Asset owners need to optimize and bolster their approach to investee engagement

• Net zero-related engagement is important for moving investees in the direction of long-term targets, but carries a risk if policies don’t keep up
• RFI’s research indicates that for ESG as a whole there may be a ‘margin of safety’ when screening engagement targets through Shariah screens, and more research is needed to evaluate its presence, especially in relation to transition-related investments
• If a similar ‘margin of safety’ from Shariah screens exists when considering emissions-related issues, this could enable investors to adopt more ambitious climate-focused company, sector, policy and asset manager engagement

The field of responsible investment has dramatically shifted the actions of asset owners and asset managers. With the investment sector moving towards having a third of professionally managed assets consider ESG in some form, the leading edge of asset owners are questioning the effectiveness of the efforts being undertaken. For example, the Net Zero Asset Owner Alliance, which accounts for $10.4 trillion of assets, has released an assessment of the effectiveness of ‘engagement’ to promote decarbonization.

Engagement is a key element of responsible investment. It comprises the ways in which asset owners vote proxies, and the more informal efforts they take to influence the actions of investee companies. It is a key part of the Principles for Responsible Investment, and the Alliance’s report outlines where, in efforts on decarbonization, it has an impact and where it faces limitations.

The issue starts with the investee companies — particular those in hard-to-abate sectors. For the investees, there are some decarbonization efforts that they can take profitably today. If they don’t, it’s a clear and easy case for engagement to make an impact. On other issues, there’s a difference in time horizons between when costs are incurred and when benefits accrue, even if the net result is positive. For some investments in decarbonization, there isn’t a technically or economically viable option to achieve the needed reduction in emissions.

This is where the Net Zero Asset Owner Alliance draws the line on the effectiveness of traditional engagement and where engagement needs to go further. The report outlines three types of engagement:

• expanding into sector/value chain engagement;
• policy engagement;
• asset manager engagement by asset owners;

Each of these expands upon the traditional engagement. Engaging through a sector or value-chain helps to address limitations on action due to lack of demand or constraints imposed by suppliers or customers. Where these are insufficient, for example because of a lack of defined carbon price, the report outlines ways for asset owners to work with other stakeholders and policymakers on policies to achieve the necessary decarbonization outcomes.

These approaches are designed to reinforce one another. Where there is room to advocate for company actions within the current policies (defined as the ‘rules of the game’), engagement strategies can work. However, in most cases — the easiest wins that generate clear and quick returns for companies and investors — there won’t be much engagement needed.

Engagement will be needed instead where there is uncertainty about whether companies betting on more aggressive climate policies in the future will see a result that validates their decision or seems over-optimistic in hindsight. The driver of the underlying uncertainty is the ‘policy’ gap between the top-down decarbonization needs to meet scenarios like those mapped out by the International Energy Agency and the bottoms-up scenarios based on current and anticipated technological and policy development.

The RFI Foundation’s research on the relationship between ESG and investment performance doesn’t address the primary questions on decarbonization and engagement. However, it does suggest opportunities for further research. We looked at ESG more broadly, taking composite scores broken down by quartile (including a category for companies without ESG data) across four distinct geographic regions.

The over-riding conclusion was that in developed markets, investors aren’t rewarded for investing in the best ESG scoring companies (or conversely that investors will pay in expected returns for more sustainability). In emerging markets, the returns were found to be greater in higher ESG scoring companies, perhaps as a proxy for some other unobservable factor such as voluntarily adhering to higher environmental, social or governance standards where enforcement was more limited.

For investors using Shariah screens to filter their investment universe, the opportunities for greatest outperformance were seen in lower-ESG scoring companies in developed markets and companies without ESG scores in emerging markets. The conclusion we drew from these results was that for investors looking to engage with investee companies, the Shariah screens may offer a ‘margin of safety’ against adverse ESG events during the engagement process.

The analytical framework outlined by the Net Zero Asset Owner Alliance doesn’t necessarily contradict this explanation, but it does offer another. The ‘margin of safety’ may offset the negative impact of policy risk-taking by working towards stronger ambition on decarbonization or other ESG issues. For emerging markets-based investments, the question may be more about sorting through companies without significant data disclosure to find the ones with characteristics most similar to high ESG scoring companies.

At the end of the day, investors are concerned about the ability of their investee companies to remain resilient however policy, financial institutions and companies’ response functions react to the onset of climate change. Those investors, companies and financial institutions will want to get out ahead of the existential risks that climate change and transition will create for some companies and sectors.

Investors will have to take calculated risks between uncertain outcomes, either leaning into investments based on current financial metrics alone, or finding those positioned at the leading edge of efforts to mitigate climate change and support more rapid decarbonization. Both carry risks.

Yet, given the increased urgency of climate change mitigation, many investors are balancing engagement to increase the level of ambition of investees against the risk that the policies these ambitions rely on are themselves uncertain to occur. Apart from stepping forward on policy engagement and working more closely with asset managers to enable cosmetic responses to climate risks, it is worth looking at whether there are ways to find a ‘margin of safety’ to sort out investments into those more or less susceptible to policy assumption errors similar to what our research indicates for aggregate ESG quality.

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