The ever expanding body of ESG-related legislation and public policies is starting to drive asset allocation decisions of institutional investors, new research shows.
After a raft of new sustainability and climate change-related regulations following the coronavirus pandemic of 2020, environmental, social and governance (ESG) factors have started to impact asset allocation decisions of institutional investors, according to new research by CREATE-Research.
Although investors expected all asset classes to be affected from the new measures over the next five years, they expected bonds to benefit most from a reallocation of capital, especially use-of-proceed, green and transition bonds.
The Passive Investing 2024 report: “Are ESG regulatory and policy measures driving asset allocation?”, showed that 62 per cent of respondents expected bonds in public markets to benefit from the new regulations over the next five years.
The distance-to-default, a market-based measure of corporate default risk, is believed to be negatively associated with a company’s carbon intensity. Those with a large carbon footprint are now perceived by the market as being more likely to default, all other things being equal
“Many pension plans are reaching the stage when replacing a part of their sovereign bond portfolio with these three types of bonds is a logical step,” the authors of the report said.
Carbon intensity is also increasingly used as a measure of default risk in bonds, the authors argued, and this could see further changes to their allocation decisions.
“The distance-to-default, a market-based measure of corporate default risk, is believed to be negatively associated with a company’s carbon intensity. Those with a large carbon footprint are now perceived by the market as being more likely to default, all other things being equal,” they said.
The survey involved 156 pension plans in 13 pension markets globally. Their combined assets under management were A$3 trillion. The survey also included the results from 30 structured interviews with senior executives from the respondent organisations.
Respondents to the survey expected that developed market assets will benefit more from the new regulations than developing market assets, largely because companies in developed markets have embraced ESG investing earlier than developing market businesses.
Most developing economies have been focused on economic growth to improve living standards.
“Industries at the core of this economic catch-up – cement, steel, chemicals – are also super GHG (greenhouse gas) emitters. With break-neck economic growth over the past 30 years, China is now the biggest GHG emitter,” the authors said.
A Regulation Watershed
Although the rapid growth in global responsible investment policies took off some 25 years ago, the coronavirus pandemic of 2020 has become a clear catalyst for many ESG-related regulations and policies to be implemented across the world.
According to data from the Principles of Responsible Investments, 2020 saw a 74 per cent increase on 2019 in rules on ESG data disclosure, and an increase of over 100 per cent in ESG integration.
A key piece of post-pandemic legislation was the US Inflation Reduction Act 2022, which contains more than A$520 billion worth of programs and funding to accelerate the transition to net zero in the US. Expectations are that this won’t affect just the US, but also many other economies around the world.
In Europe, the Green Deal Industrial Plan aims to create a more supportive environment for the European Union’s manufacturing capacity for the net-zero technologies and products, thereby protecting the sector from competitors, mainly in the US and China.
Furthermore, the Corporate Sustainability Reporting Directive came into force in Europe on 5 January 2023. The directive modernises and strengthens the rules for social and environmental reporting by a broader set of large companies, while listed small and medium-sized enterprises will now be required to report on sustainability too.
In the wake of the new measures, ESG is now seen as the biggest driver of change in the ecosystem of capital markets, far surpassing other structural drivers
“The 2020 COVID pandemic was a watershed. It accelerated the regulatory and policy tempo, putting it into overdrive in key economies,” the authors said.
“In the wake of the new measures, ESG is now seen as the biggest driver of change in the ecosystem of capital markets, far surpassing other structural drivers,” they said.
The report also speculates that the increased regulatory scrutiny and reporting duties could drive better price discovery of ESG risks and opportunities.
“Governments are introducing ambitious ESG policy measures that signal clear incentives and sanctions for pricing in ESG risks and elevate ESG as a compensated risk factor, while also supporting communities that are unduly hit in the process,” they said.
“As a result of these measures, ESG factors are finally likely to become part of strategic asset allocation. The process has been very gradual, however, since more time series-based evidence is needed than is currently available to show that ESG is indeed a compensated risk factor,” the authors said.
But there is also pushback on the rapidly increasing body of ESG regulations. In the US, critics of ESG-focused investment policies have lambasted the idea of restricting investing in carbon-intensive businesses.
One particularly high-profile case saw the State of Texas implementing a blacklist with names of asset managers that had divested from coal-generated power plants.
The US state, which is the largest producer of oil and gas in the country, passed a bill in 2021 that prohibits state institutions from investing with financial organisations that are perceived to ‘boycott’ energy companies.
“The recent back-sliding on activist shareholder proposals by large US asset managers due to the recent political backlash is a matter of grave concern, as is the growing number of large US asset managers pulling back from the prominent advocacy group Climate Action 100+ in the face of spurious campaigns against ‘woke capitalism’,” the authors said.
Although investors indicated concern over these developments, they didn’t think the world would return to a pre-pandemic state in its attitude towards climate change.
“They expect reason to prevail before long,” the authors said.
The Passive Investing 2024 report: Are ESG regulatory and policy measures driving asset allocation? is available for download here.
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