Financial services risk and regulation unravelled podcast

Episode 2: ESG – No way back

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Participants:

  • Edward Dixon, Head of ESG, Aviva Investors Real Assets
  • Paul Young, Managing Director, Head of Finance, Risk and Compliance
  • Irina Velkova, Associate Director,  Financial Services Group, Grant Thornton

Irina Velkova:

Hello and welcome to the second episode of Risk and Regulation Unravelled, our Grant Thornton's Financial Services podcast. I'm Irina Velkova, your regular host, and I bring to you conversations about the dynamic world of risk and regulations. We help our Financial Services clients understand new regulatory developments, upcoming changes and how to stay ahead of the regulatory curve by inviting renowned experts to share their insights.

Many of you would have already heard the notion that one of the few silver linings of the COVID-19 pandemic has been the increased focus on sustainability. As cliche as this sounds, it is true that we have seen a lot of regulatory activity in this space. The new European Sustainable Finance Disclosure regulation came into force in March this year, with the detail regulatory technical standards expected to be endorsed by the Commission any moment.

In the UK, the Joint Regulator and Government TCG Task Force has published a roadmap towards mandatory climate related disclosures, followed by an ongoing consultation of the proposals related to these disclosures from publicly quoted companies, large private companies, and limited liability partnerships. It is therefore to no surprise that concepts such as environmental, social and governance or the so called ESG, an impact investing have been taking a prominent place in our investor discussions lately. For some organisations ESG has become the norm, others are still finding their way with the new requirements and regulatory expectations.

To discuss where we are heading to and what investors can expect in this space, in today's episode, I have invited two deep technical experts to explore the subject.

It is my pleasure to welcome Edward Dixon, who is the head of ESG for Aviva Investors 52 billion real assets platform, leading the firm's ESG strategy across Real Estate and Infrastructure Investment, Development and Asset Management. Ed describes himself as a critical thinker and believes in the power of organisational behaviour and leadership theory as a tool to address sustainability challenges. In addition to that, he's a keen adventurer, recently joining us exploring society expeditions to the Arctic Circle, and the summit of Mount Kenya. Welcome Ed, it is a pleasure and how very impressive.

Edward Dixon:

Thank you for that lovely welcome Irina and it's really great to be on the podcast today.

 

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Irina Velkova:

We are also joined by Paul Young, who is the Managing Director in our Grant Thornton's Financial Services practice and Head of ESG and Climate Change. Both career in Finance Risk and Compliance spans across the UK, US, and Australia, having worked with a number of multinational groups, and he's so impressive that if we were to cover it in any detail, we won't have airtime for anything else today so just say thank you for being here, Paul. And most importantly, have you done or are you planning any expedition trips as nearly as exciting as Ed's?

Paul Young:

Thank you very much Irina, and I'm happy to join the call today. No, my days of expeditions and mountain climbing and Antarctica trips are probably over.

Irina Velkova:

I think we all need to join Ed in his then going forward. I guess what would be a really nice starting point is if we start with exploring just a little bit more about what ESG and impact investing mean, from your perspective Ed and the work you are doing in Aviva Investors particularly?

Edward Dixon:

Sure, thank you. Let me start by just saying that we invest on behalf of our clients over really long-time frames and this is often in excess of 20 years. So, this means that sustainability and thinking long term for real assets or private markets manager, like Aviva Investors is something that's really at the core of our investment process and it's absolutely fundamental to the way that we do business. Now ESG sustainability, it's something that's been really important to Aviva Investors for many decades now and I'm still relatively new to the business, I've been there for 18 months now so I can't claim any of this glory but the firm over the years has fought to protect World Heritage sites, its championed against pesticide killing pollinators, it's called on Governments to tackle unsustainable fishing practices and it's got one of the strongest voting records on diversity and executive pay in the industry. So, you know, there's a long heritage there in the organisation that I'm really seeking to build on in my role in private markets.

If we think more broadly about where we are today in the world, 2 billion people live on less than $3 a day while the world's richest 1% own more wealth than all of the other 99% put together, the planet is heading for at least three degrees of warming and, you know, we might be sort of starting to emerge from it now but we've been in the middle of the fastest and deepest recession since the 20s. And the inequality that we see around us in our society really makes you ask, you know, do we need a complete reset of the economic system that we've created. Even over the last year or so the COVID-19 pandemic has killed over 2 million people, infected 100 million, absolute havoc in the global economy and it will set a really long shadow over the world for years to come so we're in really serious trouble and we need really serious change fast.

 Now, I guess at the point where we are now looking at rebuilding the economy, we absolutely cannot go back to normal and I think over the last year, it's fair to say that we've really doubled down and you really touched on this in your introduction, we've doubled down on our approach to ESG and we’ve really kind of dug in. So, things like you know, our commitment to net zero, released in December last year, a long-term commitment to reach net zero by 2040, also backed up by five short term investment goals. But also, we've started to really dig into our social targets and set out an approach to that, that will follow in the years to come.

So, I think whilst you know, there's a really rich heritage in Aviva Investors of their approach to ESG and sustainability, I really think the last year, really exposing the economy and the planet that we're living in at the moment, has made us double down and refocus and as we're starting to rebuild the economy and starting to really get going again, it's going to be with complete renewed focus on delivering sustainability outcomes.

Irina Velkova:

Yeah, and you certainly own the headlines with the next level commitment as being one of the largest, obviously, insurers in the country to lead the way so very impressive. But as we are transitioning into more of an ESG regulated world, if you like, what do you think that the things that investors and generally public actually need to be aware of when it comes to ESG and impact investing?

Edward Dixon:

Yeah, so if I was a member of the public and thinking about this, you know there's a real growing consensus and real growing appetite, and recognition of the fact that where you put your pension is probably one of the most impactful things that you can do. So, members of the public are starting to think about their pensions and think about the ways that they can be invested sustainably.

Now, over in real assets here, at Aviva Investors, we typically deal with institutional clients so we're dealing with pension schemes that are representing those underlying beneficiaries and we're really starting to wake up to their needs, in terms of sustainable investing and starting to think about how they can invest into the real economy, into real assets so hopefully represent the views of their beneficiaries.

Now, the pension schemes and blue-chip clients that we invest on behalf of, have also got to start to think, as you mentioned before, about this real growing body of legislation and regulation. So whether it's Sustainable Finance Disclosure regulations and how they select asset managers to manage their money in a sustainable way, in line with those regulations, whether it's things like the FCA stewardship code, that's really setting out exactly how asset managers should be managing money in 2020 and beyond, whether it's the PRI and that focus on sustainable investment, there's a real broad spectrum and then you've got more recent pieces of regulation, like the task force for climate related financial disclosures, which is now becoming mandatory for larger employee pension schemes in the UK.

So, our clients are really facing down on this, you know, huge wave of regulatory and policy pressure that's starting to come their way, whilst also really needing to start to think about the needs and wants of the public and savers and pension holders who are starting to really get interested in this topic.

Irina Velkova:

Yeah, sounds very familiar actually, even in the work we're doing as well and I think a question to you, Paul - what is it that we see with our clients, are they now starting to get to grips with all the new regulations? Do they have sufficient knowledge of, for example, the taxonomy or SFDR, which just came into force in March this year or are they still trying to learn about it?

Paul Young:

So, there's a whole host of questions in that question that you just asked Irina, so when you look at the market, in Financial Services, it's broken down into different sectors, i.e., assurance, investment managers, banks, etc and when you look at those different sectors, there are different sized organisations.

Now, certainly the large ones are focused because they can actually be in the news very easily. And the reason they're in the news is whether it's a regulator or a government may call out something, that's not so much the issue at the moment, it's more lobby groups and protest groups are full steam ahead with changing Financial Services balance sheets and exposures to carbon-based activity. And with the expectation that these very large organisations or even the some of the smaller ones can turn on a dime when they've built up portfolios and economic activity that supports those over a long period of time.

So first of all, to be able to change your portfolio and meet the regulatory expectations, in the timeline that they've asked for, is a huge challenge for everyone. And that means that organisations are on different parts of that journey so even though climate change, as an example has been out there for a long time with sustainability ports and different types of disclosures, over the last 12 months the regulations that have come out of Europe, the UK, and now it looks like in the US for the change of Government means that there is a wholesale change in the way that organisations really need to organise themselves, talk about their strategies, the shapes of their portfolios, and how they're going to meet the various disclosures, or present those various disclosures that are required by the regulators.

So, there's a lot to do in a very short time period with an enormous tsunami of regulations that come out in a brief period of time. So, the larger organisations have certainly started to get the programmes in place to be able to do this, even if they not necessarily building off the back of what they had previously but looking at what they had previously, and then seeing how they can reinvent the new programmes to take them into the future. When you move down the scale of organisations, then what you see is some just trying to get their mind around what they should be doing, starting with how to even build a governance framework to begin the oversight, the strategy development risk appetites, transition plans, what time period should I be looking at, where do I want to be positioned in the market, what will the market look like in 5-10 years time.

All of that a very, very difficult questions to deal with when you're already dealing with other regulatory requirements and in the smaller organisations, they don't have the luxury of resources to be able to throw at things like this.

Irina Velkova:

Yeah, not really surprising, it pretty much has been the case with every single large regulations that have come into force in the last few years, we've seen that again, and again, you did mention though something really very important which is about being a frontline of newspapers, for example, or in the news.

So, I guess going back to Ed, how big of a risk is greenwashing for Aviva Investors, given that you are one of the large organisations and the bar for you is probably even higher in terms of expectations of not getting it wrong?

Edward Dixon:

Yeah, it's a good question. So, let's pick it apart and answer it in two halves. If we think about greenwashing and the risk of greenwashing, payment protection insurance policies used to be sold alongside mortgages, loans, credit cards, way back since the 1990s and they were supposed to repay people's borrowings if their income fell because they became ill or lost their jobs. And it turned out after 10-20 years of those PPI products being sold, that the banks were returning only about 15% of that income to the claimants.

Now this means that it was hugely lucrative and more so than other comparable insurance products. The Citizens Advice Bureau at the time said that this was basically a protection racket, and everybody knows how it ended. PPI became an absolutely huge scandal, money is still actively being returned to people who took out those insurance policies all those years ago, and the sector is consequently reformed, and changed off the back of it. If we think about SFDR (Sustainable Finance Disclosure Regulations) now, is that our modern day equivalent?

The rate at which things are changing just to our planet's natural systems, the realising of how quickly manmade emissions have contributed to the climate crisis, this is starting to mean that carbon is beginning to be something which won't be seen as an acceptable externality of financial products and assets anymore. So as the tables are starting to turn, can we imagine a world where products which were supposedly sustainable financial products, actually when we really start to look at the negative externalities of those products and we understand what the real impact of them was, is that going to be tomorrow's PPI scandal and will we see from the plethora of different ESG friendly, you know, impact products that have been sold into the market over the last few years, will we see actually that will become a scandal in future and I'd estimate that that might happen quite soon.

So how do we offer genuinely authentic, green, sustainable, transition focused financial products? And what do we actually need to do to be able to give our clients and their underlying beneficiaries the real confidence that their money is actually going out there into the world and doing some good? I think the way to pick that apart is to first think about the difference between risk and impact.

Now, a lot of sustainable financial products out there at the moment that you'll see that are saying that they are ESG integrated, a lot of those are liquid markets products, so they're invested in companies. And the process for embedding E, S and G factors into those products is quite mechanical, is quite binary.

So, we're looking at a portfolio of stocks, we're potentially excluding some of the poor performers and we're also taking account of E, S and G factors that could be financially material. Now really ESG investing from that perspective, it's just about protecting your money, right? You're just looking for financially material factors that could potentially contribute to one of those companies going bust or devaluing in the stock market, because of some sort of human rights issue or some environmental problems that they've maybe been contributing to and covering up and that's quite commonplace.

When we talk about our world of private markets, risk is, because we're investing for the long term in assets that are real so buildings or infrastructure, risk is really fundamental to the underwriting process, there is absolutely no way you go into a 20 year investment that you can't easily sell without understanding the environmental and social context of the asset so risk in some perspectives is almost, is built in.

So, the difference between that and impact, you know, is much more about what is the impact that your financial product is going to be having. Are my savings, is my pension going to be making a positive impact or a negative impact? And when we think about real assets, you know, there is a real possibility that money can be going out there into the world and having a very negative impact. Because, you know, railways, logistics, hubs, buildings, office buildings, you know, shopping centres, if they're not built in the right way, then they're absolutely not sustainable so we've got to be able to understand impact in terms of the negatives but then there's also, you know, looking at impact in terms of the positives, if you're investing in the right way, and it's creating green jobs, if you're creating locations that are desirable and usable for people, if you're contributing to social infrastructure, like schools and hospitals, there's actually an amazing potential for positive impact as well.

So, I think it's really, really important to get under the skin of both risk and impact. Going right back to financial products then and the original nature of the question around greenwashing, I think it's really, really important that Asset Managers are able to substantiate and to prove the approach that they take to understand the risk of investing in a liquid and long-term asset, but they also need to be able to understand the impact and those things are intrinsically related and they're both similarly important to the investment process.

Irina Velkova:

Yeah, I'm personally very passionate about impacts as opposed to simply complying with DDSG requirements but I'm not quite sure as many organisations out there on the market are as sophisticated as you describe Aviva's process and I think that's a question to Paul probably, what are you seeing with our clients, both in terms of what their focus is? Are they really thinking about impact? Are they really challenged now with the regulations and they're trying to put their houses in order first?

Paul Young:

Pretty much it's the latter, there's so much to do to get their houses in order. So, as I said before, the number of phone calls I take with organisations about how they even develop a strategy. And there is this, I mentioned it in the previous question, there is this need to do things urgently. And that's both driven by the regulator with very tight timelines. So, the transition plans, which should be mentioned in the sustainability disclosures that organisations produce, is really the place where you should focus how you're going to get to something that's more of a rebalanced balance sheet with a greener portfolio.

So, because that can take the market changes, as well as where your current exposures lie, you need to incorporate both of those as you move towards a transition plan, that then builds back up into that strategy that the governance part of your group have developed, whether that’s the board or a special committee that reports into the board. So that you can then say, here are my targets and here are my milestones that I'll be meeting over the next X number of years to reach the appropriate exposures that I would like, as far as green exposures are concerned.

And for example, I mean, if you're in the carbon-based sector, such as oil, you can see the activities such as BP, who are buying up swathes of North Sea rental areas, to eventually put in wind farms. Now, if it was up to BHP to do this over a reasonable time period, I can guarantee they wouldn't be making those investments in such a short period of time and that has actually created a bit of a bubble on the valuation of wind farms. So, this knee jerk reaction to try and meet all the regulatory goals and keep yourself off the front page of the newspaper is causing these bubbles in the marketplace, which are unnecessary.

And so, when you're an organisation trying to address, you know, just a straightforward product to an investor, you've got all of this baggage in the background that you have to address as well, to meet those other requirements because ultimately, there is also a discussion about added capital numbers, if you haven't got the right exposures, which Basel have been talking about. There is a requirement now to build ESG exposures into your, or at least climate change, into your capital documents that specify how much capital you need to hold.

All of that means that the more you're exposed to, the bigger the capital allowance that you have to keep aside in your balance sheet. So, these institutions are getting it from so many different directions and the worry is that this speed into green funds, which we all agree is the right direction, but it is the speed, the thing that could create other unknowns that could eventuate over the next, you know, five-year period

Irina Velkova:

Yeah, and you said something really very insightful there about the potential bubbles actually driven by the urgency coming with regulations. Are you seeing that as well Ed?

Edward Dixon:

What I would say is that the growth that we see into green funds or ESG funds, is mostly happening in liquid markets and we're not necessarily seeing a huge growth in sustainable products on the private market side. Now, part of that goes back to what we talked about before, which is the difference between risk and impact and the fact that in private markets, actually understanding ESG implications is really critical to the investment process anyway.

Now, an important point that I think it's really relevant to bring out at this point is the difference between green and transition. And what we have seen is, you know, certainly a lot of growth and potentially a bubble into green assets, as in, you know, assets that are already classed as being green in some way and also related to that sort of ESG funds, i.e. funds that are not bad and are not having a negative impact if you measure them by, you know, popular indices and the different measures that are available now. I think our view is where investment is really needed is the focus on transition and actually a lot of the regulation and policy changes that we're seeing at the moment aren't really conducive to success here.

So, take something like the taxonomy, which has a really clear determination between green and brown activities, take something simple, like real estate, if you're in the top 15% of performers, for your particular geography, in terms of energy efficiency, then you're green and if you're in the bottom 85% then you would be seen to be brown. Now that's good and I absolutely support the channelling of funds into green assets and into sustainable funds, but I think we need much, much more focus on impact and transition.

So, to give a couple of examples, one would be our sustainable transition loans projects, which was launched last year, where we've been working to support clients to originate assets, which are focused on the transition and that's through an active engagement between us as the asset manager and the underlying borrowers. Now, what this means is that if you're a real estate borrower, and you want to refinance a portfolio of buildings, or finance the development of a new asset, you can come to Aviva Investors for financing, which is linked to sustainability goals, and you can be rewarded and incentivized for the action that you take.

Now, that's been really successful and that's fantastic news, but we need massive, massive volumes to go into that to really make an impact. But the most important thing about it is that it's focused on the transition, we're taking existing assets, which perhaps aren't performing particularly well and we're pinning that client financing into those assets and forcing the change. The borrowers are coming forward, working with their occupiers, and delivering on their sustainability goals, usually around energy efficiency, and the client is then rewarding them for that. So, for me, that's where we need big, big growth in the sector at the moment, is this real focus on change and transition, to actually bring about the changes that we need

Irina Velkova:

 Yeah, that's very true. Paul, do you see an appetite in the UKs regulators to be a little bit more focused on impact going forward? And specifically, given that we decided not to opt in for SFDR, for example, which as Ed just said is mainly focused on the requirements as opposed to transitioning but do you perceive the UK regulators being keen to get further than that?

Paul Young:

So, the UK regulators pretty much aligned to the government's initiative on green finance. So, they're going to try and drive the programme for Financial Services to meet the government's timelines. So also, you know, the Government has said that the UK wants to be a market leader in green finance. So, all of that said, I can't see the regulator backing off or reducing any of the requirements that would be expected from, you know, the financial services sector, in fact, even the broader sector incorporating the corporates as well.

Irina Velkova:

Yeah, no, I absolutely agree, and I think that's my observation from talking to them and being involved in some discussions with different industries bodies as well. I guess a slightly different twist now, obviously the pandemic has opened the eyes of many people in different aspects, but one has been sustainability particularly, are you seeing any sort of, behaviour or shift if you like with your clients and how they would like to invest their money, which is driven less so by regulations, but actually the actual impact of the pandemic?

Edward Dixon:

Yeah, absolutely. If we go back to our real assets study from 2020, that really showed that clients were interested in exclusions and integration and as we stand in 2021, we can probably think about exclusions and integration as really being quite vanilla you know, that's almost a fairly standard part of any Asset Managers offer to their clients.

I think what's changed between now and then is that we've really started to see a growing appetite. In that study, we found that 92% of global insurance and pension fund investors were committed to or planning to achieve net zero. So, you know, a big number 92%, almost all of the respondents to the study said that they were on board. But actually, in the last year, we've started to see that feed through into RFPs, starting to feed through into queries from clients, you know, we've recently on boarded a £500m mandate, where ESG was absolutely front and central.

I've had several conversations with a big client who will have to remain nameless for now, who was really only interested in whether we could deliver against the SDGs, in the opening part of the discussions with us, with the rest of their due diligence following. So, you know, I really think it's gone from being something that is something was an intention from clients to something that is really central to their ask, it's up there, front and centre, their head of ESG is joining the early calls with us, as we're going through the pitching process, really very intelligent RFP documents that are really setting out exactly what they want. And even in one recent case, clients coming to us and asking for a proportion of their assets to be given over to positive impact and that's something in the private market space that I haven't yet seen.

So really big change, huge kind of groundswell of interest from clients, and incredible that in just a year, it's gone from something that was on the radar as a commitment and something coming down the line to something where the rubber is really hitting the road already in our space.

Irina Velkova:

Yeah, sounds familiar again and I think, Paul, is that consistent with what you're saying? Obviously, you and I operate in the regulatory world, and our conversations are mainly around regulations, but do you see a bigger drive from our broader population of clients towards sustainability, even when we don't talk about ESG requirements for example?

Paul Young:

That is absolutely right, I mean, the investing sector are really looking to have a rebalanced portfolio, because they really get it so, you know, on top of the regulator's requiring all these different disclosures to show whether you've got an appropriate green or brown portfolio, you're also getting the investors driving it the other way, they definitely want to be able to say that their money is being used in sustainable investments.

Irina Velkova:

So, it all sounds very positive, radical shift, drive for sustainability. So where are we heading to? Do we dare think of a better world coming where individuals and organisations are more mindful when caring indeed or do you both think this is short lived and as we start to go back to business as usual, the good intentions will be quickly forgotten and we will slip back into too much focus on profitability and forget about the impact, the bad impact we're having on the environment, but also the good impact we can achieve with our investments and all these regulations. I guess, Paul, maybe you first

Paul Young:

I can't see it going back, there's too much physical risk out there already, let alone COVID. I mean, prior to that this was already starting to get focused through the Australian/Californian bushfires, the hurricanes in the US and the Caribbean. It's quite obvious to everyone that the world has changed particularly in climate risk. The interesting thing though, is the being able to bring in the S and G components of ESG on top of climate risk, that's been a change, a very rapid change. Partly having people like Mark Carney out there, you know, doing speeches saying that executive pay needs to be linked to ESG metrics.

So then, you know, as the older generation moves through the business world who were used to growing up in, you know, an environment where resources were, you know, available at your fingertips, the new generation are just, all they hear about is the impact on the environment. They are the next business leaders, and I cannot see them, turning back the clock to the way that it used to be. But the important point to say is that investing in green investments isn't necessarily a reduction in profitability, some of them, many of them are as profitable, if not more profitable, than some of the old carbon-based lending.

So, it doesn't mean you have to compromise between profitability and a green investment, they do go hand in hand

Irina Velkova:

What is your view Ed, what does the future entail in terms of sustainable investments? Is there a way back?

Edward Dixon:

I'm eternally optimistic about this, and the reason why is that nobody's trying this, and then going back to their old way of doing things. Companies, investors, asset managers, suppliers, individuals are starting to realise that there's a better way to do business. And once they've realised that it can have a positive impact on their bottom line, means they probably enjoy coming to work a little bit more every day. And that they can be proud that they're giving something back and doing something positive in the world, they want to do more of it.

So, I think it's self-perpetuating, as we see growth in the sector, growth into green, sustainable investments, growth in investments that target some sort of social purpose and deliver some kind of social impact. I think people are going to get a taste for it, and they're going to want more, and I think that's incredibly positive so I'm absolutely optimistic and I think it's going to grow and grow and grow over the years ahead.

Irina Velkova:

Well, thank you very much for finishing on that positive note and I would like to thank you both very much for this discussion today. It's been very insightful indeed and obviously, you've both talked a lot about how much there is there for firms to do in terms of regulations, but also the urgency that we all need to face when it comes to ESG and impact investing specifically, and how important is actually that we continue with the social purpose, and that there is no way back so thank you once again, and it's been an absolute pleasure. And of course, thank you to all our listeners today, I hope you enjoyed this discussion as much as I did, and you found it helpful.

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We'll be back with our next episode next month to talk about other exciting topics of the risk and regulatory world. Thank you again and goodbye.