More than at any other time in history, investors are paying close attention to the environmental ramifications of their financial decisions, the social relationships maintained by the businesses they invest in, and how those companies engage in internal governance. Institutional investment allocators are therefore rapidly moving to incorporate environmental, social, and governance (ESG) criteria into their policies, strategies, and processes to screen potential investments. At Backstop, we interviewed two leading allocators and an investment consultant to hear their advice on how to set up an ESG initiative.
Prepare for a Radical Culture Shift
All three subject matter experts agreed that the foundational point to bear in mind is that embracing ESG necessitates a radical culture shift. John Kaye, COO of the endowment at the University of Pittsburgh, acknowledges that when the student population of the university lobbied for an ESG initiative, there was a strong bias against ESG within the office and on the advisory committee because people feared that it would limit opportunities. He states, “There was a lot of concern and confusion about what ESG would do and how we would approach things. Overcoming that bias was one of the big strategies we had; educating key decision makers about what ESG is and what it isn’t was very important to do. For example, our policy says that we commit to consider these things. It is not in and of itself determinative in any case, but it is a factor in the risk profile of a potential investment.”
Lucy Tusa, Partner at Mercer, a leading global investment consulting firm, encourages allocators to view ESG as an opportunity to invest in sustainable industries of the future. She affirms, “While I do think that ESG is bound to be additive over the long term, we really need to think about this as a risk-mitigation exercise rather than a return-seeking exercise. We are at risk of terrible climate change and global warming. Shouldn’t you be moving your assets in a way that helps to counter that risk? And if you can move them to do things such as help sustainable development goals, isn’t that even better?”
Define Your ESG Beliefs and Priorities
It can be tempting, given pressure from investors and society, to rush into drafting an ESG policy. However, Lucy urges a more thoughtful approach: “Our best practice at Mercer is what we call a ‘responsible investment pathway.’ There are four stages: beliefs, policy, process, and portfolio. Our experience has been that doing things in that order really does pay off in the end.”
She explains that the first step involves coming together as the group responsible for the fund to identify and define what your beliefs are with regard to ESG and what aspects you want to incorporate into the management of the fund. She notes, “Once you’ve had the beliefs discussion, the policies, process, and portfolio all tend to fall into place quite easily. It is when you don’t take that initial step of prioritizing what matters that things can become quite complicated.”
Create a Clear and Collaborative Process
Avantika Saisekar, Director of Sustainable Investing at Wafra, a $25B multi-strategy investment firm, shares the importance of developing a clear investment process to put your ESG policy into practice. It can be helpful to start small, focusing on a particular industry and a defined set group of ESG factors. For instance, a private equity firm focused on financial technology might have conversations around relevant ESG risks like data privacy, innovation, or diversity. However, starting small does not mean staying small. She states, “You should have a clear vision of what you want to accomplish in one year, three years, and five years. It is completely understandable to have certain asset classes start out with basic integration frameworks as long as there is a plan for developing deeper ESG milestones as you go forward.”
Part of putting an ESG initiative into practice is understanding the ratings that are used. This is a challenge because there are many rating methodologies, all based on different criteria. While this can be confusing, Lucy points out that it can be turned into a benefit. She comments, “I think that is really one of the best things about ESG investing: you have to stop and think a little bit. You have to understand what the different ratings mean and what the client is looking for.”
Close collaboration is essential as you roll out an ESG initiative. Avantika explains, “At Wafra, the ESG team works alongside the investment teams to conduct due diligence for most funds. So we are part of the investment committee and collaborate with the deal teams. This type of structure allows ESG risks not to be viewed separately, but to be treated as any other investment risks. Plus, many times we are actually building certain provisions into our legal documents saying that we would like a given manager to reach specific KPIs within one year of investment. By introducing ESG right at the get-go, managers understand that this is something we will be looking at.”
Pursue Sustainable Success
As you begin or mature an ESG initiative at your investment office, always keep in mind that ESG is about more than risk factors and potential returns. As Lucy affirms, “This is a change from being a shareholder to a stakeholder. It is new for everybody and reflects a different focus for asset ownership and a different expectation of asset owners.” As you align your focus and expectations around the ESG values that are a priority for your organization, you will be playing an important role in creating a sustainable – as well as successful – future.