ESG Challenges and Solutions

Passive funds and responsible investment have garnered increasing attention over the past 10 years. Together, they have driven the growth in passive sustainable funds and the global stewardship movement that has encouraged active ownership activities at passive fund providers.

The United Nation’s Principles for Responsible Investment, or PRI, created a survey on the challenges and solutions for incorporating environmental, social, and governance factors in passive investment. Here, we highlight some of our answers to PRI’s questions:

What are the Priorities? 

• Bring consistency and clarity on what counts as a sustainable economic activity, which will drive the creation of new indexes to be used as both benchmarks and to underlie product creation.
• Potentially make the use of environmental and ESG benchmarks mainstream.

There are concerns that the EU taxonomy and data harmonisation could stifle innovation for passive investment, but we are not sure this will be the case. Index and passive fund providers will always be able to create products using any data and methodology they want; they may just feel compelled to refer to the taxonomy in reporting documents and their communication to clients.

Challenges in Incorporate ESG

The UN Principles for Responsible Investment asked us to rank, in order of difficulty, a list of potential challenges to the incorporation of ESG factors and active ownership into passive strategies. Of those listed by the PRI, we believe that the top three challenges to ESG incorporation are consistency of corporate data, availability of corporate data, and transparency of benchmarks and indexes. We believe that the top challenges to active ownership are freeriding, lack of research and resourcing, and contribution to overall portfolio performance.

We also believe that tracking error is a barrier to incorporating ESG into passive investments. Many investors are either contractually constrained by tracking-error risk or are simply not willing to deviate from the market beta.

Another challenge is evolving ESG-rating methodologies. With ESG being an immature field, rating agencies are making frequent changes to their ESG-rating methodologies. This lack of continuity, coupled with the lack of consistency in corporate data, means that ESG indexes are likely to be more dynamic and active than any other types.

What are the Solutions? 

Institutional asset owners: Our suggestion to institutional asset owners who are considering including ESG factors would be to assess the robustness of the underlying company-level ESG scoring methodology, as well as to understand the index rules and how these translate in terms of holdings, biases (geographic, sector, and factor), and tracking error. 

The UN Principles for Responsible Investment: The PRI should encourage collaborative engagement and policy advocacy along with better voting and engagement disclosure. The organization should also continue to promote best practices by providing case studies. Lastly, we would advise the PRI to push passive managers to educate investors—including retail investors— about systemic risks, especially climate risk. It is not enough for a passive manager to say that there is concern about the impact of climate change on investments; a passive manager should help its clients assess this risk and ultimately provide investment solutions that mitigate it. 

How Can Passive Investing Help? 

There is no one-size-fits-all approach to effective stewardship. Here are some ways that passive strategies can promote better practices among corporations; however, there is room and need for asset managers to come up with innovative ways to influence corporations to implement better ESG solutions.

• Direct and collaborative company engagement
• Proxy voting
• Policy advocacy
• Thought-leadership papers and investor education
• Communication campaigns

Here are some of the steps that we believe passive managers can take to escalate engagement without the option of divestment:

• Disclose unsuccessful engagements: Naming companies that are unresponsive to engagement can be an effective way to apply pressure.
• Join investor coalitions (for example, Climate Action100+): This gives greater visibility to the manager's engagements and signals a commitment to escalation.
• File shareholder resolutions: This strategy has not been used by larger asset managers but would likely get support from other shareholders.
• Vote against management and the nomination of chairmen and board members: This action would send a signal to companies as well as to the broader market.
• Create indices and passive funds that integrate specific engagement rules: For example, funds could systematically exclude companies with whom engagement has failed.