11 minute read 13 Jan 2021
EY - Glass building house covered by green ivy

ESG: how mutual fund boards can manage risks and seize opportunities

Authors
Mark Watson

EY Americas Financial Services Managing Director and Board Matters Deputy Leader

Transformational leader. Advisor on matters delivering global impact and strong governance. Passionate about sound public policy. Avid moviegoer. Electronic dance music fan. Proud Anglo-American.

Chris Hagler

Managing Director, Climate Change and Sustainability Services, Ernst & Young LLP

Sustainability leader. Passionate about leading environmental and societal transformation. Avid runner. Mother of two. Casual gardener.

11 minute read 13 Jan 2021

Environmental, social and governance (ESG) investing and issues have moved to the top of board agendas across financial services.

In brief

  • Boards must be aware of the most significant ESG risks, as well as the huge growth opportunities.
  • Regulators are focused on disclosure standards, nonfinancial reporting and marketing guidelines.
  • While climate change has been a primary topic in recent years, ESG priorities are constantly evolving.

Environmental, social and governance (ESG) investing — and the broader area of sustainable finance — has become a much-talked-about issue in financial services. While these topics have been on the industry radar for several decades, interest and activity has ebbed and flowed. Recent major events, however, have captured headlines and accelerated action. For example, severe wildfires in California, Australia and Brazil made climate change a dominant topic at the World Economic Forum (WEF) Annual Meeting. Then came COVID-19 and protests against systemic racism, which put a spotlight on public health, employee well-being, diversity and economic equality.

The initial focus on incorporating ESG factors into investment decisions has led to significant growth; currently, between a quarter and a third of global assets under management (AUM) are, in some way, influenced by ESG. During the past five years, more innovative ESG-related products and services (e.g., green bonds and sustainability-linked loans) have hit the market, largely in response to rising investor and public demand for more “ethical” products and services. It’s now clear that financial services will be the engine for the transition to a lower-carbon economy. After all, the transition has to be financed.

A recent webinar hosted by the Mutual Fund Directors Forum (MFDF) and EY to explore these trends in detail with more than 70 fund directors featured an interactive discussion that covered:

  • The evolution of ESG matters from the early years of corporate social responsibility and philanthropy to a wider and more complex set of issues (including climate change), plus a boom in sustainability-related financial products
  • The role of ESG issues as a major growth platform with many significant commercial and innovation opportunities
  • Intensifying regulatory focus and the emergence of global disclosure standards with an emphasis on nonfinancial reporting, clearer measures for the efficacy of ESG products, and marketing guidelines
  • How funds can move forward and succeed in the age of commitment to ESG factors and sustainable finance
  • The major ESG risks and concerns for mutual fund directors to keep in mind

Based on surveys conducted during the session and other inputs from participants, this article will explore these ESG issues and highlight 10 major challenges for mutual fund directors to work through.

EY - Hand holding and caring a green plan
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Chapter 1

ESG and mutual funds: where we are today

Even as COVID, climate change and anti-racism activities reshape the ESG landscape, the growth momentum seems unstoppable.

Sustainable finance and ESG issues are critically important for the asset management industry. As investors, mutual funds play a central role in pushing companies in which they invest to manage ESG risks and seize related opportunities. As intermediaries, they have to offer ESG products and services to meet evolving customer and investor needs. As fiduciaries, they have to mitigate ESG risks.

The ESG agenda covers the following issues:

  • Environmental: climate change and carbon emissions, energy efficiency, use of natural resources, clean energy and tech
  • Social: labor relations, racial, ethnic and gender diversity, employee safety, human rights/child labor, product safety
  • Governance: board independence and diversity, compensation, business ethics, cybersecurity, corruption and anti-money laundering

Prior to COVID-19, environmental factors, notably climate change, had shot near the top of board agendas. Gender equality also became a priority during the last few years. But in the wake of the pandemic, social issues came to the fore. The focus has been on employee well-being and broader human capital matters, as well as on companies’ more wide-reaching societal role.

At the same time, protests against systemic racism greatly elevated and expanded the discussion of diversity and inclusiveness. The governance focus shifted to operational resilience, cybersecurity threats brought on by remote working and risk management. It’s a complex and interconnected set of issues and risks that boards must take into account.

There is no doubt that ESG matters provide a huge platform for growth. Consider that assets under management (AUM) linked to ESG factors reached almost $30 trillion in 2018, up 34% from two years prior¹ and the growth has only accelerated since. Last year was a record year for issuance of ESG-related bonds, at almost $260m², and the market for ESG data could reach $1 billion globally by 2021.³

This huge growth potential, alongside the significant risks presented by constant evolution in the ESG market, is yet another reason mutual fund directors must be focused on ESG issues.

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Chapter 2

10 ESG challenges for mutual fund board directors

From reputational risk to lack of data to emerging disclosures, boards have a lot to consider.

Despite the huge momentum in the ESG market, integrating ESG considerations into the business will not be easy for mutual funds or other large players in financial services. The lack of generally accepted reporting standards is one challenge. It’s difficult for peers to compare their ESG efforts or progress toward ESG goals without common metrics, which are still a few years away. For ratings and data, multiple agencies use different scoring methodologies, causing further confusion.

Based on its engagement with the industry, EY has identified 10 major challenges for mutual fund directors related to ESG issues to work through:

1. Reputational risk associated with proxy voting

Not so long ago, shareholder proposals on environmental and social issues attracted only minority support; in 2016, only 29% of proposals gained the support of more than 30% of shareholders; in 2019, 48% of proposals had more than 30% support. When polled, directors participating in our session cited racial diversity, gender diversity and climate change as the voting issues with the highest reputational risk.

As directors are well aware, proxy voting may be a fiduciary responsibility, but it carries significant reputational risk if it is not informed by a deliberate voting policy. Beyond policy, funds — particularly smaller funds — face challenges in managing voting policies and processes, especially when they rely on third-party proxy-voting firms. Of course, reputational threats can stem from other risks, especially in social media within which negative issues can arise and be amplified quickly.

2. Lack of rigor in incorporating ESG factors into the investment process

Building ESG matters into the investment process is not easy; the topics are complex and inevitably more qualitative than financial matters. Directors have to be confident the fund’s investment procedures perform as disclosed to investors (for example, that the proportion of investments that should be influenced by ESG factors is, in fact, determined that way).

They have to validate that the portfolio managers use ESG data consistently in the investment decision-making process and that the fund builds ESG into the due diligence for major investments as necessary. In other words, the governance of ESG investing needs to be well defined and rigorously managed.

3. Lack of quality ESG data to use in developing products and services

Though more ESG data is available, there are concerns about how useful or insightful it is. Fund directors should seek assurances from fund advisors that investment professionals are using an appropriate level of judgement and healthy skepticism when using ESG in their decision-making or in the development of ESG-related services (e.g., data or portfolio management) for clients.

Using a single provider often leaves data gaps, which has led many firms to consolidate multiple data sources and, in some cases, build their own scoring methodologies and algorithms. However, having multiple providers can lead to higher costs and increased need for coordination, while home-grown scores present new risks.

4. Mis-marketing of ESG products

Regulators are increasingly focused on so-called “greenwashing,” whereby financial services firms knowingly or accidentally misrepresent products and services as ESG friendly in nature in their marketing programs. Some growth in the number of ESG funds during COVID-19 appears to have come from funds simply rebranding themselves. The lack of industry standards makes it more difficult for investors and customers to assess the quality of the products and services. Still, directors should validate that ESG products are marketed appropriately.

Increasingly, issuers are turning to third parties to confirm that ESG offerings are in line with public disclosures and other communications, with the goal of boosting investor confidence and mitigating reputational and compliance risks. The options include agreed-upon procedures, other kinds of attestations, more detailed assurance statements and certifications. In some markets (e.g., green bonds), such assurance is almost a prerequisite for issuance.

5. Lack of compliance with evolving ESG-related laws and regulations

Mutual fund directors take their compliance responsibilities very seriously and rely heavily on chief compliance officers (CCO) to assess whether and how processes, procedures and disclosures meet legal and regulatory requirements. Fund directors know the regulatory picture for ESG products and services is evolving. Not surprisingly, when polled, 42% of fund directors identified compliance as their largest concern in terms of ESG. It is important that fund boards get routine updates on regulatory trends and seek assurance from the CCO that the fund’s practices are keeping pace.

6. Third-party ESG-related risk

Mutual funds rely on a host of third parties, affiliated subadvisors and service providers and increasingly expect more of them to meet ESG standards and requirements. Fund boards must discuss ESG with relevant advisors and seek assurance that the fund’s standards and requirements are being met fully and can accommodate future changes. Almost a fifth of fund directors view this as one of their main concerns about ESG.

7. Inability to capitalize on ESG growth

Directors may feel bullish about the growth opportunities associated with ESG. However, without a clear strategy to attract and retain ESG-seeking investors, and a plan to distinguish their ESG funds in an increasingly crowded marketplace, those opportunities might not be realized. A trusted brand and differentiation are key success factors. Directors should ensure that effective strategies are in place to launch and grow products and to remain competitive and visible in the market.

8. Lack of board reporting and oversight

Fund boards must be engaged on ESG matters. Not only is it part of their fiduciary responsibilities, but also a critical competitive issue going forward. Yet, about 20% of fund directors view this as a top concern about ESG. Specifically, they worry that they do not receive sufficient information on their fund’s ESG strategy, performance and proxy-voting record, and that they do not apportion sufficient time to ESG issues when evaluating investment managers and other service providers. Fund boards will need to rectify these governance shortfalls.

9. Misalignment between sponsors and funds

Though fund boards operate independently of their fund managers, it would be naive to believe fund directors are not aware of the full range of risks. That’s especially true when it comes to the potential misalignment between ESG strategies, the fund sponsor’s public statements and the ESG policies and proxy-voting practices of fund managers. In a world where social media quickly amplifies perceived discrepancies between statements and practices, it is important to know where and how those misalignments could create reputational risks.

10. Substandard ESG disclosures

Fund managers are increasingly committed to new voluntary standards and more demanding mandatory disclosures. Directors should understand which disclosure frameworks or requirements fund advisors have committed to or might be subject to and then validate that the fund has processes to assess the accuracy and consistency of these disclosures on an ongoing basis. It is especially important that the fund has accurate and timely disclosures about ESG fund strategies and performance.

The bottom line: thriving in the ESG era

Financial institutions of all types face increasing pressures from stakeholders — including investors and customers, employees and the communities in which they operate — to enhance how they manage ESG issues and engage in the fast-growing and ever-evolving sustainable finance market.

Summary

Looking ahead, fund boards should recognize how ESG and sustainability programs intersect with branding and competitive differentiation, social purpose and the organizational mission statement, core business strategy and performance metrics. Thriving in the age of ESG starts with understanding its direct impact across all of these strategic dimensions, as well as how it plays out on multiple tactical fronts.

In practical terms, that means directors should expect to see ESG not as a single line item on future board agendas, but rather a topic that will incorporate many areas of critical discussion.

About this article

Authors
Mark Watson

EY Americas Financial Services Managing Director and Board Matters Deputy Leader

Transformational leader. Advisor on matters delivering global impact and strong governance. Passionate about sound public policy. Avid moviegoer. Electronic dance music fan. Proud Anglo-American.

Chris Hagler

Managing Director, Climate Change and Sustainability Services, Ernst & Young LLP

Sustainability leader. Passionate about leading environmental and societal transformation. Avid runner. Mother of two. Casual gardener.