ESG investing for family offices: Measurement and monitoring

While the COVID-19 pandemic has brought on severe economic and social crises, it has also led to a watershed moment for Environmental, Social, and Governance (ESG) investing. During a period of such uncertainty, investors have shown confidence in investments with purpose, putting in the same amount of cash into ESG funds in Q1 2021 as they did in 2019 over the entire year, according to CNBC’s ETF Edge. Crucially, this turning point requires firms to develop the ability to effectively measure and monitor ESG issues, to avoid falling behind.

Defining a ‘good outcome’

For family offices, as with all investors, measurement of ESG impact begins with them defining what a ‘good outcome’ is. While setting financial return targets for investments may be a simple exercise, defining impact objectives can be personal, subjective, and not as easy as excluding investments in sectors perceived to be ‘brown’, those that damage our planet and contribute to the climate challenge. Frameworks aim to provide thinking points to which the family office can align their intentions. However, the seemingly vast array of different frameworks emerging and broad taxonomy can often be a source of confusion, with calls for the need of commonly accepted metrics. Recognising that there is a spectrum of different ESG strategies (from exclusionary screening to impact investing and active ownership) is also a key part of the challenge in setting ESG goals.

Several organisations have sought to address this lack of consensus. The Impact Management Project - made up of many of the most prominent principles, guidance, and standard-setters - has convened a forum of investors to agree on the measurement and management of ESG risks, suggesting five dimensions of performance to be assessed and reported. The International Finance Corporation (IFC) has also developed an operational framework which aims to assess impact of development projects. And becoming a signatory to the PRI, for example, provides guiding principles on ESG integration and encourages formal policy documentation. When considering the impact of an entity itself, this can be quantified through ESG scoring methodology and certifications such as B Corp.

These resources can all help to frame an ESG strategy and inform the definition of a ‘good outcome’. However, although adopting a single common standard eases comparability and verifiability, a common sense approach should be considered and tailored to the investor and what they are aiming to achieve. This is not to say ESG goals should be cherry-picked, since there can be complex feedback cycles in ESG issues often resulting in unintended consequences. For example, reducing plastic usage may mean the alternative is using recyclable aluminium or glass which can have a larger carbon footprint in its transportation. But rather, developing an ESG strategy that is right for you should make good business sense and originate from a clear and well-informed mission and purpose, beyond solely compliance with regulation.

Monitoring ESG performance

Once a ‘good outcome’ has been defined, progress against these targets must be measured and monitored and evaluated on an ongoing basis. This monitoring allows the family office to better understand the operations of its investments and gain assurance that it is fulfilling its ESG practices. From a private equity perspective, for example, investors are entitled to monitor whether ESG management is taking place within portfolio companies (and are well within their rights to ask the Fund Managers to provide evidence in support of this) and set expectations around future capital allocations. This in turn protects and enhances the investment value and also strengthens the reputation of the manager in the eyes of investors.

Measuring the results and reporting the outcome

However, ESG impact cannot be monitored if the underlying data is missing, or indeed incorrectly sourced. From a climate perspective, for example, existing tools to quantify the risk and return impact of climate-related factors often lack global coverage, are only suited to certain asset classes, and lack the transparency to enable investors to trust them. The good news is that these challenges are being recognised. The Open Source Climate initiative aims to create an open source ‘data commons’ making information on companies’ environmental performance easily accessible to anyone. There is certainly vision and intent from reporting standard-setters too. The EU’s Sustainable Finance Disclosure Regulation has a number of reporting obligations going live in 2021 for example, which will be an important step in enhancing disclosures around ESG credentials.

Pressure is undeniably mounting from stakeholders over ESG transparency, however the gap between demand for reporting and supply (both regulatory and voluntary) is beginning to narrow. This supply must not fall foul of greenwashing; with interest in ESG investments at an all-time high, it is inevitable that some will try to abuse this. Independent assurance over ESG reporting and underlying processes can be a valuable way of tackling this problem - the PRI states that external assurance of ESG information provides ‘the highest form of confidence that the reported information is reliable and relevant’. After all, where else is self-policing accepted as sufficient proof that an exercise of great importance has been conducted in good faith?

Ultimately, an ESG measurement framework and ongoing monitoring contributes to the development of a deep understanding of the business model of an investment. It is a risk management tool that can often lead to the avoidance of risk from badly run companies. Consider heavily publicised corporate scandals over data breaches, emissions or environmental disasters which may have had different outcomes with greater monitoring of their ‘E’, ‘S’ and ‘G’ claims. It is clear that the family office needs to look beyond the annual report when making investment decisions and understanding how they contribute to the ‘good outcome’ that they desire from their portfolio.

Our next blog will consider the questions that family offices should be asking of their external managers to help achieve this outcome. In the meantime, please get in touch with the authors if you have any questions on ESG and family offices.