By Altin Kadareja, CEO at private debt intelligence platform, Cardo AI
Inclusion of environmental, social, and governance factors in day-to-day investment activities has become a question of ‘how’ rather than ‘when’. However, it is often hard to define what exactly constitutes an ESG-compliant investment and when it is appropriate to embed ESG factors in investment management.
Fortunately, the correct approach to ESG is similar to many other elements of investing: at its core, it’s about defining goals, designing a strategy, quantifying success, and applying that data to improve the approach.
Setting meaningful targets
With ESG, as with other investments, the first step is to identify the goals of the investment strategy. Unlike many other investments, however, the goals will include exerting a positive influence on the environment or society, and these can be more challenging to quantify.
Investors need to ask themselves a series of questions, starting with “what are the main goals and objectives,” “how can ESG factors support those goals,” and “how can ESG factors impact the investment strategy and its performance”.
The targets that an organisation sets must be clear, time-bound and measurable. For example, a private debt fund may set a goal of reducing its carbon footprint by at least 50% by 2030 to outperform the benchmark with an average 50 basis points year on year.
However, effective targets don’t need to be purely climate focused, and they can integrate other goals. For instance, a fund may aim to improve resource efficiency and productivity by 30% within 2026 by aligning at least 75% of its investments with the UN’s Sustainable Development Goals 8 and 12.
A winning strategy
Once an organisation has set realistic goals, it needs to develop a strategy for achieving them. Specifically, this strategy should take the form of an ESG investment policy that weighs ESG factors across the lifecycle of investment management, from sourcing deals to evaluation, structuring, investing, monitoring and exiting.
One element that is particularly important to consider at this stage is data availability. Even the most ambitious and resourceful asset managers often fail to realise ESG policies because they lack data in the application and monitoring phases.
This is also the appropriate stage in the process for engaging borrowers and crafting ESG covenants. Both positive – such as application of dynamic pricing and decrease in interest rate upon the achievement of ESG objectives – and negative covenants – such as decrease in funding limits or equity conversion for failing to respect ESG factors – are tools to be used.
A final element to consider while developing a strategy is the internal ownership – it’s necessary to ensure a proper project management process takes place. The internal team’s responsibilities should include direct activities and deliverables; managing deadlines; defining external party management; and management of tools that shape the application of the strategy.
There will always be challenges, grey areas and unexpected obstacles when it comes to applying plans in practice. For that reason, it is essential that the plan is reviewed regularly. The two most important factors to consider are progress toward the objectives and compliance with the investment management agreement.
The frequency of this monitoring depends on the specific target, the complexity of reaching it, and the relationship with the borrowers. A monitoring plan should form a part of any agreement, but organisations must also recognise the need for flexibility if circumstances change.
The risk of greenwashing – the misrepresentation of ESG progress to paint an organisation as doing more for good causes than it really is – remains a significant issue for investors. There are several ways for asset managers to maintain an accurate representation of their ESG efforts.
Some groups use an annual questionnaire or regular in-person meetings to gauge the project’s alignment with the investment mandate. Another solution is to develop a framework that makes it easy for stakeholders to challenge the project’s assumptions and communicate transparently – this includes making requests for additional ESG data points to satisfy reporting requirements.
Monitoring tools that allow asset owners to receive detailed investment data and ESG KPIs that prove the application of asset managers policy in alignment with the asset owner’s expectations, can also be used – these are particularly valuable because they can quickly and easily compare all asset managers in the asset owner’s portfolio.
Clients are obviously keen to align their investments with their values and regularity responsibilities and put their money into organisations that have a positive impact on the world. As this trend continues, asset managers must actively work on improving their ESG reporting strategies to avoid accusations of greenwashing or even asset losses – they have to be able to demonstrate increased availability of ESG datapoints. Those that fail to do so will fall behind the competition, while those that create more detailed approaches to ESG reporting will have their choice of business moving forward.