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A convincing case for investment managers to apply the ESG lens

ESG By Madlen Jannaschk, Associate, Sustainability – 27 May 2024

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Madlen Jannaschk

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Recent news in Australia of superannuation funds badged as ‘sustainable’ or ‘ethical’ having capital sunk into high-carbon investments and fossil fuel projects, should be seen as a major nudge for those making capital allocation decisions to apply higher levels of scrutiny. There is also pressure coming from the new International Financial Reporting Standards (IFRS) mandates around sustainability disclosures and local applications such as the Australian Government’s new Australian Sustainability Reporting Standards (ASRS) administered by the Australian Accounting Standards Board (AASB) with the Department of Finance.

These regulatory frameworks will require larger entities to disclose matters relating to governance, strategy, risk management, sustainability metrics and targets for addressing risks and opportunities relating to material issues including climate change impacts.

This means shifting the management dial, because whether an entity is badged as a sustainable investment fund, or a real asset portfolio aims to embed best practice ESG (environment, social, governance) approaches, business-as-usual capital allocation decisions are unlike to be fit for purpose.

If an organisation does not have an ESG strategy in place, now is the time to start, before shifting regulations and investor concerns start to affect the fund’s reputation in the market.

Start here

The first step is to examine the issues that are material to your organisation, investors and stakeholders (including regulators). Best practice is to take a double materiality approach – both looking at what external parties such as regulators and investors expect, and also at what impacts (positive and negative) your operations are having on both the environment and society.

The materiality mapping exercise can also be used as an effective engagement process with staff, clients and those who trust you with their capital. Having a conversation via survey, workshop, meetings, or other means is an opportunity to build stronger relationships, while also gaining insight into which ESG topics are top of mind.

While climate change is almost certainly material for any organisation, and nature impacts are rapidly becoming front of mind. social value concerns such as fair wages for workers in the supply chain, avoidance of investment in weapons dealing, or benefits for disadvantaged communities also often rate highly.

Once you know what matters, as part of developing the strategy articulate your targets, timelines for reaching them, and how these will be measured and then reported on.

This last part of the ESG approach is where due diligence becomes critical. If the target is zero investment in fossil fuels, weapons, tobacco products or modern slavery, a laser-sharp lens needs to be applied to where capital is allocated. As the recent investigation in Australia showed, even the best-intentioned funds with the clearest targets can miss the mark if rigorous examination of investments is not undertaken.

For example, a default position for many investment funds is to sink a significant proportion of capital into low-risk, high-return options like the All-Ordinaries index shares. However, this part of the stock market is dominated by high-emissions entities including oil and gas producers, coal mining, and fossil fuel energy generation. It also often includes companies trading in weapons, tobacco and gambling which are industries most ethical funds publicly claim to avoid.

But even entities that on the surface appear to be positive from an ESG perspective may still be contributing significantly to carbon emissions, cause negative impacts on environmental or human health, be linked to entrenching poverty and social disadvantage, or have within their own business a client base and profit share derived from providing goods or services to the private sector arms trade. For example, a publicly listed cyber security provider may have a tobacco product manufacturer on their books.

The bottom line is – a credible and meaningful approach to environmental. social and governance issues requires more than a statement on the website. It requires effort, diligence and scrutiny, and relies on transparency and disclosure of relevant metrics and data. All of which possibly sounds expensive in terms of time for a Chief Investment Officer or Chief Operations Officer to manage.

What balances this cost out is the benefits, which are measurable and tangible:

1. Credible Action on Climate
: If your fund or the entities it invests in have adopted Science-Based Net Zero targets through the Science-Based Targets Initiative (SBTi), there is assurance in being aligned with a credible industry standard that is independently-verified and meets the requirements for transparency and disclosure expected by frameworks including the UN Principles for Responsible Investment. SBTi pathways also incorporate goals that are proportional to the portfolio’s impact on the environment. Also, if your fund is delivering emissions reporting to third parties, investors, stakeholders or staff, the emissions data of all the entities and assets you are invested in will be material for your own Scope 3 carbon accounting and reporting.

2. Adding tangible value
: Net zero buildings associated with credible sustainability ratings including GRESB, NABERS, Green Star and Climate Active Carbon Neutral certification are rapidly becoming the industry standard for commercial assets and generally attain higher valuations. They are also preferred by a growing group of tenants looking to lease space that reflects their own internal ESG and sustainability policies. Data from the Green Building Council of Australia published in 2020 showed an average 4.3% uplift in property value for Green Star rated buildings; and a 13.4% increase in income per square metre for leased premises. This ‘Green Premium’ is also much more attractive than the ‘browning’ of assets – loss of value and relevance as the wider market shifts. A whole-of-fund net zero portfolio target also enables the fund to take a strategic approach to the management of net zero assets.

3. Outclass your peers or competitors:
By setting ambitious emission reduction targets aligned with the SBTi criteria, a retail, healthcare, industrial or commercial property an entity such as a real estate investment trust (REIT), property trust, or real estate investment group consolidates a foundation to outperform its competitors in terms of sustainability benchmarking. Keep in mind too, that as the wider market shifts to preferencing net zero, highly efficient assets, a portfolio or asset with high emissions risks becoming a loss-leading proposition for investors.

There are other important targets to consider also, such as protection of biodiversity, water efficiency, eliminating Modern Slavery from the supply chain, gender equity and Indigenous procurement. We are seeing increasing numbers of tenders that include requirements for disclosures around social value metrics – which means they are rapidly becoming established as a benchmark for business practices.

4. Access to cost-effective capital:
Financial institutions and lenders are increasingly incorporating sustainability criteria into their lending and investment decisions. These criteria can’t be satisfied with some vague statements. You’ll need credible, verifiable data on ESG targets and metrics – and the payoff is improved eligibility for sustainable finance options including green bonds, sustainability-linked loans, or access to sustainability-focused capital funders and impact investors.

5. Stay ahead of regulatory shifts
: Reporting on ESG is increasingly becoming a must, and as bodies including the International Sustainability Standards Board (ISSB) and the Australian Accounting Standards Board (AASB) finalise their frameworks for disclosures, being on the front foot will save your executive team from needing to scramble to pull reporting together. Looking at the Australian Government timeline for enforced climate-related reporting, which will also mandate disclosure of relevant ESG policies, laying the groundwork now for your net zero pathway will be of immense benefit.

Looking a little further ahead, while the ASRS (Australian Sustainability Reporting Standards) are currently centred on climate change, there are already rumblings in the jungle that other material issues such as nature impacts and social value may come to be included in mandatory reporting and disclosure requirements.

If you’re wondering if all of this is enough to convince your board or key decision-makers in the C-suite of the importance of an effective ESG strategy, Cundall’s ESG Playbook may help you further see the path ahead. Download it here The ESG Playbook (and why you need one) - Publications - Cundall

This article was originally published by GRESB Insights.