Substantial and sustained flows into Responsible Investment (RI) strategies in recent years are commanding the attention of company boards and their key stakeholders.
But what does RI mean in terms of investment process? And how do you ensure that your savings are invested in line with your values?
Understandably, investors might see Ethical, Responsible or ESG (Environmental, Social, Governance) branding and assume that the fund is only investing in sustainable activities.
They can be left disappointed when they look at what their portfolios contain. The Wall Street Journal reported in 2019 that eight of the ten most significant US ‘sustainable’ funds invest in oil and gas companies which are regularly criticised for their environmental records and practices.
This potential for confusion and disappointment stems from the differing ways in which investors and investment managers define key terms and understand the obligations of investment managers to investors and other stakeholders.
Research house Lonsec, in their 2019 Responsible Investment (RI) Sector Report, summarised these differences.
“For the institutional investment manager ESG means that you consider and value the ESG risks that firms are taking and buy stocks if you consider that you are getting a big enough monetary payoff for the risks they pose to the firm the manager is considering for investment.
For most investors, and the general public, ESG means that you consider and understand the ESG risks that firms are taking, and you don’t buy stocks if you consider the risks to yourself, your community, the planet or to society are bigger than a certain threshold.
This is a clear difference in perspective, especially as the latter considers the aggregation of E, S and G risks across society where the former, with its focus at the company or investment level, doesn’t.”
“Responsible Investment (RI) Sector Report 2019” – Lonsec, 20 January 2020
This implies that for many investment managers in the RI sector, ESG risks are just another input in the valuation model. The sole focus is on investor return, rather than investing with investors and community impact in mind. A coal miner with a poor environmental and workplace safety record is investable, so long as the expected returns are high enough for the given risks, including ESG risks.
It is worth noting that a portfolio may never address all RI concerns. There is a level of scrutiny where all investments appear to be inappropriate. For example, most use fossil fuels for transport or single-use plastics in their operations, even if they are working to reduce this.
How do investors view RI?
Investors are increasingly concerned with how their investments contribute to, or detract from, society and the environment.
From the perspective of responsible investors, how the companies in which they invest generate profits, and the effect this has on society and the planet, needs consideration alongside (or ahead of) expected returns.
It is a desire to consider the external impact of their investments, whether that is the effect of fossil fuel extraction on the amount of carbon in the atmosphere or the public health impact of manufacturing sugary drinks.
In terms of flows into RI strategies, there have been two major bumps in the United States. One after the financial crisis in 2008, and perhaps surprisingly another after the election of US President Donald Trump in 2016.
The next bump will likely be thanks to millennials as they become wealthier and direct a more significant share of capital, although their impact is already felt in public discourse and the decisions they make as consumers.
Increasingly, there is an understanding or hope that government ignorance and inaction is almost irrelevant, as the real power to effect change lies in the hands of the corporate world and its stakeholders. For example, according to “The Ipsos Climate Change Report 2018”, the majority (79%) of Australians believe that human actions have at least partly caused climate change.
These results indicate that stakeholders e.g. customers and staff are supportive of the corporate world taking action.
Source: Deloitte Global Millennial Survey 2019
How are Corporates responding to the focus on RI?
The current debate in Australia around new coal mines and coal-fired power stations provides some insight into the corporate world’s reaction.
Large corporates are awake to the reality that investment in coal, on the debt or equity side, is not an attractive long-term proposition. Whether they believe scientists or not, they are indeed listening to economists.
The RBA and Bank for International Settlements (BIS), amongst others, have warned of the dangers of committing capital to long term projects like coal mines and power stations. They have gone so far as to suggest that refinancing risk and bad loans to the coal industry could spark the next financial crisis.
While they may still be the result of a belief in shareholder primacy, given the desire to minimise reputation risk and avoid enormous future losses, some examples of the corporate world adopting more sustainable policies include:
- ANZ plan to shed more than AUD 700M in loans to the thermal coal industry within the next four years, a reduction of 75% that brings them into line with NAB and CBA.
- Goldman Sachs has ruled out any future thermal coal-related financing, whether for new mines or coal-fired power stations.
- Rio Tinto’s chair declared in 2018 that climate change was “the greatest long-term threat” to the mining company. It has undertaken divestment from fossil fuels, and approximately 75% of the energy it uses comes from renewable sources.
Australia is one of the world’s biggest coal exporters, shipping about $30bn of thermal coal a year (and the same again in coking coal, used for making steel). However, it also has a strong presence in renewable energy and sustainable finance, for which there is a bright future. Wind and solar costs have already become the cheapest new form of electricity generation.
Sustainable finance gives companies focusing on sustainability at the corporate or project level a clear way to access capital earmarked for responsible investment.
As well as equity, ‘green bonds’ issued by companies are reviewed by investment managers for inclusion in RI portfolios. Example of green bonds issued by companies at the corporate or project level include:
- Green use of proceeds bonds are used to finance a specific asset or project. For example, an oil and gas company may issue a use-of-proceed bond to finance the building of a renewable power plant. Companies can only use the funds raised through this bond for this purpose.
- Green general-purpose corporate bonds are used when a company wants to finance a more comprehensive sustainability strategy at the corporate level. For example, investors may look at a company’s ESG score, though the company may also develop its own theory of impact, with associated measures attached.
- Green mortgage-backed bonds pool together residential mortgages based on sustainability metrics.
- Green asset-backed bonds pool together assets other than mortgages, such as receivables, that issuers base on sustainability metrics.
- Sustainability loans are bilateral or syndicated loan facilities with key sustainability targets. Issuers can base this on third party ESG scores or corporate objectives, such as transitioning the business to use more than 50% renewable energy.
The way that these equity and debt securities are analysed for inclusion in your RI strategy differs greatly by investment manager and mandate.
How are RI principles incorporated into RI mandates?
Whether they like it or not, investment managers and their consultants are scrambling to understand the implications of an increasing emphasis on RI for capital markets and their portfolios.
The pressure for change is growing. According to the Global Sustainable Investment Alliance, in 2018 investment managers in the United States reported that they applied climate-related restrictions to USD 3 trillion in assets, tobacco-related restrictions to USD 2.9 trillion, weapons-related restrictions to USD 1.9 trillion and alcohol-related restrictions to USD 1.5 trillion. Just recently Blackrock, the world’s largest investment house, announced it is drastically reducing the exposure of client portfolios to thermal coal.
It is having an effect. A growing number of companies in industries that typically raise red flags with ESG investment managers are taking actions to improve their image and business prospects by shifting towards less-harmful products and addressing corporate governance issues.
Norway’s sovereign wealth fund, the world’s largest with investment assets above USD 1 trillion, reported in June 2019 that they were removing a host of large multinationals from their investment blacklist. Norges Bank, which manages the fund, said that its council of ethics decided that Walmart, Rio Tinto, General Dynamics, Nutrien and Carlos Slim’s Grupo Carso had sufficiently changed their ways to warrant an investment.
We would note that General Dynamics still makes weapons, a corporate purpose that would likely not align with the intentions of most responsible investors.
In the absence of a specific impact or socially responsible mandate, discussed below, the typical feedback from investment managers is they have a fiduciary duty to the underlying investor and cannot invest at a premium for something with the same expected return or credit risk, even though it may have positive social and environmental outcomes. That is, the decision is purely about expected risk-adjusted returns, as highlighted by Lonsec earlier.
Cognisant of this responsibility, the UN Principles for Responsible Investment (PRI) has evolved the traditional risk-return matrix to have a ‘third dimension’ of real-world impact.
Source: UN Principles for Responsible Investment
Investment managers that are signatories to the UN PRI are encouraged to use this model to select investments with the highest impact, given similar risk-adjusted returns.
What are the different types of RI mandate?
Lonsec categorises Responsible Investment mandates into four different approaches:
- Ethical: Negative screening of companies in certain industries deemed to have a harmful societal impact. Avoiding investments in bad companies is the overarching investment motivation.
- Socially Responsible Investing (SRI): Generally negative screening of certain sectors in line with above but may also include a positive screening element seeking to include socially responsible companies. Rewarding good corporate citizens is a partial investment motivation.
- ESG investment approaches: A belief that those companies with advanced approaches to ESG risk management will exhibit superior performance than companies with sub-optimal approaches. While it is likely that these companies will tend to rank highly on corporate ethics, unlike ethical investment, financial performance is the overarching investment consideration. This segment has seen the greatest uptake in recent years.
- Impact investing: Targeted investment in vehicles such as companies, securities, organisations, or funds with the intention to generate a measurable, beneficial social or environmental impact alongside a financial return.
Impact investments are often measured against the United Nations Sustainable Development Goals framework, a collection of 17 UN principles encouraging global commitments to address areas of inequality, imbalance or deteriorating outlook such as the climate, resource management, education, poverty, hunger, and diversity.
The United Nations Sustainable Development Goals
The ESG Investment Approach category provides the most flexibility for investment managers to determine their investment process, but is the most challenging approach for investors to understand how investment managers are investing their funds.
Lonsec uses the example of a coal company to illustrate how five different ESG investment sub-approaches would assess investment in a coal company.
ESG Investment Sub-Approach 1: Value
The value approach is taken by many fund managers. In this approach, the manager works to identify all the ESG risks associated with a particular company. It then, combining these risks with the more traditional risks, makes an assessment of the overall risk profile of the company. Risk/return analysis is then undertaken as provided the expected return is deemed adequate for the risks then the stock or bond is purchased.
For a coal mining company, if the manager believes the stock is cheap enough to compensate for the stranding and other risks the firm is likely to face then the manager will still buy the coal company.
ESG Investment Sub-Approach 2: Best in Class
This approach generally requires an analysis of all the firms in a particular industry. This is often completed quantitatively, usually on metrics delivered by external data providers, to generate an ESG score for all companies in the sector. A process of then eliminating a certain percent of the worst performers, or tilting towards the higher relative performers, is then undertaken.
Under this approach, the “best” coal mining company, irrespective of the industry’s overall performance, could make its way into a portfolio.
ESG Investment Sub-Approach 3 : Rising Stars
This approach acknowledges that companies that manage their ESG risks well are likely to deliver improved financial performance over time. Managers implementing this approach seek out companies who generally have poor ESG track records but are in the process of improving in this area.
By investing in companies with “below par” ESG histories or data metrics, who are on the path to addressing these issues, managers are hoping that the improved ESG performance will result in improved future performance or market rerating (hence rising stars).
Following the above example, investors here might invest in a coal mining company with very poor ESG metrics if they believed that the companies metrics were likely to improve, impacting the stock price positively.
ESG Investment Sub-Approach 4: Minimum Standards
The minimum standards approach, as the name suggests, is where managers apply a minimum threshold for the ESG risk management of a company. The minimum standards approach is quite different to the traditional exclusions approach as it occurs after the ESG analysis is completed and is implemented on a company by company basis rather than a blanket exclusion applying to all companies in an industry.
Whether a particular firm such as our coal mining example, makes it into a portfolio depends on that individual company meeting minimum standards set by the respective investment manager.
ESG Investment Sub-Approach 5: Engagement
Engagement is a strategy sometimes used as a stand-alone ESG approach but also often combined with one of the above approaches. Here investment managers engage with companies on a range of E, S and G issues to either improve performance or to influence decisions. Engagement may also be aligned or associated with the manager’s voting approach.
While engagement is a significant strategy by many large managers, potentially leveraging their size on the share register, the actual content of that engagement is often difficult to discern. Managers often publish high-level statistics on their engagement activities but rarely disclose both the topic of the engagement and the position taken by the manager in that engagement.
How do you find the RI strategy that is right for you?
According to the Responsible Investment Association Australasia (RIAA) Responsible Investment Benchmark Report 2019, 44% or $980 billion of total assets managed professionally in Australia were classed as Responsible Investments, up from $866 billion in 2018 and $622 billion in 2016.
Methods of managing all types of investment funds continue to evolve, and investment costs have reduced across the board, including in the ethical sphere. The advent of a range of investment solutions, including ETFs, has reduced the cost of investing sustainably to levels similar to those of ordinary funds and index funds.
However, as shown above, to meet the UN PRI’s a fund manager can adopt one of the approaches described above, implement a robust integrated ESG approach to analysis, valuation and portfolio risk, engage in a highly structured and reported way with companies, yet still invest in companies which continue to contribute to the Environmental, Social and Governance problems faced by our local and global communities.
To find the right RI strategy, you need to consider the impact you want your savings to have.
Consider whether you believe in a divestment or engagement strategy.
Proponents of the engagement strategy believe that investors, via significant ESG funds, can influence the behaviour of corporates and improve their ESG impact. A divestment strategy does not have this ongoing direct influence via engagement but divesters argue that in divesting they still incentivise corporates to improve their ESG impact, as they try to attract divesters back onto the share register.
Consider which RI approach you are most comfortable with.
The Ethical approach of negative screens, knowing you will not be supporting certain industries? Many basic filters only remove companies that produce alcohol, weapons or tobacco, or extract fossil fuels.
Or perhaps the Socially Responsible Investing or Impact approaches, which add a positive selection element to the process?
You might be comfortable with a broader ESG approach, though knowing that you might have to dig deeper to understand how the investment manager defines ESG, how they use it in their investment process, and how it impacts the final portfolio outcomes.
If you need assistance, speak to your financial adviser or fund manager, who will be able to help you with any of the points above.
Sources
MSCI, Deloitte, Responsible Investment Association Australasia (RIAA) Responsible Investment Benchmark Report 2019. This article contains information first published by Lonsec. Voted Australia’s #1 Research House for 2019.
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