ESG+ Newsletter – 5 September 2024

After our annual August break, we have a bumper issue for readers, covering inflows into transition funds, integrating employee happiness into the attractiveness of stock picking and an in-depth review of emerging AI-related shareholder proposals. We also cover the differing pressures companies face on DEI initiatives and the inadequacy of action on water, while on governance, we look at differing views on compensation and potential pressure on proxy advisors from investors on climate issues.

Energy transition funds attract market beating inflows  

The inflow rate of dedicated EU based energy transition funds over the past two years has outstripped that of the wider ESG market, according to a report by EU markets regulator ESMA (European Securities and Markets Authority), with transition funds attracting cumulative inflows of EUR27M, versus EUR14M. While the size of this specialised investment market (136 funds per ESMA) is of course substantially smaller than the total green fund universe (872), which now makes up approximately 60% of all European AUM, the popularity of transition products may see increasing launches amid consistent inflows and underlying asset performance.  

The shift towards a more targeted and defined approach to ESG-aligned investment strategies has been evolving for some time now, emblematic of the growing maturity of the sector and the normalisation of the performance of ESG funds which had initially boomed. Focusing on a specific trend and activity, rather than a number of broad themes, allows for a more focused and materiality led approach – both in achieving traditional financial gains and in furthering sustainable solutions. Interestingly, the ESMA report did point to transition funds holding a higher proportion of fossil fuel exposed businesses than green products more broadly, but these are environmental leaders in the eyes of ratings agencies with a significant proportion of taxonomy eligible revenue – illustrating the degree of complexity which is ever present in the industry.  Indeed, transitioning for these companies may well present greater opportunity for investors, as well as representing progress for efforts to reduce emissions.

Harnessing employee happiness: A new approach to stock picking 

Since the pandemic, many employers have increasingly prioritised employee well-being and satisfaction. Irrational Capital, a US research firm, is at the forefront of attempting to uncover the tangible financial benefits of a happy workforce. As per the Financial Times, the firm is revolutionising stock picking by refocusing from traditional financial metrics and toward employee happiness. The firm created “human capital factor scores,” which assess employee satisfaction using data from surveys and platforms like Glassdoor. The idea is that happier employees lead to better business performance, driving stock market success. 

This approach was tested through the HAPI ETF, launched alongside Harbor Capital, which invests in large-cap companies with high human capital scores. Since its debut in October 2022, HAPI has outperformed over 90% of its peers, according to Morningstar. Supporting this strategy, research from London Business School professor Alex Edmans found that companies with high employee satisfaction often outperform their peers by up to 3.8% annually. However, Edmans cautions that this success might be most effective in countries with flexible labour markets. Despite HAPI’s success, a similar small-cap fund, HAPS, has underperformed, highlighting challenges in applying this strategy to smaller companies, which may lack the resources to gather reliable employee data. Irrational Capital is now expanding its offerings by selling human capital scores to companies seeking deeper workforce insights, emphasising the growing recognition of employee well-being as a driver of business success. 

Unveiling key trends in AI shareholder proposals 

In 2024, institutional investors in the US significantly ramped up their focus on AI risks, as highlighted in FTI Consulting’s latest report. The number of AI-related shareholder proposals rose to 16 by mid-2024, compared to just seven in 2023 and four in 2022. This increase was driven by a diverse coalition of investors pushing for greater AI oversight, with notable support for proposals demanding transparency on AI use. Two proposals expanded their ambition beyond transparency, calling for specific board responsibilities related to AI oversight. New sectors beyond Big Tech, including media, entertainment, healthcare, and a well-known restaurant chain, were also targeted for the first time. 

Some proposals gained substantial backing, particularly those seeking greater transparency; however, proposals seeking changes to board responsibilities received lower support, likely viewed as overly prescriptive from the wider market. While AI shareholder proposals have not yet emerged in the UK or Europe, similar to the early days of climate-related proposals, we may be at the early stages of an emerging, global trend. European investors like Norges Bank Investment Management and Legal General Investment Management have already outlined their AI governance expectations, while Glass Lewis is currently surveying clients on AI governance expectations. 

Stewardship teams review their approach on compensation 

Environmental Finance recently interviewed Howard Risby, regional team lead for Federated Hermes’ dedicated stewardship services provider EOS in Europe, as the advisory reviews its approach to analysing companies on executive compensation, and particularly ESG-linked bonuses. The review aims to ensure voting practices ensure clear alignment of executive pay with long-term business success, a key concern for long-term investors. While EOS remains open to the inclusion of ESG targets in incentives, it is wary of companies using ESG metrics superficially to boost compensation. As investors and their representatives analyse how best to align pay to their expectations, performance and strategy, Ola Peter Krohn Gjessing, lead investment stewardship manager at Norges Bank Investment Management, wrote in the Harvard Law School Forum on Corporate Governance blog about potentially removing performance conditions from equity grants altogether. Both leading proxy advisors, ISS and Glass Lewis, are currently surveying their clients (investors) on their views regarding the use of long-term incentives with and without performance conditions, while interest grows around European companies offering long-term awards to their executives without performance conditions, mirroring practices in the US, against a backdrop of global competition for talent. As companies consider what changes (if any) to make to pay practices toward the end of the year, there is merit in engaging with their own shareholders to ensure the Board has a clear understanding of their specific expectations ahead of voting in the new year.

DEI initiatives under scrutiny

Over the past decade, shareholders and other stakeholders have been active in pressurising companies to develop more diverse and inclusive employee practices. The Wall Street Journal reports that, more recently, vocal critics from the other side of the aisle have taken aim at companies for what they argue are “woke” or “politicised” practices. As detailed by Reuters, there has been a trend of companies backing away from diversity, equity and inclusion policies amid new public scrutiny and in light of the Supreme Court’s 2023 Students for Fair Admissions v. Harvard. As companies face pressure from competing sides, the importance of evaluating policies through a commercial lens becomes increasingly important, potentially allowing companies to address criticism around initiatives by pointing to performance enhancements. In the coming months, and particularly as annual results and reports are released in the first half of 2025, it will be interesting to see how companies balance prior requests for improvement from institutional investors and other stakeholders against the perhaps smaller – but more vocal – number of critics from the opposing side.

More investment in water needed to achieve UN SDGs 

The UN Environment Programme and UN Water have released a series of reports on the state of global freshwater ecosystems, and the results are not good (to put it mildly). The mid-term status reports are designed to track progress towards UN Sustainable Development Goal (SDG) 6, which aims to achieve clean water and sanitation for all by 2030. The reports found that freshwater ecosystems, which include rivers, lakes and aquifers, are degrading in half of the world’s countries. Water quality is worsening through pollution and river flows are significantly decreasing, creating a situation where rather than making progress, in some cases progress is relapsing. The reports highlight the large-scale data gap in global water quality measurement, which means that the poorest half of the world contributes under 3% of global water quality data points. Data is urgently needed to ensure water can be appropriately managed and quality can be improved. Often, environmental headlines are dominated by the climate crisis and comparatively little attention is given to freshwater. The results of these interim reports indicate that this lack of attention has resulted in worsening outcomes for freshwater supply and quality. Given the criticality of freshwater for not only prosperity but also life on Earth, perhaps the topic is deserving of a little more attention from regulators and investors.

IIGCC asks investors to push proxy advisors on climate issues 

In August of 2023, the Institutional Investors Group on Climate Change (IIGCC) and 36 other investors collaborated to sign a letter requesting proxy advisors further integrate climate into its’ proxy advice. The letter, amongst other things, specifically called out clear investor asks and that environmental and climate-related factors are material to investors’ stewardship and voting decisions. A year later, as per Investments & Pensions Europe,  the IIGCC has issued a statement, urging its members to fill out the ISS and Glass Lewis annual benchmark policy services with climate considerations in mind. The IIGCC specifically calls out scope 3 emissions and describes climate-related shareholder proposals as a normal part of communications around investor net zero expectations. Continued pressure from groups such as IIGCC may continue to make an impact on investor pressure and decisions, but it will be interesting to see how it interplays with some of the backlash occurring in the US.  

ICYMI 

• ESG ratings and data products have become essential tools for financial institutions to assess portfolio performance and environmental impact, according to a recent CDP report.
• The Dubai Chamber of Commerce has launched a strategic initiative to promote sustainable business practices, helping organisations assess their ESG readiness, ESG News reports.
• The inaugural chair of the Canadian Sustainability Standards Board has stepped down. The Globe and Mail reports that the board did not give specifics behind the departure, stating only that “this decision reflects his personal priorities.”