From the desks of John Arnesen, Consulting Lead and
Roy Zimmerhansl, Practice Lead, Pierpoint Financial Consulting
ESG is clearly more than just a trending buzzword and has become a fundamental criterion in the investment management decision making process across the board. While climate change is grabbing the headlines and an impassioned speech by a young Swede at the U.N has focused attention, the reality is that investors and the managers that represent them have been taking issue of “Responsible Investment” very seriously in the decisions they make and this is only set to increase as they strive to meet the standards to be considered as an environmentally and socially responsible organisation.
Some background. In 2016 in the U.S alone, $8.72 trillion of asset under management incorporated an ESG component. Put another way this represented one in every five dollars under professional management. The growth in demand for ESG products has seen the launch of ESG compliant index futures on both Eurex and Nasdaq in Europe over the past year. According to the American Council for Capital Formation, funds incorporating ESG factors grew by 39% between 2012 and 2016.
At the Climate Action Summit in New York recently some of the world’s largest insurance and pension funds representing over $2 trillion in AUM committed to the Net-Zero Asset Owner Alliance which has an initiative to being carbon neutral by 2050. Others will no doubt join. As from October 2019, UK pension funds are explicitly mandated to incorporate ESG factors into their investment decisions.
So, what can we expect in terms of how these values and principles will affect securities finance programmes? It will no doubt start at the selection process. Anyone who has responded to custody and securities lending RFPs in the past few years will have seen ESG related questions appear with more frequency and in more detail. It would be frustrating for a business unit that considers itself well governed to be let down by an overall weak rating for its institution, if that weakness led to a missed opportunity. ESG principles are everyone’s responsibility. On the whole however, portfolio holdings reflect relevant ESG criteria, so once assets are in custody and available for loan, the first phase of investor compliance has already been met and lending is "good to go".
Alongside the loan is of course collateral. Collateral acceptability will also need to reflect the ESG values of the fund. Cash reinvestment vehicles would need to be clearly defined within the guidelines at the outset but that isn’t as straightforward as it seems given the huge range of potential short- term assets that meet rating criteria. For example, A1/P1 ratings for commercial paper is a typical guideline. What if that changes to the approval of individual issuers for their ESG principles? Inevitably investors will require that any assets that are held as collateral must satisfy their ESG expectations.
Non-cash collateral will not be immune. Screening for the exclusion of individual issues that a fund has already restricted at the investment stage will need to take place and already does today on a reactive basis. However, in a marketplace that is striving to increase automation in all of its processes, it may have to break up its collateral modus operandi to ensure compliance for one or many clients. Does that lead to more segregation of collateral management? As with cash reinvestment collateral, it is inconceivable that a client that has excluded a company for investment purposes would allow it for collateral, be that on a title transfer or pledge basis. We work with investors to structure their cash and non-cash guidelines and fine-tune their oversight to ensure compliance.
What about voting? There is currently an array of policies applied by investors ranging from no voting at all through to voting on contentious issues only, voting on a percentage of holding not on loan, to recalling an entire position. What if that changed? What happens if the governance of assets extends to voting on every position on every occasion? In some ways, it would level the playing field, but it’s more likely that the market will develop into assets that are callable co-existing with those that adhere to the current scenario. Inevitably, assets subject to mandatory recall will attract a lower fee as borrowers will be required to find alternative supply for upcoming votes. Notwithstanding the revenue-generating differential between the two, how sustainable is this approach to voting? I wonder what the tipping point is between securities lending fees on a particular asset vs the increased corporate governance exercised by portfolio managers? This isn’t a new consideration but is it subject to radical change? Our view and experience suggest the market will find its own level, accommodating activist investors as well as investors that may choose the lending-related revenues over the exercise of their voting opportunity.
In an ideal world, issuers of equity or debt, both corporate and sovereign would meet ESG compliant “status”. Indeed, there is talk of main index inclusion criteria including ESG filters. However, the application and interpretation of the principles differ widely between institutions and remains very subjective and this is likely to be the case for a long time. The securities finance market is flexible enough to meet client requirements and will no doubt continue to do so. However, we expect, and are helping drive a re-think of the practices, procedures and profiles that provide for scalable solutions while simultaneously meeting investor objectives.
P.S. Our recent presentation: "Responsible Investing and Stock Lending" is available to Beneficial Owners and Trustees. To obtain a copy, message us at contact@pierpoint.info