European investors are struggling to understand new rules designed to confirm the environmental, social and governance (ESG) credentials of portfolios. Since regulatory guidelines are vague, asset managers must provide a clear framework to show how their products fit sustainable investing classifications.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) aims to improve transparency about the ESG features of investment portfolios by having firms classify them as Article 8 or Article 9 products. However, definitions of Article 8 and 9 are quite broad. When SFDR’s level 2 requirements take effect in January 2023, firms will need to provide more details explaining portfolio alignment with these categories. To decipher the disclosures, investors should focus on three issues: how ESG research is integrated in investment processes, what applicable engagement activity is conducted with issuers and whether a clear methodology is applied to classify portfolios.
Integrated ESG Research Paints a Complete Picture
Under SFDR, Article 8 portfolios should promote, “environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.” But what does this really mean?
We believe investors must integrate ESG issues in fundamental research to assess company behavior and risk/return potential. Fundamental analysts, who are immersed in a company’s business and financials, can best judge how ESG issues affect the outlook, and how a company is (or isn’t) evolving to promote positive change.
What threats does a company face from climate change? Does corporate culture support innovation and growth? Is the board truly diverse? Analysts who are familiar with a company can ask the right questions and draw the most meaningful ESG conclusions.
Many firms use third-party ESG ratings to evaluate companies. These may not capture the full picture. Ratings often reflect a company’s past behavior and not whether it is changing for the better. For ratings to be useful for investors, ESG analysis requires informed human judgement and interpretation.
When assessing an Article 8 portfolio, check whether it relies mostly on third-party data to evaluate companies. Find out whether analysts have been trained to tackle ESG issues. And ask investment teams to explain how they generate ESG research insights.
Engagement for Insight and Impact
Insight into ESG issues is hard to glean from company reports. Direct discussions with companies on thorny issues help determine whether a business is on the right track.
Engagement is also a powerful tool for influence. Buying stocks or bonds in public markets doesn’t make a direct financial impact, unlike investors who provide primary capital to fund specific projects. But active managers can wield influence as an owner, encouraging management to make improvements that benefit stakeholders—from customers to employees to communities—and support shareholder returns.
Investors are increasingly speaking out on ESG issues and companies are responding. For example, average shareholder support for environmental proposals at US companies jumped to 42% in the first half of 2021 from 31% a year earlier, Glass Lewis reports. Some 57% of Fortune 100 companies disclosed greenhouse gas emission reduction goals in their 2021 proxies, up from just 35% in 2020.
When evaluating an Article 8 portfolio, examine its engagement practices as a sign of true commitment to ESG issues. Portfolio teams with a robust engagement strategy benefit from ESG research advantages while playing an important role in shaping corporate behavior.
Consistent Methodology Helps Deliver Better Outcomes
In our view, Article 8 and 9 portfolios should actively integrate ESG issues in the investment process, with consistent and repetitive procedures backed by formal methodology. When evaluating securities, portfolio managers and analysts should first determine what ESG issues are material to a company’s business. Related risks and opportunities must be identified, assessed and incorporated in investment decisions. And when fundamental company analysts partner with subject matter ESG specialists, insights from their combined expertise can bolster high-conviction sustainable positions.
It’s also important to document research and engagement activity. In our Article 8 and 9 portfolios, we keep track of strategic and active engagement and voting, which aim to develop research insight and prompt action. We encourage management to make decisions with a long-term view that supports positive, sustainable financial outcomes for the company, its stakeholders and our clients. In 2021, AB portfolio teams conducted 1,566 ESG engagements with 1,091 companies on dozens of ESG topics from carbon emissions to employee health and safety to executive pay.
Technology also helps facilitate independent assessments. With ESIGHT, our research and collaboration tool, analysts can access ESG research notes, proprietary scoring and engagement information of other AB analysts and investment teams, as well as tap third-party data. PRISM, our fixed-income tool, records analysts’ ESG research and scoring, and syncs with ESIGHT. These systems provide quantitative evidence for assessing whether a portfolio meets Article 8 classification.
Article 9 portfolios should have “an objective of sustainable investments,” according to SFDR. But there are many ways to define and pursue sustainable investing objectives, and asset managers should clearly articulate how they meet Article 9 criteria. We believe investing in issuers that either contribute to achieving the UN Sustainable Development Goals or are aligned with the Paris Agreement are solid sustainable strategies. Portfolios with an explicitly sustainable agenda must also employ the same robust ESG integration approach as Article 8 portfolios to meet their goals.
For Article 8 and Article 9 portfolios across asset classes, we believe integrating ESG research into security selection processes is the key to success. Engagement with management must focus intensively on ESG issues. ESG integration, ESG scoring and engagement are at the heart of how we classify Articles 8 and 9 portfolios under SFDR. There are no shortcuts to creating ESG-focused portfolios that comply with regulation and investor expectations.
EU Sustainable Financial Disclosure Regulation (“SFDR”) Classifications made in accordance with and for the purposes of Regulation (EU) 2019/2088 and are not meant to provide exhaustive information on the suitability of the portfolio for a prospective investor’s investment needs.