Directors and executives of companies have become more aware of the importance of external reporting in sustainability. The more complex and relevant fact that investors can also consider environmental, social and governance topics (ESG) is less well known. It can be difficult for companies and boards to determine if investors are asking them to achieve operational sustainability outcomes that will lead portfolio decisions. This could be in public funds, private equity, or credit vehicles. This distinction matters because of an evolving issue that is currently under the radar but will soon demand the attention of every executive team and board director: the increasingly sophisticated approaches by which investors assess and employ sustainability-related information in portfolio decisions and the attention being paid to the decisions of company boards about these same topics.
Capital markets in middle
It's tempting to ignore the current debate about ESG and sustainable investment until it is better resolved. Leaders must resist the temptation to ignore this important discussion and admit that sustainability considerations in investing are here to stay.
One of the most talked about aspects of these changes involves the rapid acceptance across all investment asset classes of sustainability & ESG. ESG topics are now a common feature in investor portfolios, even if they do not include ESG. We can forgo the often cited statistics on the growth of ESG funds and instead focus on the debate about which funds should be considered ESG. Let's instead examine the importance of capital markets for sustainability and the lessons that can be learned from this development.
Capital markets and the tools they employed were not central to sustainability even five years ago. A long-standing relationship between large shareholders in publicly held companies as well as boards of directors created a mechanism linking asset managers of commingled money, and thus asset owners preferences, to company oversight, managerial decisions, and management decisions.
The expansion of corporate governance and engagement to include more proactively environment and social topics was accompanied by regional policy shifts which create incentives and penalties for certain sustainability subjects. This has led to the murky environment that we now live in.
Publicly-held companies might not know if questions from stakeholders and investors are relevant for portfolio and investment decision making or if they're part of corporate governance expectations, which may or may not be tied to specific portfolio decisions. It's also not clear when these factors may be true.
Moreover, private companies as well as infrastructure and real-estate projects are now part the same basic dialogue. Market mechanisms are constantly being reexamined, expanded and changed. In many cases, this means that the assumptions they contain are also changing. The year 2023 will be a pivotal one, and board members and executives must be ready.
Investors' portfolio decisions can be influenced by the incorporation of sustainability into asset allocation
This can be seen in two ways. This second scenario is where fund managers direct their questions to board members and executives of companies. In some cases, they are genuinely seeking a better understanding, while in others they want to satisfy those who have allocated assets to them.
Board members and executives of companies who are questioned in this manner often feel they're being asked ESG-related questions like, "Do you have a policy/commitment" for x,y,z?" Sometimes leaders can feel that ESG is separate from their operational and strategic decisions. Or that they are being asked questions too far in the future than the current business planning cycle.
Bain and Rivel conducted a survey of investors in the public markets. They found that such questions could be relevant to investment decisions. This is contrary to compliance concerns. The majority of investors surveyed stated that they don't currently have any specific targets or thresholds for carbon emissions in their portfolio decisions. However, 19% of utility investors had emission targets while 16% of oil and gas investors were looking at carbon targets (see Figure 2).
Executive teams should be on the lookout for investors from other asset classes and sectors to begin incorporating carbon or ESG in portfolio decisions. They must also make proactive decisions about what this could mean for strategy, funding and operations. Bain and the Institutional Limited Partners Association recently conducted a study that found 70% of limited partners (LPs), reporting that their investment policies already included some ESG consideration. Some investors target ESG in portfolios
Investors will have more information to choose from when building portfolios. The use of less-traditional data insights in portfolios has been growing rapidly even before ESG was common to enhance due diligence and/or valuation decisions made by private equity investors with their in-house data team and public market investors. Investors of all types are now looking for more inputs that can be used to support analysis and decision making.
Executive teams, especially those with global exposure or businesses that are exposed to Europe, must be aware of regulatory changes that can impact investor and company disclosures. Investors will be eager to see the mandated disclosures in 2023-2025 for 49,000 privately owned and publicly listed businesses located in the European Union. Portfolios that are subject to the EU taxonomy's sustainable disclosure requirements will need to report at fund level on these corporate inputs. Investors will continue to search the vast amount of information available to find any new information that could help them improve their portfolios. Active investors are motivated to seek out new insights and they do so constantly. They are interested in learning if there is a better way to understand and differentiate companies' performance.
Executives and boards should be motivated by the possibility that investors might uncover something to change how they position portfolios. Do not look away
Boards and executives alike find 2023 a challenging year to plan for. It may appear that environment, climate and social considerations are disappearing into the background, given current macroeconomic and industry business cycles. Don't let this fool you: They're not, no matter what they're called ESG.
Instead of looking away, look closely at these issues. Boards and executive teams that have made public specific environment or climate or social commitments or are considering making them may want to incorporate analytics into their decision-making to link these topics with operations and strategy. No matter where you fall on the spectrum, you should not let investors evaluate and decide on your ESG outcomes.