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The Sustainability Story
Tamara Close, CFA: The Evolution of ESG Practices for Institutional Investors
00:30:10
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- [00:00]
Nicole Garrick
Foreign welcome to the Sustainability Story Podcast. This podcast explores critical sustainability issues and trends on a global scale. I'm Nicole Garrick, Director of Global Industry Standards at CFA Institute and one of the three co hosts for the Sustainability Story. I am excited to be joined by Tamara Close, Senior Director of ESG Advisory for the PETRA Funds Group for this month's episode. And in her role, Tamara advises fund managers and institutional investors. And prior to joining Petra, she founded Closed Group Consulting, a global boutique ESG strategy and due diligence advisory firm for financial and capital markets. And she has spent 10 years in senior leadership roles at PSP Investments as well as various front office investment management positions for global investment firms. Tamara is an experienced board director, investment committee member, and a strategic advisor for various firms and foundations. And she's been an invaluable member of our CFA Institute ESG Technical Committee for the last two years for which I've had the pleasure of working with her. So welcome Tamara and thank you so much for joining us today.
- [01:26]
Tamara Close
Thank you. It's great to be here. Thank you for having me.
- [01:30]
Nicole Garrick
So, Tamara, to start, can you tell us more about your sustainability story and how you really became interested in a field in sustainable finance?
- [01:41]
Tamara Close
Sure, yeah. Well, to be honest, I was kind of thrown into it. This was probably about 10 to 12 years ago when I was working at PSP Investments, so one of the large Canadian pensions here in Canada in the public markets investment group. And I was sort of the appointed person, let's say to liaise with the responsible investing team, which at that time was a team of one, because we were thinking of becoming a UNPRI signatory. So I was tasked to see what that would entail for the public markets group. And so I decided to, in order to do this, I should really understand a bit more what sustainable finance and ESG was. So I started researching this a bit. And you know, when you start looking at these issues, so environmental, social and additional governance issues, you realize rather quickly just how material these issues could be to the financial performance of a company or an investment. And so it became sort of a personal project, I would say. I read everything I could get my hands on. I did some academic work. I did sort of a sustainable investing certification. There were, there were not a lot of certifications out there at that time. Certainly this was Sustainable Investing Certificate from CFA did not exist at, at this point. But the more I researched, the more I believe that this could be sort of that next paradigm shift, if you will, in the market. And you know, if we look back, you Know, way, way back right in, in the 80s. So before the crash of 87, no one was talking about market risk. It was just, you know, there was no risk adjusted returns. It was just what is the return on, on a portfolio or a fund. And then we had that crash of 87 and suddenly the 90s began, became about all about market risk and value at risk and coming up with that methodology to be able to, to really measure market risk of a fund and risk adjusted returns. And then sort of 20 years later we had the financial crisis. And previous to that we were speaking about credit risk, but we're very dependent on credit rating agencies. And then the 2008, 2009 financial crisis happened and then after that the next decade was really all about credit risk and building these huge credit risk teams. Teams. And so at this point I was thinking, well, EST or sustainability could perhaps be that next paradigm shift and we'd see this massive repricing due to climate change risk. And you know, in some ways there has been a significant shift in the market. Certainly we're going to talk about that today. We haven't necessarily seen that, that massive repricing yet. So anyways, I thought wouldn't it be amazing to work in ESG and sustainable finance and saw a real opportunity at that point to work with investment funds and institutional investors just as, as this was taking off.
- [04:38]
Nicole Garrick
Great. Well thank you so much for providing us some of your insights into the changes that you saw. Like you said, the paradigm shifts in how sustainability has grown and will be very important in managing risks and risk adjusted returns for different investment professionals. So I know you have many years experience advising institutional investors. Can you provide our audience with some information on how institutional investors treat ESG issues? Do they consider them a risk management tool or a value creation opportunity or kind of a mix of both? And how has the way that they treat ESG issues evolved over this past decade?
- [05:26]
Tamara Close
Yeah, absolutely. So when we look at the institutional investors, there obviously you know, differences between the various types of investors so, you know, including size and stakeholders and their particular liability structure or investment requirements that they need to manage against. But one thing that they have in common is that they tend to be longer term investors. So it's been really interesting to see how the institutional investors have evolved over the last decade or so when it comes to, yes, your sustainability and how this has shifted the way they look at both risk management and value creation. So if we go back a few years now, sort of 10 years ago, 2015, 2016, I would say it was really about responsible investments. We saw that a lot from, from the investor side and being good stewards of their capital with big focus, I would say here on proxy voting and engagement with companies and exclusions, which was mainly focused, I would say on public markets. But then as internal teams grew and more data became available, the institutional investors were starting to look forward, you know, 10 plus years down the road and started to realize more and more just how exposed they really were to some of these ESG issues and that many of these issues were or could become systemic risk factors for their portfolios. So here is really what I believe we moved into the ESG integration phase. So this is probably around 2019 and here in, you know, this was when institutional investors were really want to understand how these issues were being integrated into investment decisions. And this was much broader than just public markets. All the private markets and alternative asset classes were, were also impacted. And during this time it was interesting because in parallel there was also a shift by institutional investors, especially on the pension side, to what was called a total fund or total portfolio approach, which meant that investors were looking at risks and exposures not on an asset class, by asset class basis, but at the top of the fund. So really taking all those granular risks and aggregating them up to the top of the fund. And so this was blurring the lines, if you will, between asset classes and investment strategies and really evolving from a traditional coin quantitative only risk measurement and management framework to one that is going longer and wider and even softer if you will, to be able to accommodate a lot of qualitative elements such as ESG factors that were not necessarily being assessed previously. So at that point we really saw fund level risk teams, you know, sometimes sitting under the CIO or chief investment office and getting more involved in ESG or sustainability and things like scenario analysis being used much more frequently to ascertain what the main risk factors for the fund were. And more recently I would say we've moved into, into a new phase where it's about future proofing the funds and really creating that real world impact. So going further on, on the risk management side now looking at sort of that second derivative of those risks and understanding how these issues are interrelated such as climate and nature, and most importantly how they will impact financial valuations and then making capital allocations based on this information. And it's also about creating that impact in the real economy. So especially in private markets where investors can have much more influence, today we're seeing institutional investors carve out allocations specifically for things like climate solutions, whether these are mitigation or adaptation and sustainable opportunities and things like that. So I would say, you know, ESGsUS have really moved from more of a back office activity to that middle office risk activity and now to the front office. And so institutional investors, they, they started out focusing on, on being good stewards of capital. They're now really ensuring that they're future proofing that capital.
- [09:57]
Nicole Garrick
Yeah, I would definitely agree with what you described as really the evolution as to how esg as you mentioned, is more of a back office where you, you'd look at it from rulemaking into the portfolios of exclusion rules into more integrating it throughout the, the investment process and analysis and then now looking at it as value creation opportunities too, as you mentioned, with really creating real world changes and impact to different companies that you're investing in. And I think with that comes a lot more sophistication, a lot more expertise needed in solving and mitigating some of these systemic ESG risks as well as understanding the business models of the companies that you're investing in to really be able to bring about those changes that you talked about.
- [10:47]
Tamara Close
Right.
- [10:47]
Nicole Garrick
So I think that's something that's needed in a lot of these firms to be able to evolve in their approach to ESG to again do more of a total portfolio approach. And where you're looking at ESG across your risk management.
- [11:02]
Tamara Close
Yes, absolutely, absolutely.
- [11:05]
Nicole Garrick
So do you find that these differences in how ESG are considered are regional? Is there any differences in how institutions, institutional investors consider ESG information? And how are different regulations like the Sustainable Finance Disclosure regulation or SFDR in the EU and the sustainability disclosure requirements or the SDR in the uk, changing institutional ESG investing practices? And are regulatory developments helping or you think complicating the ESG investment landscape?
- [11:38]
Tamara Close
Yeah, no, that's a great question. There have definitely been big changes in terms of regional differences between institutions, institutional investors, even from a few years ago. I would say today, if you're a fund manager in the US and you're looking to raise capital from an institutional investor, you can probably still find a decent base of small to mid investors in the US that are not asking for that much information on sustainability really given what today's political situation is. But if you go outside of the us, either to the north, to Canada or to the EU or the UK or to the PAC region, the ESG requirements are very different. And you know, you may find yourself facing sort of a hundred line item ESG DDQ from a large institutional investor and some of this is due to regulatory requirements, especially in the UK or in the eu, where the regulators historically have really been pushing the sustainability agenda and where the institutional investors are also much more heavily regulated than say, say in Canada. But in regions where there are less regulations because the larger institutional investors are increasingly aware of the risk they face in their portfolios. For, you know, a few of the reasons that you just mentioned, Nicole, and reasons we've discussed, these investors are increasingly asking for just as much sustainability information and you can even sort of say that they're acting almost like de facto regulators if, if you will. So, you know, yes, definitely, having regulations in place is certainly helpful to move the market forward. It brings compliance departments into the mix, it opens up operating and strategic capital for sustainability initiatives. But a lack of regulations does not change how the institutional investors, especially the larger ones, are viewing sustainability risks and opportunities and hence the way they are managing their funds and allocating their capital.
- [13:46]
Nicole Garrick
Yeah, I know in like the uk where funds are looking to be labeled under the SCR labeling regime, there is definitely complexities involved in doing so. And I think I've been reading some articles that there, some managers have chosen not to choose not to take on any of the labels given the complexities and such a high bar in requirements. But then there's also requirements in those that aren't labeled as well, which I think is helpful in the marketplace to mitigate greenwashing and just provide more transparency on how these managers are considering ESG in their investment process and make sure that they are doing what they say they're doing in their marketing communications to investors. And as you mentioned, definitely in the US I think in other areas in North America where there isn't really that regulator requiring certain disclosures, it's going to be up to the institutional investors really to ask the right questions to investor in to the asset managers so that they can determine which products meet their needs and values. So taking a step back, looking more broadly across the different markets, how do investors in public markets and investors in private markets differ in their approach to ESG information?
- [15:14]
Tamara Close
So you know, when you, when you look at an industry or a company and you're identifying the most material ESG factors, so those issues that do or can impact a company's financial performance, these are generally the same whether it's a publicly listed or privately held company. And this is because ESG issues tend to be like you mentioned earlier, Nicole, these are business models, specific issues. So however, when, when you look at public markets versus private markets, as an investor, the influence you have and the levers you have to pull are different. And even within public and private markets, the influence you have will also differ depending on where you sit in sort of that capital stack, if you will, within a company. So for instance, if you're an equity investor versus fixed income, and then on the private side, if you're a private equity investor versus a private credit investor, you will have a different level of influence as that investor. So if we look at public markets, people will say that ESG integration has been around for much longer. One of the reasons for this is that there has been ESG data available for much longer, so both from companies, but also from data providers. So this has made it easier to assess sustainability characteristics of a public markets portfolio and also made it easier to benchmark a company or portfolio. And you know, I won't go into the pros and cons of ESG data and scores and ratings. I think we could spend a whole podcast on, on that issue alone. But on the, on the private market side, managers probably slower to start looking at sustainability esg, but I would say that they have leapfrogged ahead of public markets managers now in the depth and breadth of analysis that they are doing. I'm generalizing, of course, but this is probably because they have not historically been able to rely on third party ESG scores, but have had to do that analysis themselves. So I would say today that from the institutional investors point of view, because of the different levels of influence over companies and the inherent differences of public and private markets, such as things like liquidity, I would say that public markets has almost become more of a risk management play. You know, so there's a lot of data out there. And because the markets are more liquid, you can really dynamically manage what you want to be exposed to and what you do not want to be exposed to. Whereas on the private market side, it's become really a place where institutional investors can really create impact. So, you know, for example, many, many public equity managers will engage with their underlying investing companies, but being able to prove that they've actually had an actual impact on changes to the behavior of the company is very difficult to do versus being an equity investor in a private company where you may even have a board seat and are therefore able to influence the strategic and operational decisions of that, of that company's management. And you know, even on the, on the private credit side, when you're lending to a company as opposed to being private equity investor, you can still have a significant impact on that company's operations through Things like sustainability link loans. So definitely differences between public markets and private markets. And I, I believe we are going to see public markets as more of a risk management play just given the structure of the markets and private markets as more of an impact play when it comes to sustainability.
- [19:01]
Nicole Garrick
Great. Thank you so much for those insights and differences between the two markets. And I know we have been discussing impact investing in public or illicit equities as well in a paper that CFA Institute is working on. And as you mentioned, it is extremely challenging to really be able to develop and find a way to create a real world impact in a public market given the liquidity given. Like you mentioned, you're very small shareholder and there's many other shareholders that could have different opinions and views on what the company should be doing. And you really have to make that link to how the change you want the company to create is going to be a win win solution where it's going to be an improvement that can benefit the long term value for shareholders in the company as well as be something that could bring about real world changes and help people and plan it. So there is challenges to doing that and it's much easier in the private market like you mentioned, where you can have much greater say with management. You can take on board seats. So there's definitely more opportunities to create that impact. So given what we just discussed, what should managers expect when it comes to the requirements that they're looking for from institutional investors?
- [20:28]
Tamara Close
Well, first of all, definitely more data because a lot of the institutional investors are looking at ESG and sustainability across their funds and aggregating this up really from the most granular level to the top of the house. So managers should expect to get requests for more data, granular data, company or investment based data. Also requests for data on specific ES and NG issues, including classic ones like we've seen carbon emissions and water use, but also things like supply chains, biodiversity and nature related risks. Secondly, I would say probably expect to get questions on what you as a manager are doing with the data, so collecting the data, but then what are you doing with that data? So it's no longer just ESG disclosures that investors want, but an understanding on what you are doing about those ESG exposures that you have at the fund level and both on the risk management and opportunity side. And I would say here investors who probably will not be satisfied with sort of high level general statements on processes like we will engage with our portfolio companies, but these will need to be much more evidence based and outcomes based. So we really need to be able to show, to show what you're doing. So I would say more data, expect more data, expect to provide more transparency and expect to provide more evidence and outcomes.
- [22:07]
Nicole Garrick
Great. Yeah, I definitely see this change happening where, again, like you mentioned, it's going to be more outcomes related. Looking for evidence that companies, that asset managers are really integrating this information and if they are looking to create world outcomes, that they can provide case studies of examples of how they're doing that or specific examples of how they're engaging with companies on some of the ESG risks that they see in their portfolio. And I do see that this, you know, this transparency, needing to provide that information to institutional investors. And I think also with some of the volunteer frameworks out there, like the UK stewardship code that many asset managers are part of, you see this need for transparency and further information and outcome focus and not just looking at check the box exercise. Right. Where it's more of, yes, this is our policy and this is what we do. It's more of now evidence of what are the outcomes for that and provide us specific case studies and examples of how you're doing that. And I think also we see that with due diligence questionnaires that you mentioned, many institutional investors have detailed due diligence questionnaires where they're asking a whole section of questions on many of these topics as well.
- [23:28]
Tamara Close
Yeah, absolutely. Good points.
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Nicole Garrick
So what are the key questions institutional investors should ask asset managers regarding managing ESG risk and opportunities, and how should managers answer these types of questions?
- [23:45]
Tamara Close
So, you know, I've seen many different combinations and permutations, if you will, of ESG questionnaires to fund managers. And it is true that it's a real challenge for institutional investors to understand how a manager is integrating esg, because there is such a broad spectrum of maturity when it comes to ESG integration practices. However, if you had to sort of filter it down into those key questions, I think there are really three key questions that can help ascertain a manager's practices. And these are, you know, first of all, what are the top yes to risk or exposures of the fund? And then how did you identify them and what are you doing about them? So if we go back to the first question, what are the top ESG risks or exposures of the fund here? A manager that is maybe more sophisticated when it comes to ESG integration will be able to answer this with very specific ESG issues and they'll be able to name the specific issues and sub issues and even attribute them to the different geographies or industries within, within the fund. So for instance, you know, they could say maybe there's a high risk of exposure to sea level rise within the fund's exposure to the manufacturing sector for certain companies with physical assets situated along the eastern seaboard, for instance, versus maybe a less sophisticated manager, which may just say climate change, right. As one of their exposures or risk. And then the second question really stems from the first, which would be how did you identify them? So here you want to see that managers are focusing on materiality and more specifically that business model materiality from a stakeholder perspective. So, I mean, there's lots of standards and frameworks out there that talk about material ESG issues. You would certainly want the managers to have looked at those, the ones that are relevant, and then to have filtered it down to the most material ESG issues for the business model model of a given company or investment. And you would want the manager to have looked at issues both from a financial materiality and double materiality perspective, as well as that broader stakeholder perspective. So then the third question is, you know, you, you know what the top risks are, you know how they've been identified, then what are you doing about them? So here again, you know, the manager should be able to explain, explain how they're mitigating any ESG risks, right? If possible, whether these are systemic or idiosyncratic risks as well like this, explain how they're leveraging any opportunities with the ESG exposures in the fund. So here you'd want to see, you know, detailed metrics and key performance indicators or KPIs and key risk indicators or KRIs that are being measured and tracked over the life of the fund with targets and goals and reporting to the progress on those goals. So three key questions that are quite short but can be sufficient to allow an investor to understand the level of maturity of a manager's ESG integration practices.
- [27:03]
Nicole Garrick
Those are great questions, and as you mentioned, they are simple yet effective for institutional investors to ascertain whether asset managers are considering systemic and financial material issue risk, how they determined they were material, and how they are leveraging investment opportunities to achieve environmental social outcomes while mitigating those risks as well. We're almost out of time, but I'd love to hear your opinion on how the industry will evolve in the next five to 10 years and what should institutional investors and managers expect?
- [27:40]
Tamara Close
Sure, I mean, you know, if we all had a crystal ball. But I think, you know, a lot of people have, have been talking about this hype cycle of esg. And we're definitely coming down from the peak of the ESG hype, which was probably around 2021, 2022, where everyone was making commitments and pledges and putting out these glossy 100 page ESG reports. We're now, you know, moved into that tough but necessary stage of real implementation. So embedding sustainability into business and investment strategy in a way that is structured and measurable and impactful. And I would say that the next few years will be about the maturity of ESG or sustainability. So moving from ESG hype to ESG maturity, where hopefully we'll see less noise and more action. And I think that the large institutional investors will continue to lead the way in terms of sustainability risk methodologies and tying ESG or sustainability to financial impacts. And then this will help to move the industry to a full financial integration of ESG factors. So, you know, from ESG hype to where we are today, which is really ESG maturity, and then, you know, in five plus years, we'll see that full financial integration of esg.
- [29:02]
Nicole Garrick
Tamara, it's been a pleasure speaking with you. I want to thank you again for all your insights you shared with us regarding your expertise piece in advising fund managers and institutional investors. We've learned how institutional investors approach ESG issues, the differences in their approach to private and as well as reasonable differences in regulations. It's been interesting to learn what managers should expect from institutional investors and what institutional investors should be asking their managers as it relates to ESG risk management. And as you mentioned, although it would be nice to have a crystal ball, we can expect the market to continue to evolve from ESG hype to more of an implementation focus as the market matures and we look to achieve full financial integration of ESG information. So, Tamara, thank you again for speaking with us today.
- [29:59]
Tamara Close
Thank you so much, Nicole. It is a true pleasure being here.