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ESG, sustainability and beyond
At the Transcontinental Trusts International Conference 2020, Kristina Church, our Senior Investment Strategist for Sustainable Investment, spoke about sustainable investing – taking ESG beyond its narrow focus and beyond the pandemic.
We include some highlights of her interview with Grant Wilson, Chief Investment Officer, Asset Risk Consultants (ARC) below:
What is ESG investing all about?
There need to be better industry definitions around sustainable investment terminology. Environmental, social and governance (ESG) investing means different things to different people. There is a recognition that ESG factors have a meaningful influence on the performance of companies and markets. ESG analysis is increasingly integrated into mainstream investment analysis, but many organisations practise simple exclusionary ESG approaches or integrate a third-party ESG framework into existing portfolios. Generally, however, this is historical and static data, and it only gives us one part of the picture.
At Lombard Odier, we think it is important to analyse that data and weight it by materiality, to reduce the risk of company ‘greenwashing’. We then do our own analysis on how those companies have acted on their ESG commitments and what results they have seen. But we strongly believe in the importance of looking beyond ESG metrics, which focus only at companies’ business practices. Here I am speaking about issues like climate change, the digital transition, rising inequalities. We need to consider forward-looking, judgemental factors to analyse and quantify whether a company’s business model is sustainable – not just its everyday business practices.
This is crucial in order to understand investment risks and opportunities. We believe there are strong opportunities for sustainable companies to outperform and generate value.
Is there the risk that ESG investing reduces returns, perhaps by narrowing the field of investments?
If it’s done at too basic a level, ESG investing may narrow the field of investments; that’s why it’s so important to understand what the data is showing us. You can have an oil and gas company with an excellent ESG rating, but in the shift to a zero-carbon economy, investors could still be left with ‘stranded assets,’ or investments that could be caught in a downward spiral of falling valuations and fire sales as the world evolves. Pure ESG metrics don’t tell you enough. The only way to understand sustainability is a deeper analysis of business models. Are companies moving to adapt to future challenges such as the climate emergency, biodiversity risks, the need for a more circular economy etc? How do they fit with the UN’s Sustainable Development Goals?
We’ve also seen a step change in what investors are looking for in the last 18 months, particularly in Europe, but also in the US. Investors’ understanding of what sustainability means and how they want it integrated into portfolios differs. Lots are at an early stage in their journey, and want to exclude sectors like tobacco, weapons and gambling. Others are focussed on the business practices and metrics provided by ESG analysis. But there is increasing demand for full sustainability integration, to understand the complete spectrum of risks and returns. Investors increasingly appreciate that sustainability can deliver outperformance. And of course it’s not just investors; consumers too are increasingly focussed on the ‘triple bottom line’ – people and planet as well as profit.
Last year the European Commission created a sustainable investment disclosure commitment for asset managers and investment funds – will it bring a lot more information into the field?
We’re still at the stage where the information available on companies’ sustainability credentials is imperfect, so it’s an important step. How companies report on sustainability commitments, and the level of reporting, differs. Even reporting on ‘Scope 3’ emissions data, which are indirect emissions that occur in the company’s value chain, and are often its largest carbon impact, can differ widely. It’s important that we see more regulation, and quantifiable, comparable data between companies and industries. But this is just one layer, and often it comes too late. As asset managers, we have a fiduciary duty to manage our investors’ risks and returns, and we can’t wait for regulation to lead the way.
One example here would be temperature alignment, or aligning portfolios for a net-zero carbon world. We can’t wait for that disclosure to be mandatory, so we are doing our own analysis.
ESG reporting is relatively new and people are currently grappling with jargon and limited information – is that something we are going to have to live with for a long time?
Certainly right now it is a real challenge for the industry. If you take three providers of ESG metrics, they can come up with significantly different decisions on a company, either through the way they weight the data, or in the disclosures that the company makes. While we are seeing investors’ understanding of ESG and sustainability improve rapidly, a lot more education needs to be done. More disclosure will help greatly, but the risk of greenwashing remains an issue. There are big discrepancies between how companies disclose information, and what they disclose. The larger the company, the more ability they may have to focus on these areas. And sometimes companies just lack understanding. We’ve come across companies that haven’t been reporting the information that we’ve needed to fully understand their business model because they didn’t realise that it was important.
For example, a US software company, which by its nature has a low carbon footprint, may not focus on reporting its full emissions scope because it does not understand the importance of “additionality” – i.e. the fact that the software they’re producing can help reduce emissions elsewhere in the supply chain. This is where engagement and stewardship become an important part of the sustainability story.
Another danger is that investors focus purely on certain areas, perhaps on a company’s carbon footprint. If you only look at this static value, then you may exclude companies that are transitioning.
In our view, it is vital to invest in the transition of companies which may today have a high carbon footprint, but which are vital for future economic growth and have understand the importance of setting their business models on a net-zero trajectory. We still need the cement, chemicals and steel sectors, we need to make sure these companies are funded to make the transition to lower carbon models. So in our analysis, we focus on the trajectory that companies are on.
Do you believe ESG investing will continue to grow, even in a global downturn?
Absolutely. If anything, I think sustainability has risen up the agenda in the current crisis. We have the push to “build back better,” and increasing regulation in the field. We have green strings attached to recovery funds. This is all highlighting how important sustainability is, and in particular, how important understanding companies’ business models is. How prepared are they for crises? From an investor’s perspective, it’s important to understand the adaptability of companies and how they react to challenges, whether that’s a sustainability challenge, or a pandemic and supply chain challenge.
Unless we do that analysis, we won’t truly understand risks and returns.
There is increasing evidence that sustainable investing can generate excess returns. The only risk when thinking this way is that many of the challenges lie ahead. We believe there is a huge transition coming and we need to look to the future. When we look at climate change for example, the next decade is absolutely pivotal. Can we really look at past returns to understand future performance? There is already more understanding among investors that sustainable investing can generate positive returns. At Lombard Odier, we believe there is a Sustainability Revolution underway and it will create the single largest investment opportunity in history.
Wichtige Hinweise.
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