Fund Managers Will Soon Be Climate Advisers
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This article first appeared in FT Adviser.

The growth of environmental, social, and governance investing, or ESG, in the past few years has been nothing short of explosive. While interest in issues like social justice and equality, climate and sustainability, and diversity and inclusion has been growing for a number of years, the pandemic has accelerated awareness on a global scale.

Asset managers have responded with a flurry of marketing activity and product launches to seize the moment. Call this ESG Phase I, or “the great productization.”

So far they have been quite successful: ESG portfolios in Europe and the United States attracted record inflows in 2020. When compared to the outflows experienced by most managers in their actively managed portfolios, the growth looks even more impressive.

Yet there is an even bigger opportunity at hand for asset managers. This next phase of ESG could be characterized as “the great consultation”: offering strategic ESG advice and expertise to big investors.

Many large institutional investors recently have made public commitments to meeting ESG standards, most notably around the environmental (or “E”) component. Among the highest-profile efforts is the United Nations-convened Net Zero Asset Owners Alliance, or NZAOA. Launched in 2019, the group comprises asset owners from around the world with nearly $6 trillion of the world’s wealth. Together they have pledged that by 2050 the carbon emissions of the companies in their investment portfolios will be net-zero, a key tenet of the 2015 Paris climate accord.

The NZAOA is significant because these investors have voluntarily put themselves on the hook -- and indirectly have put pressure on their peers as well. Recognizing that they will be scrutinized to see if they make good on their promises, many have started making changes to their portfolios where they can. But the activity has been spotty, and the low-hanging fruit has often already been picked. Taking the next steps will be harder.

And therein lies the opportunity for asset managers.

In ESG Phase II, leading asset managers will raise their game. They won’t just offer climate-friendly products or roll out new ESG screening services that help clients’ feel good about their investments.

Instead, they will become climate-change consultants, advising their clients on how best to transition their portfolios to meet the lofty commitments they’ve made while still achieving their return objectives and satisfying risk constraints. Balancing all these objectives isn’t easy and will only become more challenging over time. The most forward-looking asset managers will offer genuine climate expertise-based solutions that can not only inform how they make their own investments and structure better investments for clients, but also help clients with their transition to net-zero as well.

We are seeing these capabilities start to bubble up in the marketplace, with some asset managers aligning in joint ventures with climate specialists  and others creating their own climate-science risk management platforms. In an industry characterized by product commoditization, firms that move aggressively to integrate these capabilities into their offerings will be able to build and sustain an advantage.

Larger asset managers are probably best positioned because they have the resources to invest in building up this expertise even though these services are unlikely to generate revenue directly. Smaller, more capital-constrained organizations might be faced with more acute trade-offs. Whether resources are dedicated to efforts like this will likely depend on leaders’ willingness to go beyond the consideration of short-term, first-order economic consequences.

The asset managers that capitalize on this opportunity will be doing themselves and the planet a service. Climate change is among the most daunting problem mankind faces, and a significant part of the solution lies at the feet of long-term investors, who hold the power to starve firms whose futures are in question and to provide a bounty to others more likely to thrive. Asset managers’ role should go beyond providing responsible investing products; it should be about providing climate expertise and hands-on consultation that helps clients transition their entire portfolios -- while still generating the returns they need to satisfy all the other commitments they’ve made.

Asset managers can help meet the challenges that will unfold over the coming decades -- if they start embracing Phase II now.