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Twenty years ago, FTSE introduced a new kind of equity index amidst considerable public scepticism. The FTSE4Good index series, launched in 2001, used transparent metrics of ESG performance to select its constituents, incentivising companies to improve their sustainability practices. RIAA speaks to FTSE Russell’s Helena Fung, Head of Sustainable Investment, APAC about the evolution of the sustainability index.

 

Having created FTSE4Good 20 years ago, it’s seen considerable changes over its life. What are some of the most significant improvements that have been made to this index to date?

 

At the time FTSE launched this best-in-class index, many investment professionals still considered ESG issues as irrelevant, and at worst as detrimental to returns.

 

Two decades later the capital markets and investment approaches have changed beyond recognition. Financial institutions around the world—including sovereign wealth funds, pension funds, insurance companies, asset managers and banks—now incorporate sustainability into their philosophy and processes as matter of course.

 

We have gone on to develop indexes specific to many Asian markets, partnering with clients and exchanges, with the aim of improving standards within those countries, and demonstrating that passive investing can be a real lever for change. To name one, we launched the FTSE Blossom Japan Index in 2017 with an industry neutral approach, but maintaining the FTSE4Good criteria. The index became part of GPIF’s ground-breaking ESG integration to passive investing.

 

We may review the methodology of the ESG ratings and data model to reflect the increasing urgency of individual sustainability issues. For example, in July 2020, FTSE Russell issued a market consultation on whether to revise its climate standards for the FTSE4Good index series, in recognition of the growing importance of climate considerations in ESG indexes.

 

The key proposals were to enhance the climate change theme score within ESG ratings, and to introduce minimum climate change score thresholds in the FTSE4Good index series inclusion rules. The respondents to the consultation were overwhelmingly supportive of these proposed enhancements.

 

We use Transition Pathway Initiative’s (TPI) methodology for analysing the climate performance of listed companies in order to determine the climate change score. At the FTSE4Good June 2021 semi-annual index review, we identified 208 existing constituents of the FTSE4Good All World index (or over 10% of the index by constituent count) that failed to meet the new climate performance standards at this date. The companies were notified and given 12 months to improve their climate performance to above the minimum threshold.

 

How important is standardisation of ESG ratings and other ESG metrics today?

 

If we first look at the demand from investors, we still see clear data challenges in the objectivity, disclosure and alignments of corporate ESG practices. We learned when surveying global asset owners last year, that the lack of standardisation in ESG data, scores and ratings is the most commonly cited barrier to increased sustainable investment adoption (59%). Almost half (45%) of respondents express concern about the quality or consistency of corporate reporting and disclosures while 42% are concerned about availability of ESG data and the use of estimated data.

 

Whilst investor objectives for integrating ESG can vary, broadly speaking sustainable investment is as much about the investment case both for downside protection and as a means of providing unique insights, as it is about reflecting values. From that perspective, I would argue that having diversity in terms of the way that ratings companies are approaching ESG is merited and not unwelcome. For some investors, the overall score could be important, for others it could be looking at the granular data and that’s fine. When investors are integrating ESG, some have the expertise and resource to look in depth at the data, others use the score as a starting point. To assist with this type of analysis, it could be argued that transparency in metrics is more important than standardisation, in informing investment decisions.

 

 

Why have sustainability indexes become so popular among asset managers?

 

The popularity of sustainability indexes is reflective of a number of concurrent trends amongst investors across the spectrum of capital markets participants, including asset managers. ESG benchmarks offer a comprehensive solution for investors seeking to integrate sustainability themes in a clear, consistent and transparent way. In addition, sustainability parameters which can be constructed to meet specific client and market needs. We also see an increasing trend towards fund managers using sustainable investment indexes as an input to investment selection as well as for reporting purposes.  From a mandate perspective, we are starting to see a clear shift towards investors replacing or complementing traditional versions of key benchmarks with sustainable investment alternatives.

 

Ultimately the desire to adopt and to offer a greater range of ESG and sustainable investment products is driven by demand from the owners of capital, whether pension fund members and beneficiaries, or as a response to policy makers or from Sovereign Wealth Funds seeking to protect investments from the impact of climate and other risks. At the same time, with the advent of Smart Beta, thematic factor-based strategies, markets have seen a shift towards passive investing as reflection of market returns and the relative cost and flexibility of investing in indexed vehicles such as ETFs. We are also seeing greater adoption of sustainable investment benchmarks across the financial markets ecosystem, for example as the basis for derivatives products. Overall this presents a clear indication of the mainstreaming of ESG and a reflection that investors view sustainability indexes as a critical part of their investments and want to ensure that this is.

 

 

Are you seeing a shift in the issues and themes that investors find important? What will be some of the major themes in 2022?

 

The COVID-19 pandemic has tended towards underscoring the impact of particular ESG issues, particularly climate change and environmental issues. Market disruptions that accompanied the pandemic provided insights into how unexpected non-financial events might materially change market forces and the value of particular asset classes and sectors. Climate change is perhaps the most urgent of these and there is now considerable analysis regarding the potential impact of a disorderly transition on capital markets. Low carbon and climate strategies have therefore been front of mind for investors regarding how they manage sustainability risks in portfolios. At the same time, the transition to a low carbon economy brings opportunities that investors want to have exposure to as well as orienting capital toward those companies that are better managing the transition.

 

Whilst we see this trend continuing, we also anticipate a broadening out to other sustainability issues such as biodiversity and gender diversity. Biodiversity risks in particular have the impact to significantly impact GDP in many economies and is intrinsically linked to the revenues of companies in a number of sectors such as agriculture, tourism, food and farming. The revaluation of natural capital as a key part of the solution to combatting climate change may also place an emphasis on the way assets are valued and present new investment opportunities.

 

Going back to the findings from our asset owner survey in 2021, for active public equity strategies, a large majority (74%) of asset owners that have implemented sustainable investment are following a broad integration approach. For active fixed income allocations, 57% are broadly integrating sustainable investment. In passive strategies, the most popular approach when allocating to public equity is through shareholder engagement and voting (40%) followed by negative screens (37%).

 

 

As Head of Sustainable Investment, Asia Pacific, Helena Fung is responsible for FTSE Russell’s Sustainable Investment indexes, data and analytics solutions across the Asia Pacific region. A core part of her role is client engagement on a comprehensive range of products and data to support them in reaching their investment decisions. Working with research and leadership teams, she has a responsibility for developing FTSE Russell’s Asia Pacific Sustainable Investment product strategy and expansion.