ESG 2020: The Transformation Of Financial Services

2020 will be remembered as the year in which environmental, social and governance (ESG) factors solidified their position as a dominant and permanent feature across the financial services landscape. ESG is a thematic wave washing over everything in its path, akin to Digital Transformation and Diversity & Inclusion in the previous decade.

In the same way that those two themes transcended sector, industry and geography to become integral components of any viable corporate strategy, so too has ESG begun to permeate the C-suites and boards of both public and private companies.

The abundance of recent headlines asking the question “Is ESG finally poised to enter the mainstream?” completely miss the mark — ESG is here now and here to stay:

• The massive pools of capital building up around the world that are dedicated to sustainable investment strategies are overwhelming and causing a severe supply/demand imbalance that will force financial services firms, especially within investment management, to deliver credible and scalable ESG strategies.
• This will exacerbate the ongoing war for ESG leadership talent, individuals who are aligned both philosophically and commercially with sustainable corporate and investment strategies.

ESG is forcing a fundamental rethink in corporate strategy. ESG will eventually have the same effect as prior “transformations” which resulted in financial services firms reinventing themselves as “tech companies” and later measuring and reporting how diverse and inclusive their work environments had become.

While thematic waves like D&I and ESG are inherently “good” and geared toward ultimately making a positive impact upon the world, neither of them could succeed purely on altruistic merit.

For themes like these to be fully embraced enterprisewide by multiple stakeholders, there needs to be compelling evidence of the financial benefit(s) of doing so. The data around this is conclusive - as it has been repeatedly shown how companies which are more diverse outperform those which are less so, companies who subscribe to and implement sustainable corporate principles will be best positioned to generate long-term financial outperformance. Going forward, the long-term success and financial performance of both public and private companies will be inextricably intertwined with the sustainability of their business models.

ESG metrics can enable risk mitigation across multiple dimensions

“Generating outperformance while delivering social and environmental good is the greatest goal of our times.” – James Purcell, head of sustainable and impact investments at UBS Wealth Management, FT.com, September 24, 2019

ESG 2020 – What is driving the overwhelming level of focus on ESG?

“2020 is increasingly looking like it may be the ‘tipping point’ year for ESG investing.” – Adena Friedman, CEO of Nasdaq, January 21, 2020

How is the market responding?

• The concentration of assets among trillion-dollar asset managers has made them not just financial stewards, but fiduciaries of global sustainability as well. There is an emerging consensus that asset management firms going forward will be held accountable for more than just financial outcomes.

  This is beginning to filter into legal and regulatory requirements, driven in large part by the widespread belief that climate change is not only a massive environmental crisis but an emerging financial crisis as well. The asset management industry is being transformed once again and is being driven toward a future focused on environmental and social impact as well as financial impact.

• The Global Sustainable Investment Alliance* estimates that there are over $30 trillion in assets that fall under “sustainable” investment strategies.

  However, while 49% of professionally managed assets in Europe adhere to sustainability guidelines, only 26% of US-managed assets meet this criteria. As one large European manager explained, “ESG policies have become absolutely central to nearly every European company.” The US is heading in the same direction.

• Incorporating ESG metrics and methods of analysis is now table stakes within institutional investing. However, despite the recently highly publicized pronouncements regarding climate change coming out of Davos and other global consortiums, there is still work to be done within the asset managers themselves to account for and manage the inherent climate risks within their portfolios.

Data highlights the accelerating growth of sustainable funds:

ESG 2020 – The transformation of the c-suite and boardroom

“We are prepared to use our proxy voting power to ensure companies are identifying material ESG issues and incorporating the implications into their long-term strategy.” – Cyrus Taraporevala, CEO of State Street Global Advisors ($3.1 trillion AUM), January 28, 2020

ESG is critical CEO and Board agenda item...

• In Larry Fink’s 2019 CEO Letter, he laid down the gauntlet for a more purpose-driven approach to corporate governance. In 2020, BlackRock took it one step further, saying, “Given the groundwork we have already laid engaging on disclosure, and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability related disclosures and the business practices and plans underlying them.”

• CEOs and corporate boards can no longer ignore global demands for more sustainable and ESG inclusive corporate strategies. The pressure coming from institutional investors is overwhelming, and somewhat predictably led to the steady stream of sustainability proclamations emanating from the corporate chieftains in Davos 2020.

  In addition, activists are tailoring their message to the ESG-focused priorities of institutional investors. They have made sustainability a key component of their efforts, and have significant leverage given the massive role index-based investors have over corporate management. Companies which ignore this will find themselves firmly on the defensive.

• In 2019, Harvard Business Review’s ranking of the “Top 100 CEOs” announced that it was raising the weighting of ESG ratings from 20% to 30% of the overall score, reflecting the fact that “a rapidly growing number of funds and individuals now focus on far more than bottom-line metrics when they make investment decisions.”

  The change in ESG weighting had an instant and significant impact: Amazon CEO Jeff Bezos, who had been the #1 ranked CEO every year since 2014, fell completely out of the Top 100*.

...driven by shareholder expectations.

ESG 2020 – The transformation of investment management

“We believe a company’s ESG score will soon effectively be as important as its credit rating.” – Cyrus Taraporevala, CEO of State Street Global Advisors, February 2020

What is it impacting?

• Investment risk is rapidly becoming a major ESG theme. With an increase in natural disasters caused by climate change, potentially disruptive “green swan” events will become relevant to all businesses. As Larry Fink said in his 2020 Letter to CEOs, “ Climate risk is investment risk. In the near future – and sooner than most anticipate – there will be a significant reallocation of capital.”

• Asset owners now routinely require a credible articulation of how ESG principles are being embedded within individual asset class strategies. Cerulli Associates reported in November 2019 that asset owners are demanding an increased commitment to ESG integration and engagement, as well as improved ESG reporting standards and greater transparency. Their findings report that 80% of asset owners would like communication on ESG activities on a quarterly or annual basis.*

• Retail investors are also increasingly focused on incorporating sustainability strategies into their investment portfolios. In addition to the massive surge in ETF inflows, ultra high net worth investors are demanding the implementation of ESG metrics into their private portfolios, and in some cases considering the amendment of their family office investment charters to include sustainability and impact as stated goals.

• Wealth management clients are a fast-growing segment of ESG investors, accounting for a significant portion of new accounts. There is especially strong demand coming from millennials, who are inheriting wealth from their parents, and who want to be more actively engaged with their investment portfolios.

This impact will only increase – 2019 saw a record $20.6b haul for ESG ETFs

Summary

• Investment management firms need to demonstrate a genuine commitment to ESG principles to be credible with their end user investors.

• Sustainable investment leadership needs to report to the top of the house and be given the remit to coordinate across all business lines and geographies.

• The alpha generation of strategies incorporating ESG and sustainability metrics will continue to outperform those that ignore them.

• Investors will continue and intensify their vigilance on whether or not sustainable funds live up to their marketing and mandates.

ESG 2020 – The transformation of private equity

“If your ESG factors aren’t that good, you probably won’t get money from an institutional investor.” – David Rubenstein, Co-Founder and Co-Executive Chairman of The Carlyle Group, Greenwich Economic Forum, November 2019

Where are we now?

Private equity firms have prioritized the development of more credible ESG efforts, targeting policy and governance experts from the non-profit world to help create and lead these strategies. However, highly publicized new “Impact” funds from firms like KKR and TPG raise a fundamental and problematic question – if these new funds are driven by more sustainable investment metrics, does that mean that all of their other funds are not?

In order to pre-empt any notions of “greenwashing”, private equity firms are now building out teams of senior ESG leaders responsible for:

• Partnering with the leadership of the firm to develop and implement a holistic, global and enterprise-wide ESG strategy

• Embedding ESG principles directly within the investment processes of the individual asset class strategies

• Partnering with Marketing and Investor Relations teams to effectively articulate the firm’s ESG strategy to the institutional LPs

• Partnering with the management teams of the portfolio companies to help them devise and incorporate more sustainable long-term corporate strategies

These decisions are being driven by a range of different factors

What's next?

Private equity funds will be focused in 2020 on putting forward a more conciliatory persona, to demonstrate to their investors that their ESG efforts permeate every corner of the organization. However, senior investment teams within these organizations will not willingly concede on their return profiles solely in order to deliver greater impact.

Private equity Heads of ESG in 2020 will need to work closely with these investment teams to explain how incorporating ESG into their already successful investment processes will actually generate incremental alpha over the long run.

To gain an edge, investors are thinking beyond the typical value creation levers:

• Private equity investors are incorporating ESG issues into investment decision-making to mitigate risk and generate sustainable returns

• PE firms are augmenting reporting capabilities and incorporating ESG into investment decisions in response to LP due diligence, regulation and reputational risks

• Portfolio companies are seeking to align financial, social and environmental value creation to enhance performance and to attract, engage and retain talent

01.  Determine Where You Are In Your ESG Lifecycle

The first step in creating a credible ESG framework is performing a self-diagnostic as to where you are as an organization in your ESG lifecycle. Most firms are somewhere in the middle, but all strive to be best-in-class.

02.  Identify Next Gen Financial Services CEO & Board ESG Competencies

“The hit to market value of an ESG controversy is significant and the impact is long-lasting. It can take a year for a stock to reach a trough following an ESG controversy. Negative headlines stick in investors’ minds.” – Savita Subramanian, Head of US equity and quantitative strategy at Bank of America, December 2019.

ESG 2020 – Next Gen CEO competency checklist

A proprietary, market leading board assessment for ESG

In addition to today’s board composition requirements around diversity, technological fluency and operational expertise, good governance going forward will dictate that every board contain C-suite corporate executives with a track record of creating and implementing sustainable long-term corporate strategies.

Russell Reynolds Associates has a globally-recognized Board Consulting and Effectiveness Practice, which actively partners with our corporate clients to identify the specific behaviors, actions and processes boards can adopt to maximize their positive impact on corporate results. As part of our process, we analyze and help to optimize board composition, performance and governance processes.

Leveraging our experience and continuous engagement with the investor community, RRA’s framework identifies 20 ESG Metrics that institutional investors tend to seek disclosure of.

03. Identify and recruit top ESG talent

We are seeing a rapid growth across financial services in demand for ESG leadership; a selection below shows recent appointments that have been announced in the public domain – and we would be happy to discuss the broader talent landscape in more detail.