The Role of Engagement in Sustainable Investing

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing

In Brief The AFM believes it is important that investors who wish to invest sustainably have access to reliable information. This includes a realistic view of the role that engagement can play within a sustainable investment strategy: what can and cannot we expect from this instrument? This exploration looks more specifically at how asset managers give shape to their engagement and its effectiveness. We show that science and practice have different perspectives on the concept of effectiveness. We also observe that demonstrating effectiveness is difficult, but this does not mean that engagement cannot be a valuable instrument within a sustainable investment strategy. Four insights are provided that can help in clearly substantiating the value case for engagement. Finally, ten factors are identified that can contribute to the success of engagement. Authors: Mark Teunissen and Gerko Wessel Publication date: June 2025

OCCASIONAL PAPER Table of Contents Introduction 3 Management Summary 4

1. Engagement as an Instrument for Sustainable Investing 7 1.1 Engagement is Part of a Broader Instrumentarium 7 1.2 Different Motivations Exist for Engagement 9 1.3 Engagement Takes Shape in a Network of Actors 9
2. Effectiveness of Engagement 11 2.1 The Scientific Perspective Focuses on Empirical Evidence 11 2.2 The Practical Perspective Reasoning from a Theory-of-Change 13
3. Success Factors for Engagement 15 3.1 Clear Client Ownership from the Asset-Owner is Necessary 16 3.2 Large Shareholding in the Company Creates Legitimacy 16 3.3 Professional Engagement Process Requires Sufficient Capacity and Resources 17 3.4 Knowledge of the Company’s Business Model and ESG Expertise is Required 17 3.5 Coordinated Collaboration Can Increase Effectiveness 17 3.6 Requested Reforms are Focused and Feasible 18 3.7 Quality of Engagement Activities Must Prevail Over Quantity 18 3.8 Credible Threat of Escalation is Essential 19 3.9 Strengthen Engagement by Activating Levers 20 3.10 The Company is Open to Engagement 20 Bibliography 23 Table of Contents

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 3 Introduction An important way for asset managers to give shape to sustainable investing is through so-called ESG engagement. Here, the asset manager uses its position as a shareholder to move companies toward more sustainable behavior. Engagement often serves as an addition to another pillar of a sustainable investment strategy, namely various forms of selection within the investment universe: excluding polluting companies or including sustainable companies. Although sustainable investing often focuses on climate change-related aspects, we use the broad 'ESG' sustainability concept in this exploration, which encompasses environmental (E), social (S), and governance (G) aspects. Reliable information for sustainable investing is an important aspect of the AFM's supervision of sustainability. Investors must have sufficient and reliable information to weigh their ESG preferences. A mismatch between the expectations of sustainable investors and the actual ESG performance of their investments must be prevented. It is therefore important that investors have a realistic image of the role engagement can play in a sustainable investment strategy. The tone in engagement reports by asset managers is that the contribution of engagement to their sustainable investment objectives is generally considered successful. To better assess the value of such claims, there is first a need for more insight into how engagement actually works and what we can and cannot expect from the instrument. This exploration aims to provide insight into the operation of engagement by asset managers, its effectiveness, and the factors that influence the success of ESG engagement. The findings included in this exploration are based on research consisting of an extensive analysis of academic literature on ESG engagement and about twenty interviews. The interviews were conducted with (academic) experts in the field of sustainable investing and ESG engagement, with collaborative partnerships of sustainable investors, and with engagement specialists of asset managers. Guide to Reading This exploration is structured as follows. After the management summary, Chapter 1 introduces engagement in more detail and positions engagement within the broader instrumentarium for sustainable investing. Chapter 2 discusses the effectiveness of engagement and the challenges involved in measuring it. Chapter 3 discusses the factors that can promote the success of engagement.

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 4 Management Summary Effectiveness of Engagement Engagement is an important instrument for asset managers to give shape to their sustainable investment strategy. It requires significant capacity, resources, and people, and is therefore a serious activity for asset managers. Practice and science have different perspectives on the effectiveness of engagement. The empirical-scientific perspective (logically) has a strong focus on the objective measurability of effects. Empirical research indicates a (slight) positive effect on a company's ESG behavior through engagement. For example, there are indications that engagement improves companies' disclosure on climate risks. Engagement also seems to moderately positively influence the management of ESG risks and, through that channel, the financial performance of the company (financial materiality). At the same time, the scientific literature reveals limited empirical evidence for the real-world impact of engagement (impact materiality). The fact that any effects can never be causally attributed to engagement activities makes measuring this intrinsically difficult. The absence of a demonstrable causal relationship implies that caution is needed when claiming positive effects of engagement. Asset managers place less emphasis on this measurability. They adopt a perspective much more often in which they place their efforts within a theory-of-change and derive their effectiveness from that. Within that perspective, success is measured against, for example, committing a company to better information provision on a specific ESG theme or a promise to reach net zero in the long term. Although effectiveness is difficult to demonstrate, it is not inconceivable that engagement contributes to a sustainable investment strategy. Given the measurement problems, demanding hard (empirical) substantiation of effectiveness might set the bar unreasonably high. Engagement can have indirect, longer-term effects that are (for now) difficult to measure and quantify. Specific ESG-promoting measures aimed at, for example, strengthening information provision, governance, or policy are useful, small steps forward and form a push in the right direction. The assumption that they ultimately have real-world impact is not illogical. A careful tone in engagement reports is important so that no unjustified expectations about the (nature of) effectiveness are raised. Many engagement reports open with the expression of the ambition to achieve real-world impact through engagement. Although attribution of this type of impact (i.e., a claim of causality) is avoided, the case studies highlighted by some asset managers and the reported success rates – added together – may well suggest a certain degree of causality. Experts therefore see a risk that such a promotional tone can raise unjustified expectations among investors. Incidentally, the reports are characterized by a variety of approaches and definitions and vary greatly in depth and form. This lack of clarity makes comparability difficult.

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 5 Success Factors Under the Microscope Our analysis shows that prioritizing the quality of engagement efforts over quantity is a prominent success factor. For an asset manager to come to a serious dialogue with the company, deep knowledge of the company's business model is needed and an understanding of how the sustainability transition impacts it. Knowledge is also needed of how the company relates to its peers and of the steps necessary to develop further in the transition (know-what-you-own). This makes engagement a knowledge- and capacity-intensive process. Therefore, it is impossible for an asset manager to engage across the entire portfolio. A key success factor for the quality of engagement is therefore to limit engagement efforts to a select group of companies and focus on a limited number of specific ESG themes. Another success factor is a credible threat of escalation if the engagement efforts do not lead to the desired result. Exclusion is the heaviest form of escalation, but caveats can be attached to this approach. The threat emanating from this seems particularly low for large listed companies. As long as there is sufficient demand for the share and thus other investors will step in, the effect on the company's cost of capital will be limited, and thus the 'pain' minimal. This lack of threat can be an obstacle to the overall effectiveness of the engagement dialogue. Engagement in other asset classes than listed equity is potentially more promising. Examples given are private equity, where the relationship to management is much more direct, and debt financing, where obstacles in refinancing debt perhaps cause more 'real pain'. Engagement can contribute to transition financing, but has a explainable selection bias. As a result, engagement focuses limitedly on true 'laggards' in the transition. In practice, asset managers state that they mainly focus their engagement programs on companies that are motivated to make the sustainability transition and are therefore open to engagement. In theory, this means that the company might take the measures requested by engagement anyway, which could distort the effectiveness of engagement. Because engagement is capacity-intensive, it is nevertheless logical that the focus initially lies on parties that are actually receptive to a dialogue. Because engagement mainly targets companies on the way to 'green', it can be regarded as an instrument that contributes to transition financing. The caveat is that the instrument reaches true laggards in the transition limitedly due to the selection bias. New transparency rules for companies such as the Corporate Sustainability Reporting Directive (CSRD) can support engagement, but asset managers also raise caveats. The CSRD can facilitate engagement because more data on the ESG performance of more companies becomes available; data that is currently only provided by a vanguard of companies. The mandatory standards also provide more comparability and consistency, making it easier to compare ESG performance. This can help in identifying companies for engagement and monitoring companies' ESG progress. Potentially, this also means that asset managers may need to focus their engagement efforts less on improving ESG disclosure in the future and can shift them to other objectives. Nevertheless, asset managers also raise caveats. CSRD compliance requires great effort from companies and this can come at the expense of their capacity to give shape to engagement. To steer the transition via engagement, asset managers also expect to need additional ESG data and an in-depth dialogue with companies in the future – in addition to public reporting.

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 6 Challenges and Opportunities The more negative sentiment around ESG presents challenges for engagement, but also offers opportunities. In the US – and to a lesser extent in Europe – the sentiment regarding the pursuit of sustainability objectives via investment policy has become much more negative. Asset managers state that this 'ESG-backlash' can lead to certain topics no longer being 'engageable' for companies in the US (such as diversity or explicit climate commitments). The engagement approach will therefore have to be more geographically diversified, which is at odds with the aforementioned importance of 'focus' in engagement. The ESG-backlash nevertheless also offers opportunities: a more critical treatment of sustainable investing is ultimately beneficial for asset managers with a convincing, realistic engagement strategy that can actually provide the added value that asset-owners seek in terms of ESG. The more critical attitude toward sustainable investing and the aforementioned complexity regarding demonstrating effectiveness increase the pressure on asset managers to clarify and better substantiate the value case for engagement. This concretely involves making visible the resources deployed for engagement and the manner in which these resources contribute to the objectives sought with engagement. More specific reporting on engagement efforts can help strengthen the insight into the value case for engagement. The exploration yields four insights that could contribute to this: • Make clear how engagement is embedded in the total sustainable investment strategy. This shows, for example, that engagement is consistent with the overarching investment beliefs, choices in the investment universe (selection/exclusion), and the exercise of shareholder voting rights. • Be transparent about the engagement methodology. Think about transparency regarding which theory-of-change is used with which time horizon, how the incremental steps to be taken by the company fit into this, and what the consequences are if the company makes insufficient progress regarding these steps. • Specify the materiality on which engagement activities primarily steer. Is the activity primarily aimed at risk management or (also) real-world impact? • Provide more insight into the nature and quality of the engagement. Who, for example, do you conduct the dialogue with (CEO or investor relations officer?) and what is the degree of involvement in the dialogue (outsourcing to a service provider or active bilateral knowledge exchange?). Finally, engagement benefits from an environment where (price) incentives are better aligned with the sought-after objectives. The institutional environment in which engagement takes place has so far failed to adequately price the actual environmental and social costs of economic activities (externalities). Think here, for example, of consequences for climate and biodiversity. As long as this market failure is not better addressed, important price incentives to make greening (extra) profitable are missing. In this context, maximum effectiveness cannot be expected from engagement. Via field building – a collective term for engagement activities that seek to influence a company's behavior through interaction with stakeholders outside the company – the government can be activated to norm or price these externalities.

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 7

1. Engagement as an Instrument for Sustainable Investing Figure 1.1: Sustainable Investments Can Target Different Asset Classes Source: based on PRI (2019), edited by AFM In this chapter, we place engagement in a broader context. We discuss how engagement fits into the broader instrumentarium for sustainable investing, what the underlying motivations are for engagement, and how it takes shape in practice. 1.1 Engagement is Part of a Broader Instrumentarium Sustainable investing is an investment form where investors weigh both sustainability risks and sustainability impact in their investment choices. This two-sided perspective of investors is captured in the concepts of financial materiality and impact materiality. That is, the influence that sustainability risks have on the value of investment portfolios (financial) and the sustainability influence of the investment portfolios on the environment (impact). Sustainable investments can target different asset classes. These can relate to investments in equity and debt and are executed via public and private markets (Figure 1.1). In this exploration, we zoom in on investments in the equity of listed companies (the sub-market of public equity) and how this specific investment relationship can be used to influence the ESG behavior of the company.

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 8 Within the instrumentarium for sustainable investing, two main categories can be distinguished: ESG incorporation and active ownership. ESG incorporation relates to weighing ESG criteria when assembling an investment portfolio and is therefore also referred to as a pre-investment strategy. Active ownership (also referred to as stewardship) refers to activities where the investor uses shareholding to encourage the company in which they invest to behave more sustainably (Figure 1.2) (PRI, 2021). Traditionally, such active ownership generally focused on improving the financial performance, strategy, and governance of the company. In this exploration, active ownership focused on ESG performance is central. Central within ESG incorporation is the instrument of 'selection and exclusion'. Selection involves choices in including sustainable companies in the investment universe or excluding (for example) polluting companies. In selection, only companies with a certain minimum ESG performance are considered. In exclusion, companies from controversial sectors – such as tobacco, weapons, or sectors with high CO2 emissions – or companies where controversies play a role, are not considered for inclusion in the portfolio at all. Earlier AFM research noted as a caveat regarding the effectiveness of exclusion strategies that exclusion by individual investors rarely seems to lead to financing restrictions for a listed company in practice (AFM, 2022). Figure 1.2: ESG Engagement is Embedded in a Broader Instrumentarium for Sustainable Investing Source: based on PRI (2021), edited by AFM

OCCASIONAL PAPER The Role of Engagement in Sustainable Investing 9 Within active ownership focused on sustainability, engagement is an important instrument. ESG engagement concerns the dialogue that investors conduct with the companies in the equity portfolio with the aim of improving their ESG performance. In engagement, investors do not exclude non-sustainable companies or companies in transition, but rather try to encourage them to become greener from their shareholder relationship. The other instrument within active ownership is the use of voting rights at shareholder meetings. The foundation for active ownership is partly legally anchored and partly based on voluntary commitments, including those recorded in so-called stewardship codes. Engagement encompasses a wide variety of activities and has an escalation hierarchy. The dialogue with companies on ESG-related issues can take many forms, ranging from sending letters to formal consultation with executives. Engagement activities generally contain an escalation hierarchy. Escalation can ultimately result in winding down the share position or even exclusion (see, for example, Bosma et al., 2022). 1.2 Different Motivations Exist for Engagement ESG engagement can be driven by a mix of motivations. Here, the following can be distinguished (based on PRI, 2022): • Financial Materiality. By steering via engagement toward good management of ESG risks, the financial return of the company is safeguarded. • Impact Materiality. By influencing the company's behavior via engagement (such as CO2 reduction or respecting union rights), one can steer toward specific ESG impact. By focusing on reducing the company's CO2 emissions, for example, one can strive for real impact on climate change. • Fiduciary Responsibility. By steering via engagement toward a sustainable, future-proof business model, the long-term value creation of companies is promoted. This is in the interest of the asset-owner, with which the asset manager gives shape to its fiduciary responsibility. • Compliance. Engagement can be compliance-driven in the sense that asset managers must comply with legal frameworks regarding responsible shareholding or wish to comply with voluntary sector initiatives. • Public Opinion. Pressure from customers, politics, and society – whether or not strengthened by media campaigns from, for example, NGOs – can be a reason to pick up or intensify ESG engagement (such as pension participants demanding a more sustainable investment policy from their pension fund). 1.3 Engagement Takes Shape in a Network of Actors Asset-owners can outsource (parts of) their engagement process to asset managers. Especially the larger asset-owners (such as a pension fund or insurer) determine their own sustainable investment policy, including the engagement policy, but the implementation of the policy is often outsourced to other actors such as an asset manager (Figure 1.3). Subsequently, the asset manager again has the choice to outsource the engagement dialogue entirely or partially – for example, only for a specific ESG theme – to an engagement service provider. In some cases, asset managers and/or engagement service providers collaborate.