Feel good investing
Liam Bailey, Knight Frank’s global head of research, confirms why Biden, Brexit and a global power play will accelerate ESG investment in 2021.
6 minutes to read
Earlier this year, in the Knight Frank Wealth Report, I talked about the need for clarity and transparency when it came to definitions and measurement of Environmental, Social and Governance (ESG) investment criteria.
Critics argued asset managers were happily labelling funds as ‘green’ or ‘sustainable’ with little oversight, and the record-breaking speed at which cash was flowing into these self-titled funds was outpacing progress towards a unified approach to an assessment of their benefits.
That appeared unsustainable at the time, and in the US the Securities and Exchange Commission (SEC) was already starting to ask pointed questions. It looked inevitable that regulators would force the pace on setting rules in this area. What was less expected was that they’d step in to try to break up the party.
The latter moment arrived in late June this year when the Department of Labor (DoL), the organisation that sets rules for US pension funds, published a proposal stating that fund managers should consider only economic factors in offering retirement accounts. The plan would allow managers to consider ESG factors, “only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”.
Or as Matt Levin, Bloomberg's Money Talks columnist put it neatly: "you can refuse to buy polluters if you think, and can document, that their factories will blow up and they’ll be fined a lot of money, because losing a lot of money is bad; you can’t refuse to buy polluters because you think that pollution is bad."
The UN Principles for Responsible Investing, an organisation that has signed up more than 3,000 investment managers, has been unqualified in its criticism and tensions have been simmering. It says the DoL is operating with an outdated perception of ESG, which assumes that investors must give up performance in order to invest responsibly.
Nevertheless, in a shot over the bow of the investment industry, the DoL implemented the new rule on 30 October in a form that kept many of the key facets of the original proposal.
The new leadership race
While the DoL in the US was busy confiscating the ESG punch bowl, regulators in Europe have been racing to embrace ESG-friendly standards.
The European Central Bank, for example, is setting capital markets benchmarks with new green bond issuance. European regulators are currently moving to embrace the recommendations from the Task Force for Climate-Related Financial Disclosure (TFCD), and perhaps most significantly, the European Commission is finalising a taxonomy to define green assets.
No financial business with an exposure to the EU can ignore these innovations. So, while the US has left the field empty the EU has been quietly setting the world’s ESG regulatory framework and at the same time forcing the world’s largest financial companies to play by its rules.
Not wanting to be outdone, and with an eye firmly on post-Brexit business opportunities, the UK has suddenly stepped up its engagement with ESG policy.
On 9 November the UK Chancellor Rishi Sunak announced that by 2025, climate risk assessments will be mandatory across the UK, including for listed companies, large private companies, pension schemes, insurance companies and banks. In an attempt to outflank the EU, the UK regime will be based on that developed by the TCFD.
But now we have Biden. While it isn’t yet clear how quickly the new US administration might change the approach taken by the DoL or the SEC, or even embrace TCFD, the prospect will undoubtedly spark a review of portfolios as US investors are forced to contemplate how future regulation could impact on asset values.
The need for evidence
The growing rush by governments to embrace ESG investment criteria does not negate the original challenge posed by the DoL, but it will be likely to help provide a solution to the challenge.
There are many arguments made for ESG, but they generally boil down to two issues: either ESG is the right thing to do because it is the right thing to do, or, ESG is the right thing to do because it defends and protects long-term returns.
The DoL has effectively said that the first argument is not enough. Whether Biden clips the DoL’s wings and downgrades the October rule is I think immaterial in the long-run. The rapid expansion of ESG investment will inevitably lead to a sharper focus on claims that these criteria actually lead to stronger financial outcomes.
There is a direct read across to real estate here, a sector which has embraced ESG, especially the ‘E’, with vigour.
As our recent Active Capital report argued: assets which are able to comply with rapidly evolving policy aimed at furthering “green” objectives should outperform, as they are future proofed against policy risk, and at the same time they should be in heavy demand from growing pools of finance looking for green assets, and finally they should fit rising needs from occupiers facing their own ESG demands.
So far so logical. But the key requirement is the need to evidence these benefits. Could for example a fund manager, if required, prove their “green” assets command a rental, liquidity or value premium that might satisfy a sceptical regulator like the DoL?
Despite the challenges, there is a race underway among numerous organisations seeking to answer these questions. While the data remains patchy, and not easily comparable across markets and sectors, significant work is being undertaken to remedy these data gaps.
However, it is likely to be legislation that helps fulfil the DoL challenge.
No choice
In the UK for example the government's consultation on energy performance disclosure for commercial buildings is expected by the end of the year. A tightening of minimum standards would put the UK on a par with Australia, and evidence of the industry’s preparation for this new reality was confirmed by the launch of the NABERS UK last month with the promise of improved energy ratings.
Other examples are evolving in the EU - the Dutch government for example has set out its intention that by 2030 all office buildings will have to achieve an EPC rating of A. The direction of travel globally is becoming clear.
As the legislative net closes the importance of proving a green premium begins to fade, at least in terms of satisfying DoL style challenges. Eventually there just won't be a choice.
Increasingly investors are focussing solely on finding assets that generate the required returns and at the same time fit ambitious decarbonisation strategies. Anything that doesn’t fit won’t be bought, and anything they already own that can’t be brought in line will be sold or developed.
Whether investors can get ahead of or just keep up with legislators will be the critical driver of ESG investment volumes in 2021. Whether returns suffer or not will, in the near-term at least, be somewhat academic.