A growing body of evidence suggests a gaping disconnect between what ESG investors expect and what some ESG funds are actually investing in. For asset managers, this poses significant reputational risk that can feature angry investors, lost credibility, regulatory scrutiny, and a spectrum of political, media and social media attacks.
Consider these recent events: Bloomberg BusinessWeek reports that criteria used by MCSI for rating companies’ ESG activities, which are used by State Street and others to market ESG investment funds, “flips the very notion of sustainable investing on its head,” by evaluating not what those companies are doing to improve the environment, but what impact external environmental factors are likely to have corporate earnings. The term “water stress,” for example, “measures whether the local community has enough water for the company, not whether the company is stressing the local water supply.”
Institutional investors sense something is amiss. BlackRock’s survey of 425 of them found that poor quality or availability of ESG data and analytics represents the biggest obstacle to sustainable investing. More explicitly, a former BlackRock executive called sustainable investing a “dangerous placebo that harms the public interest.”
Along the same lines, a whistleblower alleged that Deutsche Bank’s asset management arm, DWS, which had claimed that more than half of its $900 billion in assets were invested based on ESG criteria, had greatly exaggerated. The Department of Justice is investigating, with the crisis recently reaching upward to the parent bank.
What impact do such disclosures — shattering the expectations of investors as well as regulators — have on the reputations and future value of asset managers?
How are institutional investors that are in the public eye, such as public pension funds, going to react when it becomes clear that they’ve invested in ESG funds that aren’t what they expected?
These are not isolated events. It’s rare that more than a few days go by without seeing more revelations about haphazard, conflicting or meaningless standards for rating companies’ commitment to ESG. Politicians, regulators, the public and investors are realizing that the packaging of some of these funds may not be true to the contents. The SEC has made it very clear that it intends to standardize and regulate ESG reporting, but that will likely allow for safe harbor language that provides some leeway for companies that don’t perform as expected. Murky is not necessarily good for money management.
Clearly, it is time for some serious reputation risk management. So how can asset managers reassure investors of the reliability of their funds’ criteria and mitigate their own reputation risk with a simple, clear and compelling narrative? With robust and actuarially sound ESG insurance products now available for the funds’ portfolio companies, asset managers actually have the ability to position their funds as being invested primarily in companies that, within a reasonable period of time, either have ESG insurance in place, or have gone through the underwriting process and demonstrated eligibility for ESG insurance.
A credible insurer, with a voluminous track record of data that validates its underwriting process, can be their proxy — authenticating the validity of the controls employed by the portfolio companies of the funds.
Underwriting this type of coverage, which would pay out on behalf of the board or individual directors in in the context of ESG issues, would involve outside vetting of companies’ reputation risk governance, leadership and controls. It would review the corporate intelligence gathering process, whether it was enterprisewide and cut across silos, understanding stakeholder expectations, managing the risk of disappointment, and filtering material information up to the board of directors.
Public company investors are accustomed to relying on validation by financial instruments from trusted third parties — whether it’s credit wraps or monoline insurers backing financial instruments or the FDIC insuring the security of depositors’ money in banks — but ESG raters have proven themselves to be inconsistent, potentially unreliable and unambiguously risky to asset managers.
There’s another precedent. Today, directors and officers liability insurance is oxygen to a board. Forty years ago, however, it was a badge of honor, for only the most well-governed companies could acquire coverage. ESG insurance could have the same effect.
The benefits of using ESG insurance as a selection criterion for portfolio companies are twofold. First, as more investors realize that ESG ratings are like the Wild West, they are going to demand explanations from asset managers about the substance behind those ratings. Third-party money-backed authentication makes the answer to those questions much simpler.
It also provides reputational protection for asset managers because it eliminates any gap between investor expectations and reality. If 70% of a fund is invested in companies that either have or are eligible for ESG insurance, that’s a clear and demonstrable data point. Investors in that fund will know what they’re getting, and it will be easy to recognize any changes that occur over time.
Not unlike the energy in markets for ecommerce in the dotcom era, apps at the dawn of the mobile era, and blockchain-enabled solutions in recent times, the market for reputation and ESG solutions is bubbling with fevered demand. Investors are looking for reliable ways of sorting through the haze and gaining reliable, understandable information that enables them to focus their asset allocation decisions. Insurance can play an important role in defining and differentiating companies that deserve to benefit and ESG fund asset managers who can accurately identify them.
Nir Kossovsky is CEO of Steel City Re, which provides of parametric reputation risk insurances and advisory services using a risk management framework informed by behavioral economics. Denise Williamee is Steel City Re’s vice president of corporate services. Peter J. Gerken is senior vice president for risk transfer agency and insurance, and a co-founder of Steel City Re.