as Legal and General Investment Management (LGIM), are upping corporate engagement on climate-related issues. LGIM increased its engagement in this area by 63% in 2020 through its Climate Impact Pledge engagement programme.

As part of fund managers’ SAA, they should use tools to optimise their asset allocation to ensure Paris alignment, the report noted. These tools include climate scenario analysis and the integration of Paris alignment targets as KPIs in regular assessments and reporting.

Schmitz said planning the strategy will require fund managers to “deep dive into the fund portfolio and its assets to assess how the overall objective can be achieved”. There is a myriad of potential challenges, she said, such as lack of reliable data, difficulties breaking down Paris-aligned pathways for individual asset classes, and working out sensible exclusions for the fund while maintaining diversification and strong returns.

“Many fund managers are dealing with these challenges at the same time, but often come to bespoke, individualised solutions in the absence of established market practices,” Schmitz said.

To navigate these challenges, there are a number of voluntary tools and frameworks asset managers can use to help them align their funds with Paris goals and build on the Race to Zero’s four criteria, the report noted, highlighting the Paris Aligned Investment Initiative’s (PAII) Net Zero Framework as a reliable and credible example.

This follows ISS ESG’s announcement last month that it will be launching a suite of dedicated Net Zero Solutions with automated portfolio reporting. It will go live in Q1 2022 and will help investors identify suitable KPIs, analysis and data to transition portfolios and set relevant net zero targets, while also assessing the extent to which they investments are aligned with a net zero scenario.

Global asset manager Nuveen has also published a carbon optimisation paper outlining how institutional investors can create net zero-aligned portfolios without sacrificing returns. The report models a variety of scenarios using different asset allocations to timber, farmland and sustainable infrastructure.

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