The ESG Interview: The DIY Approach to ESG

Colin Baines, Investment Engagement Manager at Friends Provident Foundation, highlights the importance of engagement to ESG investing.

As a charitable foundation with a mission to promote a fair and sustainable economy, how do you manage your endowment when few funds on the market, if any, align with your purpose or values?

The trustees of Friends Provident Foundation – endowed in 2004 in York, England, via unclaimed shares in Friends Provident plc – decided to take matters into their own hands.

They had invested their endowment along sustainable lines from the outset, but the trustees took a further step to ensuring their investments supported their mission in 2016, by hiring an investment engagement manager. Having previously worked for the Cooperative Bank and Group in a number of ethical investment roles, Colin Baines was one of the first such appointments in the UK charitable sector.

“A lot of foundations put a lot of effort into grant-giving, but that’s perhaps 3-5% of the capital,” notes Baines. “Potentially, the other 95% could be working directly against those grants.” Once a foundation has ensured its investments are not actually undermining its mission, trustees can think about acting positively.

“You can start to utilise your endowment to progress your charitable mission, and that’s what we’re seeking to do,” he adds.

“Wading through greenwash”

In 2017, the foundation became the third partner in a recently launched impact investment fund, Snowball, created by Panahur and the Golden Bottle Trust. Snowball focuses on high-impact social and environmental investments, including community-owned UK renewable energy projects. It is open to other foundations and like-minded institutional investors, and aims to become available to the public as an impact investment trust.

“We thought we could do it better ourselves,” says Baines. “We seek to establish best practice and the norms of what mission-led asset owners expect from the impact market.”

Then, last year, faced with less-than-convincing marketing materials from asset managers, the foundation joined with two other charities to run a tender, which they dubbed the ESG Olympics. Alongside Blagrave Trust and the Joffe Charitable Trust, Friends Provident issued a £33.5 million mandate.

It was, says Baines, a response to finding “an awful lot that was greenwash and an awful lot that was just marketing and rebadging” in the ESG funds sector. “Rather than wading through all that, we asked them to come to us, with the instruction to ‘impress us’ in terms of ESG integration,” he explains.

The 60 entrants – ranging from specialist impact boutiques to global multi-asset leviathans – were whittled down to five, using indicators of ESG integration such as in-house expertise, intentional impact, stock selection, voting record, engagement and escalation, exclusion and impact reporting.

Based on the submissions, Baines compiled a report, consolidating the findings of the exercise for the benefit of other asset owners. Released last month, ‘State of the Sector 2020’ includes five recommendations, highlighting what the charities felt were widespread shortcomings in the offerings of participating asset managers.

Three of the recommendations revolve around engagement, implying a reluctance on the part of managers to put pressure on investee companies to adapt policies and practices in line with the priorities of shareholders.

Specifically, the report called for managers to back ESG resolutions at AGMs on a comply-or-explain basis, to engage proactively with company management – for example, to secure tangible, science-based and medium-term targets for reducing carbon emissions – and to institute formal escalation policies detailing next steps in the event of prolonged disagreement with management.

The report’s other two recommendations reflected, firstly, a general lack of integration of social factors by asset managers in stock selection and engagement activity and, secondly, still patchy and inconsistent levels of disclosure, across holdings, voting records and engagement goals, assessments and outcomes.

Filling the skills and data gaps

Baines is keen to point out the quality of the entries that made the short-list, topped by the Cazenove Sustainable Growth Fund, launched in February and available to charity and private clients. But he is also unsparing in his assessment of the overall current state of ESG offerings to UK charities, suggesting that many managers do not have the basic skills and policies in place to meet the needs of sustainable investors.

Much of the information required from investee companies to understand their ESG risks and opportunities is either hard to access or hard to compare. This means asset owners – especially under-resourced ones in the charitable sector – rely heavily on fund providers to conduct detailed due diligence on the constituents of their portfolios.

“The lack of data creates challenges,” acknowledges Baines. “To deal with that, asset managers in particular need to invest in people. They need to invest in their skills and knowledge base, so they’re able to take a materiality approach, reach meaningful assessments, and make decisions based on the best available information.”

Instead, he says, a lack of in-house expertise at some firms leads to over-reliance on third-party inputs, including screens, scores and data. “There’s a dual issue of problems with data and over-reliance on data,” he says. “They don’t have the people to overcome the challenge. Some don’t know where to start.”

Despite variations, overall levels of transparency from funds are improving, with the flow of information on main holdings becoming available on a quarterly basis. To assess a manager’s ESG integration credentials, Baines first looks at holdings, to get a sense of ESG integration in stock selection, then voting and engagement record.

“If they’re holding big tech and fossil fuel stocks, that would ring alarm bells. Big tech would raise concerns about how well the ‘S’ of ESG is integrated. And if there was any fossil-fuel related stock, I would expect to see really quite forceful stewardship, with very high levels of support for ESG resolutions, maybe even co-filing resolutions.”

A question of credibility

For Baines, voting record is important because it reflects a willingness to effect real-world change at investee companies to address ESG risks.

“I would expect to see 80+% support for ESG resolutions. If it’s low, it just raises those flags for greenwashing. It’s not credible for an asset manager to claim a fund is ESG and then vote against ESG resolutions,” he says.

The comply-or-explain recommendation of the ‘State of the Sector’ report – echoed by several organisations in the sustainable investing sector – offers managers the opportunity to justify their rationale for voting against ESG-related resolutions.

“We don’t expect asset managers to vote for 100% of ESG resolutions,” says Baines. “But we would like to see a comply-or-explain approach. Very few actually take that approach, but a good number vote for good number of the resolutions.”

Baines also sees a willingness to change among many asset managers, with several entrants to the ESG Olympics stating their openness to working with Friends Provident and peers to institute robust engagement escalation policies. This is to be welcomed, he says, but it suggests many firms have not yet taken on board the necessity to challenge boards on occasion in the spirit of active stewardship.

Good engagement starts with a point of difference,” he adds. “If you’re not willing to oppose management, escalate engagement, and vote for these independent resolutions, you’re not doing ESG. All you’re doing is mis-selling a fund.”

Does charity begin at home?

Recent research suggests that the charitable sector is underserved with sustainable investment options. A UK-focused survey of funds offered exclusively to charities concluded that providers of pooled funds “could be better at demonstrating innovation” and advised charities to undertake due diligence to ensure they were using products aligned with their mission.

The EIRIS Foundation survey found that 67% of funds employ negative screens, with 30% applying positive screening, but almost 20% have no screening policy. Only half of funds surveyed had an explicit climate change-related exclusion policy and much fewer were entirely free of fossil fuel investments.

Charitable foundations themselves have been less urgent in their demands for ESG investment solutions than one might expect.  Around 60% of non-profits are pursuing either sustainable and impact investment or ESG integration strategies, according to Cambridge Associates’ 2020 global survey of around 200 non-profit organisations including foundations, educational, religious and cultural institutions, compared with 36% in 2018.

The report noted much stronger growth in Europe and the UK than in the US, with around half of those not currently engaged in sustainable and impact investing saying their mission “is solely addressed via programmatic / philanthropic activities”. Around a third of institutions not currently engaging in sustainable and impact investing anticipate seeking exposure in the future.

Regulatory developments are accelerating change. In January, the UK Charity Commission said it would publish draft guidance in the spring for public consultation, with the intention of publishing a “final updated responsible investments guidance” in the summer. At present, the commission only requires trustees to seek the best financial returns at an acceptable level of risk, while asking them to consider ESG factors and the consistency of investments with their aims.

Differences between suppliers and customers are already becoming more apparent. A recent ShareAction survey of 37 UK charities and universities with more than £12 billion in assets under management, published in February, found asset managers were still not yet aligned with their clients’ responsible investment policies.

More than half (54%) of the group’s asset managers had not yet set investment targets related to climate change, while slightly more than a third of managers (36%) linked executive pay to performance on responsible investment issues, such as boardroom diversity, engagement with investee companies and voting on shareholder resolutions.

On voting behaviour, 59% of the group’s asset managers publish their voting decisions, while less than half (49%) provided rationales for these decisions. The survey follows up on a 2018 discussion paper, ‘Improving the conversation’, in which ShareAction’s 18-member Charities Responsible Investment Network – which includes Friends Provident Foundation –  outlined expectations from asset managers on proxy voting, engagement and escalation, holdings and governance.

Engaging with energy

Looking ahead to the UK 2021 AGM season, Baines says Friends Provident will be focusing its efforts largely on its long-term engagement programme with energy utilities. The foundation and its partners enjoy good ongoing levels of access with firms in the sector, making AGM-related activity less of a necessity, he says. The firm has, however, co-filed a resolution calling on HSBC to publish a strategy and targets to reduce its exposure to fossil fuel assets consistent with the Paris climate goals.

Focused on effecting a ‘just transition’ for the energy utilities sector, the most visible outcome of the joint engagement programme by Royal London and Friends Provident has been the publication of SSE’s strategy document in Q4 2020, which Baines describes as “a big win”. The two investors are also part of a wider campaign, the Financing a Just Transition Alliance, together with 40 other organisations, coordinated by the London School of Economics’ Grantham Research Institute on Climate Change.

Royal London and Friends Provident Foundation have been engaging with firms in the UK utilities sector for several years to help them develop post-fossil fuel strategies which not only encompass net-zero emissions pathways with short- and medium-term goals, but also incorporate a transition plan that “goes beyond decarbonisation”. This means engaging with the communities the utilities are moving their operations away from and toward, as well as embracing energy sector megatrends such as decentralisation, democratisation and ‘pro-sumers’. “Pro-sumers are people who both consume and produce electricity. Technologies like rooftop solar and electric vehicles mean markets are being disrupted like never before, leading to all sorts of risks and opportunities,” says Baines.

SSE’s plan was the first formal just transition strategy in the utility sector, the result of very close engagement with Royal London and Friends Provident Foundation, involving a high degree of collaboration on the strategy, across several iterations. SSE and its investors agreed a set of 20 principles to guide future decision making around the transition plan.

“Basically, all our feedback was taken on board. The end result was brilliant,” says Baines, who is hopeful that SSE’s UK peers will follow, and soon. “We’re hoping most of the UK operating energy utilities will publish a formal just transition strategy of some description by COP26. The discussions we’ve been having so far have been very positive,” he says. “We couldn’t be more pleased with how it’s going.”

Taking responsibility

The engagement exercise with energy utilities can be seen as a further example of the DIY approach to ESG investors. Certainly, Baines argues that asset owners do need to take responsibility, rather than assume public policy will do the heavy lifting. He welcomes but notes the limitations of the regulatory changes being made to increase transparency to investors on ESG factors, such as the EU Disclosure Regulation, Taxonomy Regulation and Non-Financial Reporting Directive.

“Public policy and government intervention is important, but I don’t think it’ll solve the issues on its own,” he says, noting the tug-of-war over the details of the Taxonomy Regulation, which have yet to be finalised after draft delegated acts were criticised in December.

“It’s perhaps more effective for asset owners to establish expectations, minimum standards and norms. If asset managers don’t meet them, asset owners should call them out publicly,” he says. “If asset owners say, ‘This is our money, this is how we want it invested. And if you don’t [invest according to our wishes], we’ll go elsewhere,’ there is enormous potential to bring about real change.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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