Every investment manager faces a version of the same fundamental problem: they are not investing their own money. They are acting on behalf of someone else. This is the agency problem, and it shapes everything about how mandates are designed, monitored, and held to account.
The challenge is not unique to investment management. Corporate boards face it too: shareholders own the company, but executives run it day-to-day. Corporate governance has developed a rich set of tools, board oversight, executive pay structures, disclosure requirements, to keep agents accountable to their principals. The investment world has been developing its own equivalent toolkit, and ESG mandates sit at the heart of that effort.
The Agency Problem in Investment Management
When a pension fund or endowment gives its money to a fund manager, their interests don't always align perfectly:
- The Client cares about long-term survival. They are worried about 50-year risks like climate change and regulatory shifts.
- The Fund Manager often faces short-term pressures. They are reviewed quarterly and paid based on short-term returns.
This tension is the agency problem. A manager might prioritize short-term numbers over long-term risk management simply because of how they are evaluated.
The Double-Agency Problem
The investment chain is long. A pension fund manager is an agent for the fund, but the fund itself is an agent for its beneficiaries (the future pensioners). If oversight is weak at any link in the chain, the final portfolio will not serve the beneficiary's true long-term interests.
Think of giving your car to a valet to park for a decade. The valet's incentive is to park it quickly and make it look good right now. Your incentive is for the car to run perfectly when you pick it up in 10 years. Good mandate design is the strict instruction manual and payment structure that forces the valet to care about the long term.
Two principles from corporate governance translate directly into investment mandate design:
Alignment, the structure of the relationship (fees, performance assessment, timeframes) should mirror the client's actual needs and time horizon.
Accountability, the manager should respond to the client's clearly expressed intentions and report against them fully and honestly.
Good mandate design delivers both. But it starts long before any document is signed, it starts with the client understanding what they actually want.
Clarifying Client Needs: Defining the ESG Investment Strategy
Before an asset owner can hire a manager, they need clear investment beliefs. This is a core philosophy about how value is created and risks are managed over the long term.
Beliefs answer foundational questions:
- Is ESG primarily a risk management tool, or a source of alpha?
- Which specific ESG factors (e.g., climate, board diversity) matter most to us?
- Does active engagement actually change company behavior?
Investment goals vs. Investment beliefs A goal is what you want (e.g., "5% return"). A belief is how you think markets work to get you there (e.g., "companies that manage climate risk will outperform"). Without firm beliefs, you cannot design a good ESG mandate.
Example, Institutional investment beliefs in practice:
CalPERS, the California public pension fund, publishes its investment beliefs publicly. One of them states that long-term value creation requires effective management of ESG risk factors. Another affirms that a long-time-horizon investor has an obligation to engage on systemic risk, because diversified portfolios cannot simply escape macro-level threats by switching holdings.
Norges Bank Investment Management (the Norwegian Government Pension Fund Global) similarly publishes its expectations documents, setting out, sector by sector, what governance and sustainability behaviour it expects from companies it invests in. These beliefs are not abstract. They flow directly into engagement strategies, voting decisions, and the framing of manager mandates.
These beliefs are often codified in a Statement of Investment Principles (SIP), a governing document that sets out the institution's overall investment approach, including its stance on ESG factors. In many jurisdictions, such statements are now a regulatory requirement rather than merely good practice.
Fiduciary Duty and ESG: An Evolving Understanding
For decades, some institutions hesitated to integrate ESG factors because they feared it would breach their fiduciary duty to maximise financial returns. That view has been decisively overturned.
The Freshfields Report (2005), commissioned by the United Nations Environment Programme Finance Initiative, found that integrating ESG considerations into investment analysis is permissible, and in some cases required, under fiduciary duty. A decade later, the PRI's "Fiduciary Duty in the 21st Century" (2015) went further: failing to consider material ESG risks is itself a breach of fiduciary duty, not a fulfilment of it.
The logic is simple. If an ESG factor is material to long-term financial performance, and many are, then ignoring it is not financial prudence; it is financial negligence.
The Two Foundational Questions
When building an ESG investment philosophy, two questions frame everything that follows. The first is whether ESG is primarily about managing risk or capturing opportunity. The answer shapes the mandate entirely:
- A risk management focus leads to strategies that identify and exclude or underweight companies and sectors seen as ESG-risky. The emphasis is on downside protection.
- An opportunity focus leads to strategies that overweight companies or sectors where ESG factors are expected to drive superior long-term financial performance.
Many mandates seek to do both, but the relative emphasis matters enormously for portfolio construction and manager selection.
The second question is which ESG factors are most material. Materiality varies by asset class, sector, and geography. Governance factors tend to dominate in private equity (where ownership is concentrated and regulatory oversight thinner). Climate risk is most pressing in fossil fuel extraction and real estate. Supply chain labour standards are most relevant in consumer goods. The investment portfolio's specific exposures determine which ESG factors deserve the most attention.
Example, Two institutions, two different belief sets:
A pension fund with strong climate-related beliefs might determine that: (1) physical and transition climate risks are material to long-term returns; (2) engagement with high-emitting companies is a preferred tool; and (3) sovereign bond mandates should consider countries' climate vulnerability. These beliefs would flow through into every mandate it awards.
A charitable foundation with a mission focused on human rights might instead prioritise: (1) exclusions for companies with significant human rights allegations; (2) geographic exclusions for markets with deteriorating labour standards; and (3) engagement focused specifically on supply chain due diligence. Same broad framework, very different practical implications.
Fully Aligning Investment with Client ESG Beliefs
Once a client has clarity on their own beliefs, the real challenge begins: translating those beliefs into mandates that fund managers can actually act on.
The beliefs need to be operationalised, turned from philosophical positions into investable parameters. The ICGN Model Mandate Initiative identifies four core areas where this operationalisation needs to occur:
- Monitoring and use of ESG factors, how the manager is expected to track and incorporate ESG data in investment decisions.
- Integration into the investment decision-making process, the mechanism by which ESG considerations influence stock selection, weighting, and portfolio construction.
- Adherence to good stewardship practice, expectations around engagement with investee companies and issuers.
- Voting and reporting requirements, how the manager votes at shareholder meetings and how it communicates all of this back to the client.
The PRI has articulated what this means in practice. Mandates should require fund managers to:
- Implement the asset owner's investment beliefs and relevant investment policies.
- Integrate ESG issues into their investment research, analysis, and decision-making processes.
- Invest in a manner consistent with the asset owner's time horizons, understanding the key risks to be managed.
- Implement effective stewardship processes, including engagement with companies on ESG issues and, for listed equities, voting all shareholdings.
- Report on actions taken and outcomes achieved, enabling the asset owner to assess how investment beliefs and policies have been implemented in practice.
The Six Dimensions of ESG Belief Operationalisation
The PRI Asset Owner Implementation Framework identifies six dimensions across which leading institutions operationalise their ESG beliefs. Together, these form a practical checklist for any asset owner designing a comprehensive ESG programme:
| Dimension | What it covers |
|---|---|
| Investment beliefs | The institution's written philosophy on how ESG factors affect risk and return over relevant time horizons |
| Governance and policy | Board-level oversight of ESG strategy; responsible investment policies that guide day-to-day decisions |
| Targets | Specific, measurable objectives, e.g., net-zero portfolio by 2050, or minimum ESG score thresholds across mandates |
| Strategy | How ESG beliefs are translated into asset allocation, manager selection, and mandate design across all asset classes |
| Engagement / stewardship | The institution's own direct engagement priorities, and expectations placed on managers for stewardship delivery |
| Reporting | How the institution discloses its ESG approach and outcomes to beneficiaries, regulators, and the public |
The mandate is not just a legal agreement, it is a communication device. A well-crafted mandate tells the fund manager precisely what the asset owner cares about, how success will be measured, and what accountability looks like. Vague mandates produce vague delivery.
Strategic and Tactical Implications
A client's ESG beliefs will also shape their strategic asset allocation (SAA), the long-term mix of asset classes and geographies. A client deeply concerned about climate change may structurally underweight fossil fuel-exposed sectors. One focused on human rights may limit exposure to certain sovereign markets. These beliefs filter down from strategic level into each individual mandate awarded.
Not all ESG expectations make it into the formal legal mandate. Some clients communicate their specific ESG requirements through side letters, ancillary documents that sit alongside the formal investment management agreement and carry contractual weight. Side letters allow clients to add tailored requirements without renegotiating the core mandate terms. They can specify exclusion lists, engagement priorities, reporting formats, or timeframe expectations. For ESG purposes, this flexibility is valuable: a client may want to require a manager to consider specific exclusions that are unique to their beneficiary base, without that becoming a standard term that applies to all the manager's clients. The practical effect is the same as a mandate clause, the manager is contractually bound to deliver it.
Key Takeaways
- 1The agency problem in investment management creates tension between clients focused on long-term risks like climate change and managers evaluated on short-term quarterly performance - good mandate design forces alignment
- 2Investment beliefs are distinct from investment goals: a goal is what you want (5% return), a belief is how you think markets work to get you there (companies managing climate risk will outperform) - without firm beliefs, you cannot design a good ESG mandate
- 3The Freshfields Report (2005) and PRI Fiduciary Duty report (2015) established that failing to consider material ESG risks is itself a breach of fiduciary duty, not a fulfilment of it
- 4The PRI Asset Owner Implementation Framework covers six dimensions: investment beliefs, governance and policy, targets, strategy, engagement/stewardship, and reporting - together forming a practical checklist for comprehensive ESG programme design
- 5A client's ESG beliefs shape strategic asset allocation directly - climate concerns may drive structural underweighting of fossil fuel sectors, while human rights focus may limit exposure to certain sovereign markets
- 6Side letters allow clients to add tailored ESG requirements alongside the formal mandate without renegotiating core terms, specifying exclusion lists, engagement priorities, or reporting formats with full contractual weight