Though ESG investing is increasingly being adopted by asset managers, asset owners

 

should be more assertive about driving this issue.

 

Sacha Sadan, the director of corporate governance at Legal and General Investment Management (LGIM), believes that asset owners should pressure the asset managers more on ESG investing if they want the industry to take ESG more seriously.

 

LGIM aims to raise the ESG standards of invested companies and markets by exercising the shareholder rights of their clients, via its Active Ownership scheme. The asset manager communicates with the companies’ boards and uses their clients votes to urge companies to adopt a higher ESG standard. Sometimes, the results are successful. For example, the board of Toyota endorses the 2°C target of the Paris Agreement and also plans to make all its cars available as either electric or hybrid models by 2025.

 

In the past, many asset managers could get away with ignoring ESG investing because their clients (asset owners) were not familiar with the matter. Hence, they were not in position to demand it. According to Sadan, the most frequently asked questions from investors and asset owners are how much ESG investing costs and whether it will outperform conventional investments. A simple but controversial answer is that ESG costs nothing and in the long term, corporates with a higher ESG standard reduce portfolio risks.

 

“Investing in an ESG compliant manner should not cost you anything. We are not talking about ethics here, and we are not refraining from investing in industries like tobacco and gaming. We wouldn’t be doing our job as investors if it were that easy, of just kicking out a few “nasty” sectors,” says Sadan. “In reality, things are much more complex: how E, S and G risks and opportunities affect different sectors and stocks. Just because Tesla’s business is green does not mean that there aren’t other ESG issues where it needs to improve, like its governance. We’d been calling for years for CEOs not to be able to mark their own homework as board chairs.”

 

“It took sustained pressure from investors like us and the regulator to finally get Elon Musk not to hold both roles. Conversely, you can have an oil and gas company that is the least-polluting, most resource-efficient of its peers, and therefore move more money towards it. A focus on good, or improving companies, can be much more fruitful than a focus on bad sectors,” Sadan explains.

 

Asset owners can drive change
Apart from the lack of understanding, there are other factors preventing asset owners from advancing the ESG agenda with their service providers. The relatively smaller size of asset owners compared to asset managers is one of the major hindrances. “In the US, asset managers have consolidated to the extent that they are really big in terms of assets under management. This gives them the opportunity to use scale to drive change at investee companies, though sadly there is quite uneven progress in this space,” says Sadan. Though asset owners have a few billion dollars, they might still think that they are small and thus their voice does not count. In fact, they have this power and can exercise it by moving their money away. “As Greta Thunberg says, “no one is too small to make a difference”, especially when you’re talking millions or billions. Using collaboration, public pressure and, at the limit, the nuclear option of moving money away, they can have significant impact,” says Sadan.

 

The assumption that asset managers know more about ESG investment than asset owners is unfounded. Yet this widespread misbelief has influenced asset owners who, consequently, fail to recognize and exercise their own rights and power.

 

Together with asset owners, investment consultancies should also step up and start providing holistic and ESG compliant advisory services. Sadan realizes that most of the time consultancy firms are only looking at financials. Yet, there are a lot of non-financial factors which have a financially material impact on companies.

 

Since a lot of asset owners trust the consultancy firms immensely, they often do not push the consultancies to widen their risk management perspective. Thereupon, asset owners are not driving ESG investment as much as expected. This is the very reason why it is good to see asset owners like Japan’s GPIF (the largest pension fund in the world) endorse ESG factors strongly in their investment. LGIM is one of the global asset managers that retains a mandate from GPIF.

 

In response to the increasing awareness of ESG among asset managers and asset owners, a lot of corporates have made an effort to be open and transparent about the governance issue. From Sadan’s observation, more companies are attempting to reflect their strength in corporate governance by mandating a third party to conduct an independent board review. The outcome and suggestions based on the review are then published in the company’s annual report.

 

This certainly shows that more companies are trying to uphold higher standards for themselves. However, this is also susceptible to whitewashing, malpractice, and superficial lip service.

 

“The usual boilerplate language found in the annual report is: ‘The board has commissioned XYZ to conduct the board review, and the review shows that the board performance is satisfactory.’ What is the point of paying thousands of dollars to a consultancy to write this comment? What we are keen to look for is some constructive criticisms and future proofing,” says Sadan.

 

Such trivial practices like this show nothing but board hypocrisy in its commitment to raise ESG standards of the company. A more constructive and sincere attitude from the board can be shown by stating evidently what problems the board is suffering and what the action plans are to address those issues. Even if the board fails to come up with immediate responsive actions, it should neatly state the possible timeline for the board to come up with solutions.

 

Piercing through the annual report cliché, investors are always searching for financially material corporate governance indicators. It is especially true for fixed income investors as the company could technically refuse to service the debt even if the debtor is capable of fulfilling the obligation. When looking into corporate governance, which is complex and abstract as a concept, Sadan and his team look at five things at the board level, namely, the board independence, shareholders rights, protection of minority shareholders, climate change agenda, and diversity of the board.

 

In addition, Sadan suggests that the trend of companies having different voting rights for different shareholders is worth noting. “Let’s take the example of WeWork. It was planning to launch its IPO with a valuation of US$47 billion. Yet there are burning concerns over the corporate governance of the company that we are very vocal about. These include the Chairman-CEO having 20 times more voting rights than other shareholders. The disproportional voting right will stay with the Chairman-CEO until his death and his spouse would have the right to choose the next holder of those voting rights. The board is still all male, and had it listed would have been the only all-male board in the S&P 500 in 2019,” says Sadan.

 

Though the separation between the chairman and CEO roles has been advocated for decades, a lot of industry leaders have resisted this arrangement, with the most notable case being Jamie Dimon, the Chairman-CEO of J.P. Morgan.

 

Apart from corporate governance, climate measures are also at the top of the agenda for LGIM. Strongly committed to alleviating climate risks, Sadan believes there is not an asset whose value is not linked to climate change in some sort of way and mechanism. “For example, banking is funding a lot of the coal mining and coal industries. The large food companies are using palm oil for their products and their operation is hurting the Amazon forest and other rainforests which are the ‘lungs’ of the planet,” explains Sadan.

 

Pessimistic about hitting the 2°C target of the Paris Agreement, Sadan expresses his strong attitude towards the imminent danger and risks brought by climate change, “Achieving well below the two-degree target is going to be challenging. However, the consequences of missing those targets, for both the market and our clients, would be incredibly significant. We are not giving up because we only have one planet.”