By Hamlin Lovell, NordicInvestor

This interview is part of our upcoming report on ESG in the Nordics

NordicInvestor interviewed Lingyi Lu, Head of Sustainability at Söderberg and Partners AB, who is also a board member at Sweden’s Sustainable Investment Forum (Swesif). Söderberg’s ratings are sometimes controversial and asset managers with a “red” rating do not always agree with it, because Söderberg’s opinion of best practices in areas such as engagement can be different from the approach pursued by some asset owners and asset managers. .  

Söderberg oversees around oversees more than 500 billion SEK of assets, across internal, external and advisory mandates, spread over equities, fixed income and alternatives.  

Söderberg considers E, S and G together, on an integrated basis, measuring the sustainability of portfolios and funds. A rating system, split into green, yellow and red, is mainly based on data from OM ratings. (Analysis for SFDR and PAI reporting is more for compliance purposes).“All portfolio mandates that we offer have minimum thresholds of sustainability. The thresholds for the sustainable mandates chosen by clients explicitly prioritising sustainability, are higher,” says Lu.  

Asset managers and allocators should do their own ESG research to fill data gaps  

The analysis applies across all asset classes and instruments, including passive indices and derivatives. “We look at the process of sustainable integration, active ownership and engagement. ESG is probably easier to integrate for a Swedish equity fund, because Swedish companies report more data. If hedge funds or private equity funds invest in companies that are not reporting ESG metrics, then the asset managers need to do more work or source the data from third parties. If the asset managers are not prepared to do this, they will not receive the highest rating,” says Lu. Söderberg itself uses a Morningstar database that includes company data from Sustainalytics, and has also built its own database of how funds work with sustainability.    

Trade offs between ESG aspirations and portfolio diversification   

Environmental SDGs prioritised by clients are mainly climate change, but sometimes also biodiversity. On the social side, gender equality can be a common objective for Nordic clients. Thematic portfolios are a growing area including climate themes. “Sustainable literacy amongst clients is growing and the market needs to reflect that. We have therefore created sustainable climate portfolio mandates, but we would not recommend investing 100% into them as this would not be diversified enough. Longer lists of excluded companies, funds, and asset managers, may reduce investors’ portfolio diversification,” says Lu.   

 Growing exclusion lists   

Sustainable and customised mandates may have exclusions. Exclusion lists are growing longer, partly due to stricter criteria for existing categories, but also because more categories are being excluded. Historically, ethical funds would exclude weapons, tobacco, alcohol, pornography and gambling. Then to align with the Paris agreement, the Swedish Church added fossil fuels, and thresholds for percentages of revenues have been going down, which results in more excluded companies. Of course, there are companies that are transitioning their businesses to meet the climate targets and can thus be added to the investable universe. However, clients who want a sustainable product will not be happy with a best-in-class approach identifying the least unsustainable oil companies are included, because they want to exclude the sector based on their values,” points out Lu.   

 Slow adoption of ESG benchmarks   

So far very few Söderberg clients are using Paris-aligned or other transition benchmarks, though some funds in Sweden are using them. “Sustainable benchmarks are of secondary interest to clients, the real question is whether sustainability enhances financial performance, and they would compare it to a traditional portfolio. We expect that it does because sustainable companies are more likely to succeed in the long-term and will be more resilient to shocks. The latter is something we’ve already seen during the 2021’s pandemic ,” argues Lu.  

How to define transition?   

Client preferences vary. “Exclusions can make organisations feel safe about fiduciary duty. There is also growing interest in transition, but this is more difficult to explain. For instance, policies may specify transition companies but try to avoid fossil fuel companies due to headline risk from the media,” says Lu.   

Differences between retail and institutional clients around exclusions and thematics  

“Retail clients might choose a sustainable product because they believe that the strategy will contribute either to sustainability or to financial performance, or both. Still, many retail clients might seek exclusions and they do it for emotional reasons that do not always make sense if they do want to make a difference through their investment. The better alternative could be thematic strategies that invest directly to solution companies and projects, such as wind farms and green construction. On the other hand, institutional clients are more interested in exclusions and best-in-class because of their fiduciary duties. Exclusions offers shelter against head-lines and best-in-class diversification of investments,” says Lu.  

Direct and personal engagement is preferable to indirect, anonymous engagement  

Philosophically Söderberg’s approach emphasises engagement to create value from sustainability and financial perspectives. Many asset owners and asset managers in the Nordics might engage directly with local companies, but tend to engage collaboratively via third parties, in relation to global companies. ”Engagement can include collaborating with firms such as Sustainalytics, which will voice concerns without attributing them to specific investors. We do not think engagement should take place anonymously: fund managers should talk to the CEO in the same way in which quarterly performance is reviewed,” argues Lu.  

Climate and carbon targets, metrics and reporting: data quality issues  

Setting carbon targets for carbon neutrality has been a slow process. ”The most proactive institutional clients are setting them, usually based on some globally recognized framework. Asset owners have moved faster than asset managers and are driving the market forward. The most common reporting standards and initiatives to engage in are TCFD, PRI, Transition Pathway Initiative and UN Net Zero Alliance”.   

 Typical climate reporting includes carbon footprints; positive impact according to the SDGs; negative impact via principal adverse impact (PAI) according to SFDR, and climate Value at Risk (VaR).“Managers are more interested in climate Value at Risk (VaR) metrics than clients, who select products more based on their added value to sustainability ,” says Lu.   

 But data quality is variable. There are data gaps and there are different opinions about some data items. “Most asset managers use one provider and complement it with in-house data, in areas such as smaller companies, non-listed companies and emerging markets. We expect that some asset managers will scale up their own data and may become less reliant on agencies. Raw data may be sourced externally, though some asset managers have built their own models. Aggregation and measures such as climate VAR may take place in house,” says Lu.  

Environmental concerns are broadening out. “Beyond climate, the Task Force on Natural Financial disclosure reporting standards, which consider biodiversity risks as well as climate change, will become more common after the SFDR has calmed down”  

EU Taxonomy: narrow; social metrics subjective and differences between countries  

Söderberg shares the widely held concern that the taxonomy in its current form could be too narrow.  The taxonomy could create bubble risks, as it is rather narrowly limited to some sectors and issues,” says Lu. The taxonomy will over time become broader in at least two ways: the technical standards  will be expanded to cover more environmental issues, and EU is beginning to look at a social taxonomy.  ”There is a need for a social taxonomy but this will be very difficult because social sustainability metrics are less defined, parameters are more difficult to measure and more subjective to the societal norm. For example, what is the right pay-gap between top-management and regular employees, or is there a “correct” way to divide parental leave?.” 

The EU taxonomy is at an early stage, but there are already some difficulties emerging. “For example implementation of the Energy Performance Certificate (EPC) directive for buildings differ with EU, but the Taxonomy applies to all EPC Class A buildings regardless of the underlying criteria for obtaining the certificate,” says Lu. 

SFDR: just one extra parameter to consider for sustainable and impact investing 

For now, Söderberg expects to be offering funds in all three SFDR categories, however only funds that contribute to sustainability or have sustainable investment as their goal (Article 8 and 9 products) are recommended to clients. “The SFDR has not changed our fund selection or rating process. This is because the SFDR covers ESG-integration strategy, a parameter that is already part of our sustainability rating. Today we do offer some article 6 products but these products will not be selected into our portfolios. As the supply of sustainable funds grows, we will set even higher bars,” says Lu.   

However, the bar will not be based only on SFDR categories, because article 8 may be too broad, and not all sustainable funds will meet the article 9 criteria. “There are currently a broad variety in the interpretation of the requirements for Article 8, creating a group of products with different sustainability strategies and criteria. A product categorised as Article 8 could be only applying exclusions without any positive selection or engagement components at all. Article 9 is clearly defined with a high bar, though engagement is never a factor considered in the Article 9 classification, meaning that one of the most effective strategies managers can use to enhance their investee companies’ sustainability levels is disregarded” says Lu. 

One challenge will be explaining and articulating what the SFDR disclosures mean in a manner that is comprehensible and digestible for the end investors.  “The SFDR will lead to more data and information, but this may not be easy for retail investors to understand. As financial advisors, a part of our task going forward is to translate this information to clients,” Lu concludes.