Effective environmental, social and governance (ESG) investing requires a balance between pursuing the mission and achieving the required returns. It means making decisions that are part art, part science.
Strong ESG performance during the pandemic has generated trillions of dollars in inflows. This supported the underlying philosophy and universe of ESG labeled products and led to previously unthinkable forecast of $30 trillion in ESG assets by 2030. Already, the statistical barriers are broken. In 2021, for example, banks would have for the first time earned more money through the issuance of green energy bonds and lending than traditional fossil fuel debt.
Yet, as the spotlight has intensified, the ESG conversation has shifted to more existential questions – including whether there is a “Mirage ESG.“Some skeptics started asking”where is the ESG going?But proponents argue that ESG benchmarks, products and strategies need to be considered in the context of broader investment goals and market constraints. Shades of gray are unavoidable, they argue, and do not cover simple greenwashing.
These debates are important, but for many the ESG horse has already left the stable. Today, the task is to determine how to engage and rekindle the original spirit and impetus of ESG as a vehicle for managing and transforming investment portfolios. So which approaches actually work?
For those looking for wisdom rather than noise, it’s worth exploring what some of the world’s less talkative but most sophisticated investors – insurers – are saying and doing around ESG.
Insurance companies take a long-term, strategic approach to their investment decisions, a perspective that also characterizes some of the best ESG programs. Insurers have been dealing with the analysis and underwriting of all components of ESG for decades, if not centuries. They assess exposure to natural disasters and social and political transitions as well as the continuity and composition of corporate management. Insurers in Europe and Asia have already made significant progress in transferring these considerations from actuarial risk analysis to their balance sheets. As the spring of 2022 begins, more US-based insurers are following their lead.
New tools, new way of thinking
Earlier this year, Conning published his investigation of nearly 300 insurance company decision makers in the United States to understand how they engage with ESG investment principles. While a large majority commit to these principles, 41% only started implementing their ESG programs in the last year. Therefore, insurers need new tools to measure the impact and new, longer lenses through which to view the associated risks and opportunities. They want to integrate ESG through strategic asset allocation, investment guidelines and risk management practices – the same principles and methods that also support and inform traditional investment objectives and performance.
This careful calibration is one of the reasons why commoditized ESG solutions are problematic and why a tailored approach is important. Consider the asset classes that often make up insurers’ portfolios. Combining ESG considerations, in particular the quantification of downside risk with the search for yield and the need for sufficient liquidity, remains an important issue. Consequently, many survey participants highlighted the costs of implementing and preparing for future standards and initiatives as critical concerns. Indeed, respondents ranked them more important than the potential effect of ESG on overall performance.
This dynamic plays out when ESG integration is developed in a multi-asset context. New ESG-linked bonds and other fixed-income instruments offer an attractive opportunity but require further examination of their underlying purpose and mechanism. In energy, for example, investors may prefer a tilt based on their conviction and philosophy on specific ESG elements. This may mean balancing priorities such as economic development and climate change differently. This can bring specific ESG elements into conflict. Intentionality requires tailored asset selection, rather than just selection, to strike the right balance.
Like most investment factors, ESG principles should also be dynamic and responsive to changing landscapes. Our survey found that corporate reputation – not regulatory compliance – is the primary motivating factor behind insurance companies’ commitment to ESG. This may come as a surprise amid new rules on wrappers and ESG reporting. But financial and insurance regulation in the United States tends to focus on the financial risks associated with climate change rather than the broader social and governance aspects of ESG investing. These are often outside the scope of regulation. This distinction may help explain why regulation is not the primary concern.
US insurers have long taken a market-driven approach. Their ESG mindset is focused on opportunities and participation. Smaller companies may see the potential to take on influential roles, while more established players may struggle to keep up. Conning’s survey shows this dynamic at work. The growing importance of data standardization and industry-agreed targets, such as the Task Force on Climate-Related Financial Disclosures (TCFD), have created new incentives to commit to ESG principles.
The lived experience of their teams and key audiences and the relationship between that stakeholder experience and how they invest in ESG is equally crucial for insurers and all businesses. It’s no coincidence that impact investing has taken on greater prominence in 2021. Insurers are realizing that for ESG programs to be authentic, they need to be empathetic and responsive – reinjecting emerging priorities in investment programs. As new tools and solutions are developed, programs must be flexible enough to integrate them quickly.
The novel is no more
The past year has been pivotal for ESG, and as capital continues to flow into ESG assets in 2022, investors of all stripes can learn from the perspective and experience of insurance companies. In an environment of record growth and growing calls for ESG stock picking and greenwashing, we must remember that the best ESG apps take a long-term strategic view: they are methodical in their engagement, nimble in their decision-making, open in their perspectives and deployment, and transparent in their construction.
Change is difficult and effectively integrating ESG principles into the investment process will require ongoing effort and perseverance. New models and data, better products and partners, and yes, even a bit of healthy skepticism – all play a vital role in sustaining progress as this journey evolves and endures.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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