By: Hilary Wiek, CFA, CAIA, Society Volunteer
After the morning breakfast presentation, chronicled in my previous Freezing Assets blog, the Intellisight Conference offered four panel discussions to further explore the current state of investing with an ESG perspective, how to approach with different asset classes, ESG data coming from companies and ratings groups, and issues investors and managers are still facing in this space.
The first panel, called “Risk & Opportunities across Asset Classes,” was moderated by Michael Corelli of Moody’s and included Jodi Neuman of Trillium Asset Management, Mike Pohlen of North Sky Capital, and Emily Robare of Gurtin Municipal Bond Management. The main message from this group was that ESG investing has moved well beyond the screening of stock universes to remove morally objectionable companies from a portfolio. The panelists discussed how they have folded ESG thinking into the investment process across all asset classes.
The rationale for many investors to consider environmental, social, and governance factors boils down largely to risk and opportunity, principles that even those with little interest in saving the world generally find important. Bond rating agencies and bond purchasers are thrilled to have new metrics to incorporate into their analysis of a bond’s risk. Equity managers are also looking for companies with positive attributes that will make them more sustainable businesses in the future. By embracing companies that treat their employees well, have a high-functioning governance structure, and avoid misuse of resources, investors can focus in on a subset of companies more likely to do better in the future than their peers.
One example: when evaluating insurance companies, ESG factors, particularly climate risks, have become a very important lens that had previously been difficult to assess. With natural disasters coming more frequently and in greater magnitude (2018 had the 4th most natural disasters ever recorded; 2018 was the 8th consecutive year with 8 or more natural disasters costing more than $1 billion; learn more here, it is important to factor in the likelihood of such events when evaluating the health of an insurance business. Some insurers are more heavily geared to geographies more likely to face bigger losses, such as in Florida (hurricanes) and California (fires). In January 2019, Pacific Gas & Electric had a wildfire-related bankruptcy, a loss investors may have avoided if they properly assessed the fire risks facing California.
Moody’s is continuing to develop work around ESG factors in its ratings methodology. They assess 84 global industries representing $75 trillion in rated debt. They have identified 51 sectors with $62 trillion in debt that are considered low risk; some of these may even possibly benefit from emerging environmental trends. An example of the latter is the construction industry benefiting from repair and reconstruction after natural disasters and investments being made into the building of energy efficient systems.
While some would avoid entire sectors due to them being “dirty” or some other objectionable rationale, many equity investors utilizing ESG principles believe that the magnitude of the risks are specific to each company, so there is potential for a company in a dirty industry to outshine the competition, leading to better stock performance. In addition, many companies in carbon-heavy sectors are developing technologies to more efficiently use fossil fuels or even to swap out such fuels into cleaner energies, becoming a solutions provider to the energy transition instead of a victim of the trend.
Even in municipal bond analysis, ESG considerations can play a part. Climate risks are often very local and what are municipal bonds but plays on the ability of a local economy to continue to pay back investors? While it is likely that coastal areas around the U.S. will be impacted by heavier rains and coastal erosion, some communities have a broad and wealthy enough population to rebuild while others will lose population to more sustainable areas. It is likely that residents of Malibu, CA, would have the resources to rebuild after landslides, but New Orleans, LA, could suffer a permanent decline in its tax base. This translates to a bond issue from Malibu being a better credit than one from New Orleans. One difficulty, however, can be in modeling the timing. Even in an area likely to suffer from rising oceans, a five-year credit may encounter no difficulties, but the longer the time frame, the more likely a significant event could hit a locale.
ESG in the private equity landscape is usually focused on solutions to the environmental risks facing so many locales. They seek out portfolio companies with clean technologies that can profit from shifts in attitudes toward fossil fuels and climate change. Even when you find a clean technology, however, ESG risks must be considered. If a hydro-electric project faces a multi-year drought, how would the project do with decreased output for a sustained period?
The biggest issue for analysts hoping to assess ESG risks is the availability of reliable data. While companies have just recently been getting better at reporting things like carbon usage, other risks are only reported sporadically and there is a danger that some would penalize a company that is being forthcoming in reporting its ESG risks but then not penalizing companies not reporting because there is nothing for analysts to go on. There is very little ESG data reported to a muni bond investor hoping to assess environmental risks to an area, though some county by county government data can be useful in extrapolating a location’s risks. Later panels discussed the state of ESG data in the world today.
The next panel, titled “Who’s Who in ESG and Impact,” was moderated by Chris McKnett of Wells Fargo Asset Management and included Mac Ryerse of Columbia Threadneedle Investments and Michael Young of US SIF: the Forum for Sustainable and Responsible Investment. Ryerse has done a lot of work for the Sustainability Accounting Standards Board (SASB), who is working to standardize the company reporting of financially material impacts of sustainability on their businesses. In other words, SASB is working to address the data problem raised by the prior panel.
The topic of ESG and sustainability, and whatever other terminology one might prefer, is fast-moving and still being debated heavily. That said, there is a lot of talk and the category cannot be ignored, even if the AUM are still modest.
One news item of note from the session, Young recently worked with the College for Financial Planning to create the first professional designation for sustainable investment.
US SIF (social investment forum) has long been a resource for understanding the state of play in the sustainable investment space. They continue to work to drive awareness and adoption of sustainable investment principles. SASB has taken on the burden of working with industry participants, including public companies themselves, to establish industry-specific frameworks for the reporting of financially material information that would not typically be required by GAAP standards of financial reporting.
In 2018, US SIF published its biennial Report on US Sustainable, Responsible, and Impact Investment Trends. The report can be found here. From the website:
“The 2018 Trends Report presents data from new survey questions on the asset class allocation of survey recipients’ ESG assets, their percentage of ESG assets in passive strategies, and their support for the UN Sustainable Development Goals. The Trends Report also focuses on the extent to which ERISA-governed pension plans added ESG funds after the Department of Labor’s 2015 guidance acknowledging that “environmental, social, and governance issues may have a direct relationship to the economic value of the plan’s investment.””
When it comes to the adoption of ESG principles in investment management, there appears to be a hockey stick upturn starting in 2012. Readers should be aware of issues with the data, however. There are very few new mandates in the public equity space these days as money is being pulled from active management and placed into passive ETFs and index funds. There has, however, been a surge in mandates seeking active managers integrating ESG principles into their investment process. Investment managers have realized that selecting Yes to questions in databases about ESG will open up their products to searches. Asset managers may change nothing about their process, but reason that since they’ve always considered corporate governance in their investment process, they can say yes and be considered for a prospective mandate. This “greenwashing” can inflate the amount of true ESG offerings available and can make it more difficult for asset owners to identify the right partners for these new mandates.”
Being a signatory to the United Nations Principles for Responsible Investment (UN PRI), is a phrase heard from industry participants as evidence of a commitment to invest with some sort of ethical guidelines. That said, any mechanisms to hold people’s feet to the fire in showing their commitment to responsible investing are rather toothless.
UN PRI has championed 17 SDGs or Sustainable Development Goals, which include such areas for global improvement as Zero Hunger, Quality Education, Gender Equality, Decent Work and Economic Growth, and Responsible Consumption and Production. 1,700 asset managers and investment providers are signatories to what the speakers called a framework for a conversation. The goals do not all neatly map out to easy financial choices, but the idea is that if investment dollars were to target some of these global issues, the world could be improved.
SASB is connecting businesses and investors on the financial impact of sustainability. They have brought some shape and focus to the marketplace, helping the area grow and become more robust. In a world where corporate valuations have become more and more dependent on goodwill and other intangible assets, analysts need to find ways to evaluate the sustainability of those assets. ESG factors can provide forward-looking insights into a company’s performance and risk.
There has been an explosion of data. In 2011, 20% of S&P 500 companies produced a corporate responsibility report. In 2018, it was 86%. That said, while companies surveyed think they are doing very well in their responsibility reporting, investors still feel there is a lot of room for improvement. The reports are inconsistent to each other, making them difficult to compare. The data points used are not governed by any accounting rules, leaving analysts unsure as to what is being reported and how reliable the metrics are. Analysts wanted data they can reliably build into models.
SASB stepped into the gulf as a standards-setting board taking an evidence-based approach to provide standards for issuers (of both stocks and bonds) to use in disclosing their ESG efforts. In order for something to be considered for a standard, there must be: 1) evidence of investor interest and 2) evidence of financial impact. This has led to ESG factors reasonably likely to affect the financial condition or operating performance of a company. 2,900 people worked on this standards-setting effort; a third each from: asset managers, asset owners, and academics.
The full standards (broken out into 77 distinct industries, as not every metric pertains to every company) were released in November 2018 and can be found at the SASB website here. While these are called standards, adoption is still strictly voluntary. The hope is that the investment community demanding to have the data will pressure the companies to provide it. Major accounting firms are starting practices to verify the reports that are published. Only a couple of dozen companies have implemented the SASB standards thus far; JetBlue was the first.
The third panel of the ESG track of the Intellisight conference was titled “Clarity from the Chaos?” and was moderated by Eric White of Cogent Consulting. The panelists were Matt Sheldon, CFA of KBI and James Spidle, CFA of Breckinridge. For context, Cogent is a Minneapolis-based investment consulting firm working with mission-driven investors on impact investing around the region. KBI is an Irish-based asset manager and Sheldon is a portfolio manager on the firm’s water strategy. Breckinridge is an investment grade fixed income manager that fully integrates ESG into its investment process.
The chaos of the panel’s title is largely the confusion clients and other industry participants feel about what everything means. As a fixed income manager, Breckinridge had to explain that ESG wasn’t just a concept important to equity managers. They had to make the case that as fixed income has set maturities sometimes far into the future, considering ESG risks is only prudent in evaluating a potential credit investment.
One point KBI feels is important for investors to know is that having an ESG lens does not mean that they cannot invest in “bad” ESG companies. If the risks are priced in, the issue may be a good investment. But they feel the company can get to a more appropriate valuation if they are more inclusive in the risks they consider. In addition, they want companies to be better and will engage with management teams to share views on how they feel the companies could improve their ESG practices.
Another issue in the chaos of ESG investing is that not every client prioritizes the same set of values. So while KBI may look for companies that are solving water problems, an investor might protest that a company is solving the problem of accessing water in order to facilitate fracking. Breckinridge largely manages customized separate accounts, allowing every client to have its own values overlay. No companies are pristine, but they have the information to be able to tilt a client’s portfolio to the areas they care about.
Another point of confusion is between investors and companies. The investors serious about ESG are often attempting to engage with issuers on various ESG topics, but each investor may have a different set of priorities in terms of what they want to see reported. Overall, everyone wants better disclosure and transparency, but what form that will take is still evolving.
Asset managers have been struggling with how to report their ESG efforts to clients. They’d love a generic report to supply, but each client has a different set of interests on which they want to see results. Reporting is definitely still evolving.
The idea that you can do well while doing good is another point that is still not fully accepted among investors. More and more asset managers believe they can integrate ESG thinking into their investment process without sacrificing returns, but discussions are ongoing with clients as to how realistic it is to invest to a narrow set of principles and still expect market or better returns. Given that many believe integrating ESG into the investment process will decrease risks, some advocate that at the very least you can achieve better risk-adjusted returns with this approach.
What it means to incorporate ESG into the investment process can vary widely. There are so many different approaches to integrating ESG and investors must do the work to look under the hood and evaluate the veracity of the ESG claims, given the incidence of “greenwashing” (see above) in the industry. Just falling back on an ESG rating by a service provider will not give the full picture, particularly as many companies who are rated have never had a conversation with one of the providers. Differentiated ESG integration will have the asset manager asking its own questions and coming to its own conclusions on a company’s ESG record.
An interesting point made by Sheldon: the best rated ESG companies are often trading at high valuations. The worst are at low valuations. So a good portfolio from a valuation perspective (perhaps banking on improvement through engagement with the low-rated companies) may have a low score from the ESG service providers like MSCI and Sustainalytics.
The main way to avoid the confusion and chaos in the ESG landscape is to start with very basic discussions with clients to ensure everyone is speaking the same language. Do not assume that when someone uses the word sustainable, for example, that it means the same thing to all parties. For that word alone, some think about it in terms of energy sustainability, while other think about how sustainable a competitive advantage is for a company; two very different concepts. So ask questions, form a common foundation, and the end result will be much closer to the vision of what the investor is truly looking for.
The final panel in the Intellisight ESG track on August 13 was called “Demystifying ESG Data, Ratings and Research” and was moderated by Chris Eckhardt of Columbia Threadneedle Investments. Geeta Aiyer of Boston Common Asset Management, Trevor David, CFA of Sustainalytics, and Jennifer Sireklove, CFA of Parametric were the panelists.
Columbia Threadneedle has a large sum of assets in ESG-related quant strategies. Boston Common is an ESG boutique incorporating ESG at every stage of what they do. Sustainalytics is a service provider offering ESG ratings on public securities issuers. Parametric is a quant manager with no individual securities analysis, but they are providing custom ESG integration for clients upon request. They have been thinking about active ownership practices with an ESG lens, however – voting proxies and the like.
ESG data allows you to do ESG research at scale. Columbia trades in 6,500 publicly traded companies and does not have time to trade them all. They use 3rd party ratings/research as a starting point. ESG data, now coming from many public companies, can be critical to ensuring a portfolio is meeting client expectations.
Sustainalytics provides company-level risk ratings meant to get at a company’s exposure to ESG risks. The firm starts with which factors are material at the subindustry level. They speak with companies and leverage Sustainalytics’ analysts’ expertise for this. They will make adjustments at the company level related to geography and other company-related idiosyncrasies.
A question for Sustainalytics was how they account for the fact that companies eagerly report good news, but are hesitant to provide data that will make them look bad. Sustainalytics will screen news sources daily and pull relevant incidents in that analysts will assess in the context of what they know about the company already.
Other areas Sustainalytics is developing: a carbon risk rating; country-level ratings; municipal bond ratings, including looking at the proceeds and how they are used. They also have product information at the company level – not just identifying “sinful” products, but also if the company is deriving income from things like affordable housing or sustainable transportation systems.
Parametric began having conversations with clients about ESG in 2018, but found that many of the client’s aims do not map well to public equities. Growth in affordable housing is a good example, as there are few public stocks that will impact this objective. Things that can work in public equities is controlling the types of companies you own and changing the way companies behave. Companies will be influenced more by owners of the company, so sometimes you need to own shares of a company whose practices you don’t like in order to effect change.
How to benchmark custom ESG portfolios? Most asset managers leave it up to the clients, but will have conversations about tracking error expectations, particularly if the client decides that a standard benchmark is the index of choice. Too many client-driven restrictions will lead to wide dispersion from a benchmark, but the ESG mandate being fulfilled may be more important than a tight performance profile.
Boston Common has an independent investment team as well as an ESG team. The output from the ESG team is a source of information to the investment team – a corroborating source from a different vantage point. Ideas can come from both sides and have to be vetted by the other. The team feels that it would be irresponsible to throw away any relevant data; more and more is becoming available for ESG factors. That said, in markets that are less efficient for financial data (emerging markets, small caps), there is less ESG data available, as well.
In terms of engagement, while some ESG risks are systematic and cannot be diversified away, investors can try to steer companies away from the iceberg. One needs to look beyond the typical dirty industries to companies that on the surface seem less likely to be impacted by ESG risks. But if a bank is making loans to oil producers or coastal developers and is not itself asking relevant ESG questions of its customers, it could face losses that could have been avoided.
Reporting is still a work in progress for the industry. Some are using the UN PRI Sustainable Development Goals, others tailor reports to client objectives, and still others are attempting to come up with standard reports that can meet the needs of most of their clients. Many asset managers are in continual discussions with clients on how best to meet their needs.
Are you interested in helping plan the 2020 ESG Track at Intellisight? E-mail Amanda at events@cfamn.org.
