In our recent article “Future Gazing in Asset Management – The Lead Up to COP26 and Beyond”, we assessed the implications of a number of emerging themes expected to dominate the ESG & Responsible Investment landscape for the foreseeable future.
As the debate concludes from COP26 and the countdown to fulfilling the pledges begins, asset managers should also be horizon scanning and considering how their business models would be impacted by the emergence of some ‘uncomfortable concepts’ that could potentially, yet fundamentally, disrupt the asset management industry. These concepts may crystallise more quickly than we expect if the private and public markets fail to follow up on pledges, scientific evidence fails to demonstrate progress against climate change and policy-makers / regulators come under intensive pressure to exercise their powers to effectuate change.
Designed to provoke discussion (rather than scaremonger), the following concepts will bring significant risks to the unprepared. Yet, there are interesting business opportunities for firms that have strong strategic and risk-focused processes to anticipate and prepare their business strategies.
Some of these concepts include:
Replacement of “stranded assets” for “sticky assets”
This is essentially a concept to require companies with “brown” assets to retain them on their balance sheet, with an obligation to “manage” the problem these assets represent rather than shifting the issue by selling “dirty” assets to another, less ESG-focused, firm who continues to operate them. Adoption of this concept would accelerate the ever-growing importance of Stewardship and Active ownership by asset owners and asset managers.
Potential introduction of legal liability to asset managers, as well as investee companies
There is potential for legal liability to be introduced to firms providing capital (equity or debt) to “brown” industries or “significantly harmful” companies that do not have credible transition plans in place. This would clearly go beyond the current legal liability often limited to the investee company itself as opposed to the investor/financing organisation. Introduction of legal liability would require a significant enhancement to due diligence and active ownership activities by asset managers. However, the introduction of sustainability linked instruments, which have specific ESG related KPIs associated with them, could provide a vehicle to help align investment with better outcomes.
Delivering sustainable outcomes
Whilst some responsible investors are starting to integrate high level sustainability-focuses metrics such as GHG emissions into investment mandates, the majority of investment mandates remain focused on maximising financial returns. However, if scientific evidence continues to demonstrate deterioration of the physical and social environments, significant capital may need to reorient toward maximising sustainable outcomes whilst capping financial outcomes. In anticipation of this path, some asset managers have started to build their impact investing capabilities; however, this remains a niche market and significant scaling of outcomes focused investing would require different approaches to investment management, performance reporting and overall operating environments.
Accountability for lifetime carbon
Whilst the world debates the identification and measurement of scope 1, 2 and 3 emissions in investment portfolios, there has been little discussion of who should be responsible for the lifetime output of carbon emissions from a particular company or asset. Significant capital expenditure is needed to further build infrastructure; yet current investment practices do not yet factor in the future emissions that an investment will generate. Carbon abatement and avoidance will need to become significantly more prominent in investment management activities, from asset and project valuation to designing investment products that help avoid carbon or more fully capture the product’s carbon impact.
So what are the conclusions for asset managers?
- Enhancing Risk monitoring: Risk horizon scanning processes need to identify, model and effectively identify the impacts that sustainability risk related events could have on a firm’s business strategy and operating model
- Strengthen active ownership approach: Market participants who develop effective engagement and stewardship models will have the most success of managing “brown” assets, including an understanding of when successful outcomes can be generated alone and when cross-industry action is required.
- Embed transition-related monitoring: Risk oversight models should already be robust and consider ESG and Responsible Investment factors, but teams may need to further develop their models should specific transition-related regulation be introduced.
- Understand how your clients are changing: Investment and Sales teams must keep up with asset owner preferences and may soon need to offer “progress-oriented” products where a pre-defined level of return is accepted based on client sustainability preferences and outcomes.
To learn more about how to prepare for the ‘uncomfortable’ in ESG, please get in touch with our team.