How to Start an ESG Strategy

ESG is now Mainstream and Growing

An increasing number of firms are offering an Environmental Social and Governance (“ESG”) related product or strategy. Many others have plans to launch such a strategy. Some experts predict total ESG investments will eclipse $1 trillion by 2030. However, it is not as simple as just professing to care about the environment or social and governance factors when picking investments. Investors and regulators have grown weary of something known as “greenwashing,” which refers to citing ESG without substance behind it. So where does one start when considering an ESG strategy? What are the operational, legal and compliance issues to keep in mind?

ESG is not a new concept. It has been relevant in the United States for several years and in Europe even longer. Firms with ESG programs in place are experiencing a tangible competitive benefit that makes ignoring the area no longer an option. Investor appetite for ESG products has increased tremendously over the past several years and it is becoming a standard question an investor will ask of its managers before investing.  Regulators are keeping up with these developments.  In both the United States and Europe, scrutiny has increased tremendously over the past year.  “What are you doing in the area of ESG?”  This article provides some tips as you begin to consider designing and launching an ESG strategy, including areas of regulatory focus.

Give me an “E,” an “S,” and a “G”

Each component of ESG includes important and unique attributes.  Environmental considerations may encompass a company’s carbon footprint and climate related issues, including energy consumption, carbon dioxide emissions and waste output.  These may impact areas such as oil or coal production, consumption of natural resources, pollution, and occurrences of extreme weather.  Social considerations include issues pertaining to how companies interact with and treat its employees. This may include gender equality, diversity and inclusion, and a company’s hiring operations.  It also may include labor standards and employee engagement.  These issues may impact a company’s performance (and profitability) by contributing to high turnover rates, labor strikes and shortages, or litigation risk.  Governance issues include a company’s processes and record on corporate governance. This includes board composition and diversity, executive remuneration, serving multiple board positions, ethical conduct, and compliance.  Lobbying efforts, political contributions and whistleblower procedures also bear relevance.

Formulating an ESG Strategy

An opening question for most firms will be whether they will exclude investments with a poor record on ESG related issues, or whether they instead will use their position as a shareholder to engage with the company and press for positive change.  Where an unconditionally exclusionary process is selected, firms should consider whether such an approach reconciles with its fiduciary duty to serve its investors’ best interests (i.e., to maximize investment value).  Based on a firm’s strategy, there are effective ways to address these issues and the approach should be well defined and documented.  A firm also should look at its current investment strategy and determine if there are any natural complements to its investing approach.  For example, for managers that frequently engage with their portfolio companies, there likely will be natural opportunities to address each ESG component as a part of its interactions.  Such a firm should take care in explaining how it engages with portfolio companies on ESG related issues and clearly disclose it will not automatically exclude a company from their investable universe, even if that firm has a poor record on ESG.

Another question that often arises is whether a firm may have a single ESG product, while the rest of the firm’s strategies and products do not take it into consideration.  One key indicator of how investors will view the seriousness of a firm’s ESG is whether the firm is making certain public commitments to the area.  This may be demonstrated by signing onto the Principles of Responsible Investing, or publicly supporting the Task Force on Climate-Related Disclosure.  These undertakings may preclude selective application of ESG related factors in a firm’s investment practice and must be carefully considered when formulating a strategy.

Regulatory Scrutiny

Regulators in both the United States and Europe are zeroing in on investment managers claims to pursue an ESG strategy in their offering materials.  It is no longer acceptable to include broad statements about the types of investments your firm may make with environmental, social and governance factors in mind.  Among other things, regulators are looking for disclosure of analytical tools that may be used to facilitate an ESG process, how those tools are used, whether a scoring system has been devised and whether a full or partial exclusionary approach is undertaken by the manager.  The European Commission has adopted the Sustainable Financial Disclosure Regulation (“SFDR”) in order make it easier for investors to distinguish and compare among the increasing number of sustainable investing strategies.   A key goal of SFDR is to assist investors choose among products by classifying funds into three distinct categories.  These categories are based on the degree to which sustainability is a consideration.  Specific disclosures are also required for each category. These categories align to Articles 6, 8 and 9 under SFDR, with Article 9 having the most stringent requirements.   As European managers undertake to update documents or launch new strategies, they are being met with fierce regulatory inquiry of their ESG descriptions.

Regulators also are holding managers accountable for their assertions in this area.  If a manager claims it is applying a tool, process or technique, then regulators will test to ensure that is in fact the case.  We expect regulatory actions to arise in this area.  In 2021, the U.S. Securities and Exchange Commission (“SEC”) announced the formation of a Climate and ESG Task Force in its Division of Enforcement.  Recognizing the increasing investor focus and reliance on climate and ESG-related disclosure and investment, the Climate and ESG Task Force will develop initiatives to proactively identify ESG-related misconduct.  The task force will also use sophisticated data analysis to mine and assess information across registrants, to identify potential violations.  This includes disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.   The SEC also is encouraging whistleblowers and others to bring potential violations to its attention.

FiSolve Can Help

The ESG area is growing rapidly. Ample opportunity exists for other firms to participate in this important area, which is of enhanced interest to investors. FiSolve can assist your firm in formulating and documenting an ESG strategy. We will assist in crafting a policy conforming to regulatory and client expectations, and potentially opening a significant new avenue for growth. Visit us at www.fisolve.com or contact us at growth@fisolve.com.