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Environmental, Social and Governance Investing: Trends and Considerations Spotlight on Money Market Funds

Sabrina HartzogGlobal Product Manager, Liquidity Management Services, Treasury and Trade Solutions, Citi

Climate change, sustainability, diversity and inclusion: These topics continue to be focal points for environmentally and socially conscious companies and, increasingly, the individuals within them who drive investment policies and decisions. This article provides a look at factors institutional investors may want to consider when incorporating environmental, social and governance (ESG) strategies into their money market fund portfolios.

Despite the current buzz around sustainable investing, it’s hardly a new idea. Today’s schema of sustainable investing, also known as “impact” investing, can be traced to the rise of social activism in the sixties and seventies, an era of history-making events that included the passage of landmark civil rights and environmental laws in the U.S. and the first appearance of a social-responsibility issue on a company’s proxy statement.1

Despite a steady rise in corporate commitments to social responsibility over the years, sustainable investing itself has only recently gained traction, having ballooned by more than a third since 2017 to represent some $30 trillion, or more than a quarter of the world’s professionally managed assets.2

This fast-growing niche of the money market fund industry offers an array of investment opportunities and considerations for companies looking to advance their sustainability agendas. It has taken shape around a relatively new set of evaluation metrics with ESG components. Fund providers might, for instance, analyze underlying securities against environmental factors, such as a firm’s carbon footprint or pollution-related criteria. Social considerations could include activities related to human rights or an ethical culture, while governance criteria might include factors such as minority ownership or board composition.

1 Source: https://www.thebalance.com/a-short-history-of-socially-responsible-investing-30255782 Source: https://corpgov.law.harvard.edu/2020/01/13/into-the-mainstream-esg-at-the-tipping-point/

Sustainable investing can pay offImpact investing, once perceived as a semi-philanthropic or altruistic move, is increasingly driven by fiduciary duty.

In some cases, sustainable investing aligns directly with a company’s core business or aids in the management of its supply chains. Impact investing also can help boost stakeholder perceptions or contribute to an organization’s commitment to, say, shaping a sustainable economy. While in other cases, the key force behind ESG investing may be a perceived risk to ignoring ESG impacts.

Bottom line, sustainable investing carries with it a responsibility to weigh traditional investments risks and returns along with ESG factors. That said, research by Federated’s Hermes Investment Management3 found that companies with good or improving ESG characteristics have on average outperformed companies with negative characteristics. “This is being driven by the strength of their corporate governance and, for the first time since our investigation began in 2014, social metrics,” said Geir Lode, Hermes’ head of global equities. In a separate report,4 Hermes concluded that even in a short-term environment like money market funds, the considerations of long-term, material ESG factors can help mitigate risk.

Varying MMF approaches While most money market fund providers use similar types of ESG factors to evaluate potential investments, they do not all use the same strategy to incorporate ESG principles into their offerings. This can create challenges for institutional investors who may be looking for more of an “apples to apples” comparison across funds.

Some funds use an exclusionary approach, which precludes holding securities in a particular industry, such as tobacco manufacturing or oil and gas, for instance. Others take a sensitivity approach where rather than strictly excluding a certain sector they would give preference to higher-scoring securities

3 Source: https://www.hermes-investment.com/wp-content/uploads/2018/10/hermes-esg-investing.pdf4 “ESG in Money Markets: Long-Term Perspectives in a Short-Term World”, Federated Investments Hermes Investment Management, July 2019

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within that sector. Funds using this approach would not necessarily exclude a security in the oil and gas industry; instead, they would prioritize oil and gas issuers that have a strong track record in renewable energy R&D or other ESG-related criteria, for instance. Some funds also deploy an inclusion approach whereby they seek to include women-, minority- and veteran-owned broker dealers among their trading partners.

Regardless of the approach that is taken, when it comes to evaluating a company’s ESG performance, there are no standard rules or reporting guidelines for constructing a quantitative assessment of a company’s ESG metrics, despite general alignment around a set of qualitative ESG factors.

In addition, although the industry has seen a surge in ESG data providers, there is no leading data provider. Top funds use a mix of in-house and third-party data sources to conduct comprehensive credit reviews and to assess an issuer’s ESG profile, applying their own individual research and credit evaluation methodologies. As a result, overall ratings for an issuer can vary across providers. As Peter Crane, President of Crane Data, explains “The space still lacks a clear definition, and it’s a tough sell saying a fund is ‘ESG’ if it invests in the same list of multinational banks as every other MMF.”

Absence of standardsIn response to increased demand for ESG options, financial providers and regulators alike have been laying the groundwork for a unified classification system and standardized taxonomy that will further strengthen the industry and respond to investors’ demands for a conclusive methodology to assess ESG components.

One such effort is the UN-supported Principles of Responsible Investment (PRI). Launched in 2006, PRI provides a voluntary framework on ESG issues that can ultimately aid investors’ decision-making. More than 2,500 organizations, with approximately $80 trillion in assets under management, are signatories to PRI.5

The Sustainability Accounting Standards Board (SASB), which was founded in 2011, represents another standardization effort. Its purpose is to establish industry-specific disclosure standards about financially material information across ESG topics. More than 100 corporations, over one-third of which are based outside the U.S., have reported with SASB since late 2017.

More recently, regulators have boosted their efforts around disclosure and reporting. The European Union in December outlined a comprehensive set of green-financing rules that will define the regulatory framework for sustainable investments and other financial products. And in the U.S., the SEC is also moving toward mandated standardized reporting and inclusion of ESG disclosures in public company filings.

5 Source: Signatory Relationship Presentation Q42019 (Slide 2: 2, signatories; Slide 7: $89 trillion assets under management): https://www.unpri.org/signatories/quarterly-signatory-update; https://www.unpri.org/

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The path forwardThe appetite for sustainable investing is real and growing among individuals and businesses alike, with ESG providing a concrete path forward. “At Citi, our mission is to enhance our client’s lives through innovation, our global network and world class products. Partnering with our clients on their ESG goals is core not just to this mission, but also to our role as a bank that conducts business in a responsible manner,“ said Czeslaw Piasek, EMEA Head of Liquidity Management Services.

Companies looking to incorporate ESG principles into their investment strategies and MMF portfolios should keep in mind a number of factors that will help maximize the benefits of a sustainable investing strategy:

• Are the company’s ESG investment strategies aligned with its overall ESG mandate?

• What is the fund provider’s strategy for managing the ESG fund? And how does that strategy compare to the company’s goals?

• What portion of the company’s portfolio should be held in ESG investments?

• What percentage of investments should represent various ESG-related factors or should be represented by investments with a social versus an environmental focus, for example?

As with investing in any MMF, studying a fund’s prospectus and other related materials prior to investing can help determine if the fund’s objectives, risks and other characteristics align with the investor’s strategy and objectives.

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In response to increased demand for ESG options, financial providers and regulators alike have been laying the groundwork for a unified classification system and standardized taxonomy that will further strengthen the industry and respond to investors’ demands for a conclusive methodology to assess ESG components.