Perhaps the greatest challenge to designing and implementing a sustainable investment strategy is that the answers to many questions are not always clear — nor agreed upon by a majority of investors.
What is ESG and how do you measure it?
The lack of commonly-agreed standards for sustainability and ESG—from measuring and metrics to reporting standards and investment strategies—is one of the first bumps in the road that insurers will face as they start on the path to designing and implementing a sustainable investment strategy.
The challenge of ESG data and measurement exists throughout the process of ESG investing. To begin with, the lack of ESG data makes it more difficult for portfolio managers to perform proper analysis of the assets from a sustainability point of view.
Adding to the challenge, a lot of ESG metrics are based on historical data, but ESG-related issues require a forward-looking approach. This is particularly vexing when attempting to account for companies that might be in the process of improving their sustainability—but are not quite there yet. In fact, all of the interviewees for the survey suggested that the companies they find most attractive from an ESG perspective are the ones that are undervalued because they may not be ESG-friendly today, but have clear transition plans in place that will make them more sustainable in the future.
Regional disparities in ESG standards can further complicate attempts to make fair comparisons. While Europe and North America have some agreement on ESG standards, many Asian assets don’t meet them. This poses a tricky situation for insurers who are keen to invest in Asian assets for their yield or growth prospects or have underwriting activities in the region. CIOs reported various pragmatic and flexible solutions to account for varying regional ESG standards and needs of their businesses.
The lack of a commonly-agreed standard on how to report ESG information is severely inhibiting reporting. While 64% of survey respondents1 said they measured and reported ESG criteria in their investment portfolio, interviews produced a more nuanced picture. Five CIOs admitted their firms did little measurement because they do not believe the metrics currently available are robust enough to be accurate.
How do you define a successful ESG strategy?
Is a successful ESG strategy defined by outperformance, better risk management or improving the world we live in? As with defining and measuring ESG itself, there are many interpretations.
The data and academic literature on ESG performance is mixed. And even if ESG considerations tend to have a favourable impact on returns in the long term, executives responsible for sustainable investments will need to have strong conviction to weather shorter-term underperformance in a world highly focused on quarterly results.
Yet even if ESG does not increase the return of a portfolio, the idea that it might reduce risk and even reduce volatility in a portfolio is more widely accepted because these assets tend to be more resilient in market disruptions.
And many CIOs interviewed actually focused on a deeper purpose to ESG investing, with one noting that it is not to support the profitability of business but to finance the world we want to live in in 50 years.
What asset classes are best suited to ESG investing?
ESG is more established in equity portfolios and 88% of survey respondents said they are likely or very likely to consider ESG strategies for developed market shares. The liquidity and transparency of the equity market make applying ESG criteria to equities somewhat easier than to bonds. The view from one CIO is that investing in equity creates a greater sense of accountability for the actions of that company because equity investors are owners who have voting rights and share in the profits.
However, many insurers have the majority of their assets in fixed income. The good news is that debt investors can have a significant impact because of the sheer size of the market. One CIO believes the impact could even be greater than in equities, explaining that if a company has a poor ESG score, investors can demand a premium in the spread over Treasuries for new issues, which could have far more impact because it directly hits the company’s bottom line.
However, ESG can be more easily applied to some areas of fixed income than others. For investment grade fixed income, 91% of survey respondents say they are very likely or likely to consider ESG strategies, but the numbers drop off quickly to 67% for high yield and 55% for emerging market debt.
When it comes to alternative assets, many insurers start their ESG integration efforts with real assets because it is easier to quantify the impact on something tangible. Of those surveyed, 81% said they were very likely or likely to consider and ESG strategy for their real asset holdings.
What happens in poor market environments?
Many CIOs acknowledged that in poor market environments, day-to-day financial concerns may have to take precedence over ESG goals. At the same time, most seemed to indicate that this would be a temporary phenomenon. Others explained that their firms’ ESG activities are well integrated into the overall operations and will be a part of the investment process regardless of the markets. In fact, the Covid-19 crisis has highlighted the dangers of being overweight some vulnerable sectors or exposed to stranded assets.
1 The survey was designed by JP Morgan Asset Management and Insurance Asset Risk and comprised of 40 questions across four broad themes: sustainability considerations in firms’ overall operations, sustainability operation in firms’ investment processes, considerations with regards to third parties and regulatory considerations. A total of 53 individual responses were received. Combined disclosed AuM of respondents stood at approx. $2.2trn (subject to FX conversion & disclosures). The majority of responses came from Europe, with contributions from Asia and North America. Insurance Asset Risk also conducted 14 in-depth interviews with mostly chief investment officers and heads of sustainability to provide context and greater depth to complement survey responses. Data as of October 2020.
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