Having a well-articulated and credible active ownership strategy is becoming a hygiene factor for many investors and applicable strategies.
Engagement has evolved from primarily a focus on fact-finding and utilization of voting rights to working closely with issuers and other stakeholders to set expectations and help develop strategies to tackle many of the challenging issues currently facing our societies. Today it’s about advancing your fiduciary duty to clients and beneficiaries by ensuring proper governance of assets, balancing both financial as well as social and environmental objectives.
For anyone looking to advance their stewardship strategy, there are some excellent resources and guidance out there which will help you understand value creation mechanisms for investors and companies alike, opportunities and barriers to effective engagement and so forth. However, striving for best practice is to aim at a constantly moving target.
- in this three-part series, we focus on the engagement process and provide views on evolving expectations and market practice for more effective investor stewardship.
Engagement process - summarized in phases:
Objectives and Strategy: Establish, revise and provide transparency on engagement strategy to stakeholders
Prioritization: Observe portfolio companies to identify risks and opportunities to inform selection
Engagement and monitoring: Engage, review of progress and suggested actions
Escalation: Where unsuccessful or insufficient progress, escalate according to strategy
Reporting: Provide insight on activities and value creation to clients, beneficiaries and regulators
Entry no. 1: Engagement Objectives, Strategy, and Prioritization
This article addresses the following areas: (see drop-down sections below)
Getting the foundation right
A strong foundation is essential to enable a successful engagement program. Investors should ensure they have a well-defined management system and plan in place to progress on identified stewardship objectives. Building blocks should include for example how your organisation has governed and resourced stewardship as it regards processes, systems and team structures. On the latter point of responsibilities, we come across a mix of setups reflecting different organizational conditions such as engagement being embedded in the investment process and conducted by portfolio managers and analysts; conducted primarily by a responsible investment or dedicated engagement team; or through a combined approach whereby ESG specialists lead on some activities and work alongside investment professionals to contribute with subject matter expertise.
/ Using the Esgaia platform, investors manage and coordinate engagement activities across different teams /
Growing expectations on stewardship across asset classes
Active ownership has been most prominent in listed equity, and while we are seeing steady growth in other asset classes too, deeper commitments are needed to structurally progress on many challenging issues.
Expectations are increasing however. By example, the updated UK Stewardship Code(1) demands of signatories to exercise stewardship across all asset classes and geographies in which they are invested. Investors are expected to use the resources, rights and influence available to them and report accordingly. The FRC (Financial Reporting Council) in the UK comment on this in a recent report on “Effective Stewardship Reporting”(2):
"There are high-level commonalities to the overall stewardship approach taken for listed equity and other asset classes such as identifying the conditions that enable positive outcomes from stewardship activities, the types of performance and value those undertaking stewardship are delivering for their client or beneficiaries, the use of targets to assess stewardship performance, the interaction investors have with investee companies to encourage better stewardship outcomes and overall measurement of success from stewardship activities.
There are also important differences in asset classes outside of listed equity that signatories should consider when practicing stewardship. Issues such as access to management, size of holding, ownership rights, liquidity, time horizon and the direct or indirect nature of the investment will determine the approach to stewardship in different asset classes."
On courtesy by the council, see pages 36-40 in that report where they list examples of stewardship activities across the asset classes Fixed income, Real estate, Infrastructure, Private equity, Hedge funds and Derivatives that can be used to exercise influence and rights.
/ Using the Esgaia platform, investors can record engagement activities across different asset classes and actors /
Investor specific prioritization
Ahead of setting a priority, there needs to be a due diligence and monitoring process in place to monitor ESG practices and performance by investee companies.
Today, there is no shortage of information and expertise on esg risks available to investors. On the contrary, investors are expected to identify which risks they prioritise and why to improve outcomes to the economy, environment and its stakeholders. However, given different organizational conditions and as many investors own thousands of companies across portfolios, it is recognized that not all ESG risks and opportunities can be identified and addressed.
Importantly, investors should prioritise quality over quantity in establishing the scope of their stewardship efforts to ensure responsible activity levels and avoid resources spreading too thinly. In turn, this will increase the collective impact and minimize risks of fueling market inefficiencies, which is to the benefit of all stakeholders in the investment ecosystem.
Here are some examples of typical engagement prioritisation criteria:
Focus topics based clients and beneficiaries interests
Credit quality / duration of FI holdings, i.e. less balance sheet flexibility for negative esg impacts, or exposure to ESG factors over certain timeframes
Worst performers from a chosen esg perspective, e.g. breaches of international norms; poor esg risk rating scores; based on PAI peer analysis; and so forth
Focus on sectors, industries and value chains with significant material/systemic esg risks/impacts, targeting issuers across the performance continuum, i.e. industry leaders, followers and laggards
More information on prioritization can be found in the PRI’s studies on Active ownership in Listed Equity and Fixed Income respectively(3,4).
/ Using the Esgaia platform, investors can include research inputs and data points of relevance to different engagements /
From reactive to proactive
Most would agree that traditional ESG related engagement - aside from proxy voting - has stemmed from a reactionary approach of engaging investee companies in breach of international norms and conventions. Sprung out of demand and necessity from values driven asset owners to ensure they weren’t complicit in any such breaches, this in turn trickled through to investment managers.
With expectations aligned with for example the UN Global Compact or OECD Guidelines for Multinational enterprises, utilizing well-defined escalation strategies, this approach has become the starting point and backbone of many investors’ engagement strategies. It enables investors to stay invested and demonstrate responsible ownership in contrast to a screening approach where your strategy and main point of action is to divest - which has far less support in academia from an impact perspective.
Over the years, as engagement has grown in importance, investors have increasingly started to proactively address shared material esg risks and opportunities with companies - today, engagement is all about protecting the downside and capturing the upside of esg impacts on portfolio companies and their impact on society and stakeholders.
The materiality continuum
Above section provides a nice segway over to the emergence of double or dynamic materiality in business and finance. With corporate sustainability reporting on the rise and strong investor utility of for example ESG risk ratings - frameworks aimed at measuring the impact of financially material esg risks on companies and their management of such issues -, there is a shift underway to also account for a company’s impact on the environment and stakeholders.
From a regulatory perspective, the launch of the International Sustainability Standards Board (ISSB) on COP26 last year marks an important step to address the fragmentation in disclosure and reporting regulation by introducing a baseline standard that can be adopted by companies across the globe and implemented by policymakers. Currently, ISSB is focusing on developing standards based on financial materiality - initial focus on climate disclosures - , which align with the approach in TCFD. Many are therefore asking for the adoption of a “building block approach”, which could allow for an introduction of double materiality over time. Importantly, the standards are not designed to limit region-specific approaches, such as the EU’s Sustainability Reporting Standards, which are being designed through a double materiality lens (applicable for companies falling under the coming Corporate Sustainability Reporting Directive - CSRD).
In terms of the relevance to investors’ engagement prioritisation, in Europe for example, the Sustainable Finance Disclosure Regulation, SFDR, - applicable for financial market participants - covers both ESG risks to companies as well as Principal Adverse Impacts (PAIs) of companies’ activities on society and the environment. As engagement is relevant to investor practices in both instances, it should reasonably be reflected upon in strategy design, in particular as it regards prioritized engagement objectives and utilised research inputs.
/ Using the Esgaia platform, investors can link specific engagements to for example certain PAIs, which is then reflected in records and reporting /
Mitigating systemic risks
To a higher extent than present, investors should also address systemic issues as part of their stewardship activities, which may otherwise result in adverse impacts detrimental to both portfolio risk and return as well as to the society and environment. In addressing such risks and opportunities, investors can instead improve stability of portfolio investments and markets, while contributing to the sustainability agenda.
Best practice efforts include utilising thematic approaches: by engaging groups of companies and relevant stakeholders in specific value chains, preferably in collaboration with other investors, we have a better chance at addressing root causes to enable system-wide changes.
/ Using the Esgaia platform, investors benefit from templates developed for either individual or thematic engagements. In the latter, joint milestones or KPIs can be tracked for multiple companies /
Continued focus on collective action
Broader industry collaboration and advocacy is critical to progress - pooling capital is a powerful way to increase influence. Investors should consider collaborating bilaterally, through engagement initiatives, and on public policy (both in direct support and through coordinated efforts). Realized benefits will include for example strengthened reputation, knowledge transfer, increased local market presence and expertise - all important to increase legitimacy and efficiency in activities.
/ Using the Esgaia platform, investors can invite and collaborate with external parties. Clients can also record activities with other organizations such as networks, initiatives, NGOs, and so forth /
In the next entry, we will focus on engagement initiation, progress evaluation and escalation. Stay tuned!
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