European Companies in the Crosshairs of Regulators
Regulation of sustainable investing is gaining momentum, and national and supranational lawmakers are striving to prevent empty promises—such as greenwashing. This is intended to promote a higher degree of transparency and reliability with regard to the distribution of financial products and corporate reporting. This has been driven primarily by the European Commission and EU member states, which have initiated 60% of global initiatives since 2000 (Fig. 1). The catalyst for the most recent surge was the 2019 EU Green Deal, which fleshed out the goals of the 2015 Paris Agreement on Climate Change to pave the way for EU member states to transition to a climate-neutral economy by 2050.
According to the Principles for Responsible Investment (UN PRI), a UN-backed investor initiative, 60% of all sustainability-related regulations in the EU since 2000 have applied to companies—only a quarter have applied to investors. However, recent proposals to amend the MiFID II (taking into account investors’ sustainability preferences) and UCITS (taking into account sustainability-related risks in fund management) directives have led to a shift in this ratio, which had remained relatively stable since 1995: In 2020, the share of sustainability-related regulations pertaining to investors rose to 40%—up from 25% the previous year.
We expect this to increase pressure, above all, on publicly traded companies to report consistently on sustainability aspects in capital investments and to align this with their public image in the capital markets. This is because a lack of transparency and contradictions could lead to reputational risks that negatively impact corporate value and implicitly make refinancing via capital markets more expensive. Companies that, for example, profess their commitment to internationally recognized values and standards but invest their own capital in securities mired in serious controversies related to these issues will come under increased scrutiny from critical NGOs and the media.
Investment decisions should be consistent with the company’s public image
The exclusion of individual securities is economically sensible within the context of portfolio construction only to a certain extent—namely, to the point where the ex-ante tracking error of a portfolio relative to its benchmark index is not disproportionately strained. Chief Financial Officers should also prioritize robust ESG integration. ESG integration specifically incorporates financial and material aspects when analyzing investment alternatives across the thematic areas of environmental, social, and governance factors to strengthen the risk-return profiles of investment strategies. Two things are important in ESG integration: first, a systematic, closely integrated, and, above all, documented consideration of sustainability criteria in the investment process; and second, effective risk management that identifies and corrects misalignments—without diluting sustainability criteria in the process.
Consistent ESG integration in accordance with these principles should also apply to all areas of a company’s investment activities that, while currently exempt from regulation, could fall under disclosure regulations in the foreseeable future. This applies in particular to strategic liquidity management as well as funding sources from direct commitments and lump-sum-funded support funds within the framework of corporate pension plans (Fig. 2). In Germany, for example, according to the Working Group on Occupational Pension Provision (aba), funding from direct commitments and lump-sum-funded support funds accounted for over 50% of all corporate pension expenses in 2018—equivalent to 10% of the German economy’s gross domestic product.
► Strategic liquidity comprises those funds that are not immediately required for day-to-day operations. These are primarily invested, for example, in multi-asset strategies managed on the basis of fundamental analysis. The allocation across asset classes is determined based on the investor’s risk tolerance and return expectations. Since, in our view, only a certain degree of exclusion of individual securities makes economic sense when constructing portfolios, financial and material sustainability aspects should also be taken into account in order to specifically strengthen risk-return profiles.
Professional ESG integration is particularly effective when allocating assets across the various asset classes within the framework of multi-asset strategies. In addition to a focus on return drivers, risk management tailored to sustainability criteria is indispensable. Only in this way can the unintended biases toward certain risk premiums, sectors, or regions—resulting from sustainability preferences—be offset without diluting the investor’s individual sustainability goals.
► The defined benefit plan is one of five methods for implementing an employer-sponsored retirement plan, in which companies voluntarily commit to paying employees a fixed amount directly from company assets when they become eligible for benefits. Direct commitments can be offset against pension provisions on the balance sheet using contractual trust arrangements (CTAs). This reduction in balance sheet liabilities achieves three things:
1. Strengthening financial metrics such as return on equity,
2. Improving financing terms through a lower debt-to-equity ratio, and
3. Reducing administrative effort and the associated costs.
However, if the company does not disclose information regarding the sustainability aspects of the spun-off funds in the notes to the financial statements, investors cannot verify the consistency of the company’s external reporting. The higher the proportion of funds that are financed through profit-oriented capital investments, the more likely it is that the regulator will take up this matter.
► This also applies to cover funds of flat-rate-contributed support funds (just under 6% of cover funds), where—unlike with reinsured support funds—it is the company, rather than the product provider, that decides on the investment. Permissible investment options range from precious metals, securities, stocks, or funds to real estate in individual cases. Consequently, these funds also carry potential reputational risks, which must be disclosed to stakeholders such as employees or investors.
The remaining portions of a company’s retirement benefits are managed by EbAV-II- (pension funds at 28% and pension schemes at 7%) as well as Solvency II guidelines (direct insurance at 11% and, indirectly, for reinsured support funds) in terms of sustainability.
Transparent companies can put pressure on competitors
We do not expect initiatives for greater transparency to originate from international organizations such as the United Nations. According to the UN PRI, these and similar organizations have been responsible for only 2% of all sustainability-related investment regulations worldwide since 2000. In contrast, there are numerous examples of individual companies—exemplary in their sustainable management and highly transparent in their reporting—forcing competitors to take action. Specifically, this can be illustrated by the initiatives of some stock exchanges, which create locational advantages by publishing “best-practice” guidelines. This demonstrates that differentiating initiatives create comparative competitive advantages, which can have a positive impact on corporate value.
Key initiatives promoting transparent reporting originate from investors
Even if companies are required to fully disclose their investments, asset managers, in their fiduciary role toward investors, are still obligated to review investments for inconsistencies with regard to sustainability principles. For example, if a publicly traded company claims to uphold human rights in its supply chains but invests in securities that violate these rights, excluding that issuer from an investment universe could be justified.
Conclusion
A company’s sustainability commitment should be credible, transparent, and effective. This should also be reflected in its investment portfolio, which will be scrutinized even more closely for inconsistencies by regulatory authorities in the future. As investors increasingly differentiate between companies that are exemplary in their sustainable management and those that lag behind, issuers of securities that take the lead will have an advantage.
Specifically, this means: anticipating regulations, setting standards, eliminating reputational risks, and optimizing risk-return profiles in investment strategies. This not only offers advantages in refinancing the business model; an intrinsically motivated initiative toward greater transparency in sustainability reporting also reduces the implementation costs of future regulations. Expertise that is proactively built up internally does not need to be sourced externally.
Disclaimer
This information is not intended for private investors. Metzler Asset Management GmbH does not guarantee the accuracy or completeness of the content. For further information, please refer to our legal notices at www.metzler.com/disclaimer-mam.
This information is not intended for private investors. Metzler Asset Management GmbH does not guarantee the accuracy or completeness of the information presented here. Please see our complete disclaimer at www.metzler.com/disclaimer-mam-en.
