Effective environmental, social, and governance (ESG) investing requires a balance between pursuing the mission and achieving the required returns. That means making decisions that are part art, part science.
Strong ESG performance during the pandemic led to trillions of dollars in inflows. That buoyed the underlying philosophy and the universe of ESG-labeled products and has led to previously unthinkable predictions of $30 trillion in ESG assets by 2030. Already, statistical barriers are being broken. In 2021, for instance, banks for the first time reportedly made more money from green energy bond issuance and lending than from traditional fossil fuels-linked debt.
Yet as the spotlight has intensified, the ESG conversation has shifted to more existential issues — including whether there is an “ESG mirage.” Some skeptics have begun to ask “whither ESG?” But proponents maintain that ESG benchmarks, products, and strategies must be viewed in the context of broader investment objectives and market constraints. Shades of gray are inevitable, they claim, and are not cover for mere greenwashing.
These debates are important, but for many, the ESG horse has already left the barn. Today, the task is to determine how to engage and reanimate ESG’s original spirit and impetus as a vehicle for the stewardship and transformation of investment portfolios. So, what approaches actually work?
For those seeking wisdom instead of noise, it’s worth exploring what some of the world’s least talkative but most sophisticated investors — insurers — are saying and doing around ESG.
Insurance companies take a strategic, long-horizon approach to their investment decisions, a perspective that also characterizes some of the best ESG programs. Insurers have dealt with analysis and underwriting across the components of ESG for decades, even centuries. They assess exposure to natural disasters and to social and political transitions as well as the continuity and composition of company leadership. Insurers in Europe and Asia have already made significant progress in transferring these considerations from actuarial risk analysis to their balance sheets. As spring 2022 commences, more and more US-based insurers are following their lead.
New Tools, New Thinking
Earlier this year, Conning released its survey of nearly 300 insurance company decision makers in the United States to understand how they are engaging with ESG investing principles. While a vast majority do engage with these principles, 41% only began implementing their ESG programs in the last year. As a result, insurers need new tools to measure impact and new, longer lenses through which to view the associated risks and opportunities. They want to incorporate ESG through strategic asset allocation, investment guidelines, and risk management practices — the same principles and methods that also support and inform traditional investment objectives and performance.
This careful calibration is one reason commoditized ESG solutions pose a problem and why taking a bespoke approach matters. Consider the asset classes that often compose insurers’ portfolios. Combining ESG considerations, particularly quantifying downside risk with the search for yield and the need for sufficient liquidity, remains a significant challenge. Consequently, many survey participants highlighted implementation costs and preparation for future standards and initiatives as crucial concerns. Indeed, respondents ranked them higher in importance than ESG’s potential effect on overall performance.
This dynamic plays out when ESG integration is developed in a multi-asset context. New ESG-linked bonds and other fixed-income instruments provide an interesting opportunity but demand closer examination of their underlying purpose and mechanics. In energy, for example, investors may prefer a tilt based on their conviction and philosophy about specific ESG elements. That may mean balancing priorities like economic development and climate change differently. This can bring specific ESG elements into conflict. Intentionality requires tailored asset selection, rather than simple screening, to achieve the right balance.
Like most investment factors, ESG principles also need to be dynamic and responsive to the shifting landscape. Our survey found that corporate reputation — not regulatory compliance — is the leading motivator behind insurance firms’ engagement with ESG. This may come as a surprise amid new rules on ESG wrappers and reporting. But financial and insurance regulation in the United States tends to focus on the financial risks associated with climate change rather than the broader social and governance aspects of ESG investments. These are often outside the regulatory scope. This distinction may help explain why regulation isn’t the top concern.
US insurers have long embraced a market-driven approach. Their ESG mindset is focused on opportunity and participation. Smaller firms may see the potential to take on influential roles, while more established players may struggle to keep pace. Conning’s survey shows this dynamic at work. The rising importance of data standardization and industry-agreed goals, such as the Task Force on Climate-Related Financial Disclosures (TCFD), has created new incentives to commit to ESG principles.
Just as crucial, for insurers and all companies, is the lived experience of their teams and key audiences and the relationship between that stakeholder experience and how they invest in ESG. It is no coincidence that social impact investing took on greater prominence in 2021. Insurers realize that for ESG programs to be authentic, they must be empathetic and responsive — feeding emerging priorities back into investment programs. As new tools and solutions are developed, programs must be flexible enough to incorporate them expeditiously.
Novel No Longer
Last year was a pivotal one for ESG, and as capital continues to flow into ESG assets in 2022, investors of all stripes can learn from the perspective and experience of insurance companies. Amid record growth and increasing ESG stock picking and greenwashing callouts, we should remember that the best ESG applications take a long, strategic view: They are methodical in their engagement, nimble in their decision making, open in their outlook and deployment, and transparent in their construction.
Change is hard, and the effective integration of ESG principles into the investment process will take ongoing effort and persistence. New models and data, better products and partners, and yes, even a bit of healthy skepticism — all play a vital part in sustaining progress as this journey evolves and endures.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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