Sustainability has evolved from a niche concern to become a foundational aspect of long-term investing. However, research into sustainability and finance is still in its infancy. As an industry, we need to cut through the rhetoric that obscures the very real sustainability risks we all face.
That means abandoning the race for quick fixes and ever more disclosures and instead refocusing on the critical questions that need to be asked.
This requires independence from commercial interests. We need to zero in on how investors approach sustainability when investing for financial results, and how to invest in a way which delivers the environmental outcomes sought.
Academic research can meet this need. It can be a valuable source of new thinking for targeted investigations into sustainability risks and opportunities, which could yield actionable insights for the investment industry, if their work reflects the practical realities of portfolio management.
There are three areas that new academic research might focus on.
The first is research into how the uncertainty around financial impacts of environmental systemic risks can be assessed at a portfolio level across different asset classes, rather than just equities.
Climate change is an obvious example of such risks, for which quantifying the long-term impact is important but also incredibly complex.
There is broad acknowledgement that conventional analysis, which relies on backward-looking data to inform volatility and risk assumptions, is inappropriate for considering the risks from climate change, which is without historical precedent. This has rightly led to a focus on scenario analysis, whereby multiple possible futures are considered, and analysts seek to generate robust solutions which will perform well under all scenarios. However, the scenarios used (such as those devised by the Network for Greening the Financial System) were not generally created to assess financial risk, and asset managers need help interpreting their use for company and portfolio assessments. Expertise relating to climate scenario models resides in the academic community rather than among asset managers.
The second focus of research could be to explore new methodologies and techniques, perhaps relating to the development and evolution of financial instruments or asset classes. A key area to understand here is which characteristics and attributes would have advantages for professional investors, and for investors looking for new ways to invest that align with their goals.
Third, targeted research into the implications of direct sustainability risks for portfolio construction and integration in sub-asset classes is valuable. Assessment of direct sustainability risks, rather than those that are contingent on certain scenarios unfolding, anchors research into factors that are relevant and drive investment performance today. Such risks are generally readily identifiable, can be quantified and are often investment-specific. Where the investable universe of a portfolio is large, individual instruments respond to a range of factors and risks in different ways depending on the market environment. Research into how direct sustainability risks impact financial performance of different instrument types can support improvements in investment precision and outcomes.
To help develop relevant research in these areas, investment managers could consider concentrating more time on building long-term relationships with higher education institutions, and making sure academics have access to sit alongside and discuss their analysis with investment teams and trading desks.
Ideally, this would be a symbiotic relationship. By immersing themselves in day-to-day investment operations – and by understanding the specific goals, approaches and constraints faced by portfolio managers –academics can potentially identify ways to ensure that their research has real-world applications while portfolio managers can benefit from the rigour in research methodologies developed.
The challenge is that financial research can fail to recognise the complex and sometimes irrational behaviour we experience in financial markets. In particular, the differing interests of stakeholders can play an important role in how investment decisions are made when it comes to sustainability. Data can help to quantify issues to a certain extent, but academic research can help to refine our understanding.
Take, for instance, environmental, social and governance (ESG) ratings: for such ratings to be useful, they should not be used in isolation. Portfolio managers should understand how to interpret and apply the specific ratings, which can differ by provider; the implications of how those characteristics have evolved over time; how they relate to a client’s stated preferences; and their likely impact on investment portfolios.
Investors have a huge amount to gain by better understanding how systemic factors like climate change and the interplay of responses to it might affect different economies, issuers and financial instruments. Such insight could improve the thinking behind and foundations of portfolios in seeking to improve their resilience in the face of these challenges. With a collaborative approach, research could move beyond analysing public data and consider rigorous financial analysis techniques used by portfolio managers to increase the practical applications for them.
Focused research could also help to show whether investment managers’ processes for integrating sustainability considerations are likely to result in meaningful improvements in outcomes for investors. This would also lay the groundwork for future academic input to challenge the status quo and inject fresh ideas into investment practices.
As well as providing practical experience and input to academics, there are other important ways for investment managers to support such research, such as providing funding and recognition to identify where work has been applied, while ensuring freedom of inquiry and keeping academic analysis independent of commercial interests; sharing relevant data with researchers based on their own research and investing experience, and allowing reproducible analysis related to it; and encouraging research that is open to all and publicly available.
Ultimately, it is often said that when it comes to sustainability and solving some of the problems society faces, no-one can do it alone. We believe closer collaboration between the investment industry and academia could help to build a more robust and resilient financial system that benefits all stakeholders – and ensure we better understand how our actions today could influence the investment and environmental outcomes of tomorrow.
