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The ESG Interview: Passive Investment, Active Engagement

FTSE Russell CEO Arne Staal says passive vehicles can – and must – join the race to net-zero if the investment sector is to achieve positive real-world impact on people and planet.

Today, sustainable investments are enjoying record-breaking popularity, accounting for more than half of all European fund inflows in Q1 2021. Demand is expected to continue to grow further, with PwC forecasting that ESG-focused funds will attract 57% of European mutual fund assets by 2025.

But for now this shift is put in the shade by the migration of assets from active to passive investment vehicles over recent decades. Passively-managed funds represented 41% of all US mutual and exchange-traded fund (ETF) assets under management in March 2020, according to Morningstar, up from 14% in 2005 and just three percent in 1995. The switch to passive might be most striking in the US, but it is “a global phenomenon”, according to the Federal Reserve Bank of Boston.

With passive vehicles holding more than half of US publicly traded equity fund assets, mobilising indexed funds, trackers and ETFs in support of sustainable investment objectives matters.

“If there is to be real impact from investors on sustainability and climate outcomes, passive has to play a big part, because of the [size of the] capital flows that have to move,” says Arne Staal, CEO of FTSE Russell, the index and benchmarking arm of the London Stock Exchange Group (LSEG).

“Index houses have a really big role to play, first working with asset owners to understand their views, then providing the benchmarks and [supporting] the investment vehicles that link to our indices that really drive those capital flows.”

Acting as a universal owner

Asset owners do not see passive investing as a natural fit for active engagement on sustainability issues, partly because it lacks the ultimate sanction of divestment, the influence or focus generated by a large stake and the often lack of resource to engage across a diverse portfolio.

Some argue these challenges are being offset through the increased active ownership efforts of the major passive fund houses – BlackRock, State Street and Vanguard – which have recently begun to use their influence more proactively to persuade investee companies to address ESG risks. Staal sees this as only part of the solution.

“Indices, in many ways, represent the universal owner, because there’s typically a wide spread of ownership across a large portfolio. It’s hard to imagine the individual owners of passive investment vehicles then engaging with all the corporates in a portfolio, but we can do that on behalf of a large number of investors that otherwise individually don’t have much of a stake or leverage,” says Staal, who joined LSEG in January 2020 as Global Head of Research and Product Management in the group’s Information Services Division, from Aberdeen Standard Investments, where he was Head of Macro Systematic Strategies and Risks.

Staal sees index and benchmark providers as increasingly serving as clearing houses for ESG investments. Benchmarks are typically built around market capitalisation, giving investors in passive vehicles exposure to stocks in proportion to size, but index houses have been developing themed indexes for many years, increasingly tuned to sustainability factors, which are used by fund providers to develop ESG-focused passive investment vehicles.

Index providers as ESG clearing houses

For two decades, FTSE Russell has operated and gradually broadened its FTSE4Good series, with constituents drawn from parent indexes, but excluded via screening or removed – after a grace period – if they fall short of expected standards, with performance monitored by in-house analysts, using a mix of in-house and third-party ratings, analytics and data. The process includes an incremental ratcheting up of inclusion thresholds, to improve outcomes over time, overseen by a committee which includes independent investment professionals with ESG expertise.

In this respect, FTSE Russell staff act as stewardship intermediaries, discussing with corporates the behaviours and policies they need to pursue to meet the expectations of – and maintain their exposure to – the investors who choose to invest in funds guided by FTSE4Good investment criteria.

“As our business model increasingly shifts to being sustainability orientated, we will direct resources to back that up. It’s more efficient for an organisation such as ourselves which has the scale to serve as a ESG clearing house for the financial system, rather than individual investors seeking to do so through their limited efforts,” says Staal.

Asset managers including Royal London Asset Management and Legal & General Investment Management have developed ESG fund solutions using FTSE4Good indexes, which now number almost 20, covering developed and emerging markets. These sit alongside a range of other sustainability indexes, including some focused more specifically on climate-related goals.

Engagement as an effective lever

Staal recently explored the models for indexes to steer passive investment toward sustainability objectives and support active engagement in a report, co-authored by David Harris, Global Head of Sustainable Finance at LSEG.

In essence, if sustainability index providers set clear and transparent rules for inclusion, supported by widely understood assessment methodologies, issuers will be rewarded for ‘real-world’ sustainability performance improvements, both through enhanced reputation and stronger capital flows, they argue.

The paper positions engagement through index-based investing as “effective new lever” which complements rather than replaces traditional channels of active ownership, but highlights too the importance of design and scale.

For example, it notes the growing popularity of approaches derived from smart beta investing, whereby indexes are ‘tilted’ toward sustainability objectives, for example weighting constituents according to their carbon efficiency alongside other factor exposures. Other examples include EU Climate Transition and Paris-aligned Benchmarks, which include rules designed to reward ambitious emissions reduction targets, but the paper notes the absence of an engagement process in this latter process, which may weaken incentives and outcomes.

Making the transition

A further evolution is an index created by FTSE Russell in collaboration with the Transition Pathway Initiative (TPI), an investor-led research project which works with partners including the London School of Economics to assess the transition preparedness and reduce the carbon emissions of portfolio companies. The FTSE TPI Climate Transition Index includes companies drawn from the underlying FTSE Developed index, weighted according to their performance against five criteria – fossil fuel reserves, carbon emissions, green revenues, TPI management quality and TPI carbon performance – which are all based on publicly available data.

No sectors are explicitly excluded, meaning any firm can work toward inclusion through engagement and improvement of their transition metrics. The index is used by the Church of England Pension Board for its core passive equity fund. Staal is hopeful of its wider application, but admits that sustainability-related indexes have not yet achieved widespread usage.

“Nothing is mainstream yet, but interest is huge. Initiatives like the TPI index have driven a lot of engagement with asset owners and asset managers. But in terms of assets exposed, it’s nascent. Of the total investments tied to our indices in some shape or form (approximately US$16 trillion), only a very small percentage are related to ESG investments broadly, and an even smaller percentage relate to climate. But the growth rate is very high,” he says.

In particular, Staal is hopeful that the combination of transparency, engagement and data-driven rigour of the TPI index can gain traction, attracting assets from members of the ClimateAction100+ initiative, whose members – which collectively manage more than US$50 trillion – use TPI data and analysis as part of their engagement with heavy-emitting corporates.

“The power of the ‘old-school’ benchmarking – i.e. FTSE 100, Russell 1000 and 2000 – is that they are institutions in their own right with trillions of dollars in assets linked to them. The ESG and climate index space is very fractured, with many products. To really start impacting capital flows and driving behaviours, we need some critical mass. Something like TPI index has a good chance to gain that momentum, helping assets to point in the same direction, and have real impact.”

Data disconnects

For now, sustainability-related indices suffer from the same problems of data quality and consistency that frustrate the wider ESG investing sector, with indexes from different providers using different underlying data and giving inconsistent indications of ESG performance for individual firms. The overall effect being that asset flows from such indexes cancel each other out, having little effect on how firms behave or are funded.

Staal, who has a background in quantitative analysis, says the disconnects in how ESG and climate data is modelled, captured, measured, and analysed are inevitable given the current stage of development in sustainability-related data availability and reporting frameworks.

“We need to work towards a world in which we have much more transparency in the way we capture [ESG risks] from a quantitative perspective. Qualitative [analysis] is the most important, but it’s easy to just speak the language and not entirely agree on what it actually means, unless you have agreement on the underlying data, models and definitions.”

As standards-setters and regulators develop new rules and frameworks, Staal expects a full integration of ESG data into investment and reporting processes, in much the same way that standard financial reporting from companies is integrated into the how the financial markets operate. He draws an analogy with the evolution of value investing.

“Over time, we’ve coalesced around a common understanding of what value means and the underlying data required to measure it. People will have their own proprietary tweaks, but there’s not a lot of disagreement on how companies need to report fundamental data or how you measure value as an investor. This will happen with sustainable investing too.”

The resolution of ESG’s data challenges is essential to unlocking passive’s potential positive impact, Staal suggests. He expects a combination of mounting inflows and regulatory focus to help to address these data issues, allowing for critical mass to build up behind the most effective solutions and reduce fragmentation. But he also argues that a more collaborative approach is required than traditionally has been achieved in the finance sector.

 

“These things need to happen fast, especially in relation to climate,” says Staal. “Due to the urgency, the model can’t be for each of us to try to do it ourselves by building our own data collection efforts and our own proprietary modelling approaches, etc. The business model should be to support the development of an open architecture layer, on top of which we can be a solution provider and work with our clients to help them solve their problems.”

To this end, LSEG recently joined OS-Climate, a non-profit platform dedicated to the development of open data and open-source analytics for climate risk management, finance and investing.

Pace of change

Staal’s sense of urgency is in part a reflection of the pace of change in the priorities of clients and counterparties.

“It’s truly phenomenal how quickly everything has started revolving around ESG, sustainable investing and climate. In the space of two or three years, we’ve gone from thinking of ESG as relevant but still a niche topic, to it now being core to most discussions that we have. That’s going to continue, not just for us as an index business but for the financial system overall,” he says.

ESG may be dominating the conversation, but different views are being expressed. Based on recent discussions, Staal cites different expectations among large asset managers, one of which forecasts that “traditional benchmarking to change significantly in the next five years”, shifting from being focused on market cap to being driven by sustainability factors, such as climate.

“They see the whole investment world shifting to being driven by ESG considerations, but one of the other large asset managers that that we work with – also very much alive to what is happening and wanting to be part of it – doesn’t see such a fundamental change. They see more of a case for offering solutions which remove the investments they don’t want from traditional approaches.”

With clients working through future scenarios and their business model implications, Staal is in no doubt that FTSE Russell, and its parent group, will need to continue to evolve. LSEG’s recent purchase of Refinitiv, he suggests, will help it support institutional investors as they broaden previously rigid asset allocation frameworks in search of positive impact opportunities.

“At one end of the spectrum, we’re working hard to make sure we have data and ESG scoring for our existing universes, while also expanding across asset classes where data is less developed, such as fixed income and real estate. At the other end, there is the more proactive climate investing issue, where we are working especially with asset owners to drive change,” he says, acknowledging the growing relevance of non-listed investments.

“Private markets are quite opaque but can play a huge role. There needs to be a drive to develop more data, modelling and tools to bring transparency so that people can actually measure, make decisions, and achieve impact. There is a big opportunity to bring transparency, which starts with more data,” he says.

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.

Copyright © 2021 ESG Investor Ltd. Company No. 12893343

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