ESG: From why to how

Environmental, social and governance-led investing, otherwise known as ESG, has risen in popularity to such an extent that conversations about the strategy have moved onto the next phase. Investors have immersed themselves in the topic over the past few years to understand why they need to consider these factors when making investment decisions. The next step is to understand how to implement such considerations into their portfolios.

To tackle this topic, portfolio institutional, in association with Candriam Investors Group, assembled a panel of experts to discuss how they are integrating ESG factors into their investment decisions.

ESG is a mainstream strategy. Once considered a niche approach to investing reserved for those eating lentils in between protest marches and who want to avoid their savings funding the development of armaments, today it has become a regular topic of conversation at shareholder meetings. Indeed, more than nine in every 10 asset owners and asset managers surveyed by BNP Paribas Asset Management predict that at least a quarter of their capital will be allocated to assets based on ESG factors by 2021.

The event kicked off with a presentation by Wim Van Hyfte, Candriam’s global head of responsible investments and research.

He outlined Candriam’s investing process, its philosophy and how it implements ESG factors into its portfolios. As part of the asset manager’s offering, it has developed specific policies for its clients on topics such as engagement, voting policy and training.

Candriam also has a range of thematic funds, including a climate action strategy, which is based on its energy transition philosophy that targets a 1.5 degree scenario. “From our experience, from why to how is where conversations around ESG are heading more and more,” he said. “This is how we are being challenged by our clients.”

When Van Hyfte became an ESG fund manager 15 years ago, it was a different story. “There were two people in the room. Now it is fully packed,” he said.

ESG strategies were initially about negative selection, but in the UK it has moved onto fiduciary duty and engagement. In Europe it is about positive selection, best in class, ESG integration, thematic investing and impact investing.

“The problem with ESG is that it has always been black and white. You exclude or you don’t exclude. Well, it doesn’t work that way. There are 50 shades of grey too.

“ESG is about allocating capital for me,” Van Hyfte told the audience. “It doesn’t matter if you are talking about fixed income or equity – it is the way you do it. It is the principles that are set out in your investment strategy.”

The major energy companies are clearly vulnerable to climate change risk and in the 2030s this is going to be real for them. Yet ESG is about social issues too with health, wellness, diabetes, sugar, obesity and plastics impacting consumers.

“There was a lot of stuff that was under the radar, but this stuff is now becoming real from a consumer point of view,” he added. Mandated disclosure could be a big step forward in improving ESG integration, and Van Hyfte hopes that mandated disclosure will happen before 2020, if the European Union (EU) can define what sustainable activities are.

“Sustainability means many things to many people; the problem is that it means many different things to many people,” he added.
ESG

THE PANEL

Joining Van Hyfte on our panel was Leo George, head of sustainable ownership at RPMI Railpen.

They were joined by Laetitia Tankwe, who advises the president of French public sector pension scheme Ircantec’s trustee board. She is also a Principles for Responsible Investment (PRI) board member and a member of Climate Action 100 plus’ steering committee.

RPMI Railpen manages around £30bn on behalf of former and current railway workers.

Its goal is to pay pensions securely, affordably and sustainably. One of the scheme’s investment beliefs is that ESG factors materially impact long-term investment returns and must be reflected in how the assets are managed.

Incorporating ESG into investment decisions and portfolio management has the potential to enhance returns, reduce risk and boost the reputation of the trustee as a responsible investor as well as impact the world members retire into, George said.

It seeks to influence companies by improving its policies. Boardroom diversity is one example. “When we look to invest in a private company we look to ensure that there is adequate board representation as a condition of our providing capital,” George said.

“It is a work in progress, but we do see that companies and people are more engaged on this topic,” he told the audience. “As an issuer you cannot ignore this. We are part of the ecosystem.”

Tankwe pointed to Ircantec’s responsible investing charter as crucial to implementing its sustainable agenda.

“It is key for the decision-making process, the first pillar,” she said. “The second pillar is proxy voting and the third pillar is shareholder engagement, which is a way to influence companies from the outside. You are trying to contribute to a good ecosystem for responsible investing.”

OFF THE DRAWING BOARD

All of Ircantec’s assets are invested in-line with its responsible investment policy and climate is a big issue for the scheme. Addressing climate change is not only about investing in low carbon portfolios for Ircantec, it is about assisting the transition to a low carbon economy.

It is a similar story for RPMI Railpen. “We have used a bottom up approach to managing climate risks,” George said. “We measure our carbon footprint under the Montreal Pledge [a commitment to disclose a company’s carbon footprint]. That gives us an indication of where the biggest emitters are in the portfolio.”

The scheme is a signatory of the Task Force on Climate-Related Financial Reporting. This requires RPMI to report on how it is managing climate risk, which encourages scenario analysis to understand how climate risk fits into asset allocation.

“The aspiration is that climate is a legitimate risk, like interest rate risk or longevity risk, so pension funds should look at it in that way,” George said. “ESG has tended to be separated but it should be part of the risk dashboard that applies to the overall risk management of any financial institution. That is the direction of travel.”

The debate then moved from policy to implementation.

George said institutions have a range of tools to deal with companies and that engagement is the scheme’s preferred approach to effect change. Exclusion and divestment are options when those discussions are not successful.

Human capital management is an issue that RPMI Railpen considers when investing in companies. “It is possible to incorporate this into our decisions, but it depends on what you are buying rather than having a rule for human capital management,” he added.

“This reminds me of a Warren Buffet quote that investing is simple but it is not easy. ESG is similar,” George said.

However, some areas fit quite easily into ESG integration. Real estate is an example of where if you can manage the energy consumption you could make a more profitable investment. Areas like tobacco are a little more difficult. Whether or not you should remove it from your portfolio depends on if your objective is financial or social.

Other challenges include what to do with the data you collect from measuring carbon footprints, George asked. “It is not obvious that you should reduce the number because the data is not that reliable and there are many different measures of carbon exposure,” George said. “So you have to form judgements and take a view. With certain types of investments, distressed debt is an example, you might find a great investment but it might introduce large reputational risk. So you need to balance these and formulate a review.”

Van Hyfte said that ESG is approached in different ways in different countries. In France it is driven from a philosophical perspective, while in the UK it is linked to fiduciary duty. He said that the challenge for regulators will be to manage both.

He added that scenario analysis should not only be linked to climate change. “You should do it across your assets or factors that you believe will impact your portfolio.” He cites tobacco as an example. It was once on exclusion lists, but it is becoming seen more and more as financially material.

“It is not only climate it can also be social,” Van Hyfte said. “It can have an impact on the consumer, so you need to know where the risks are in different sectors and how it will affect the assets in your portfolio.”

Another concern that investors need to define their policy on is that many sectors are involved in building wind farms or developing electric cars, for example, so how does the huge mining effort, and therefore carbon footprint, needed affect decision-making?

Institutions own a lot of these companies by default because they are in indexes. “We are likely to hold some of this because we are a large investor,” George said.

“Engagement with all companies in the portfolio is one way to make sure that they are managing it,” he added. “We use our voting policy to signal where we don’t think that they are doing a good enough job. It is not as simple as removing mining stocks, but rather engaging with them to ensure that they adopt sustainable practices.”

A TWO-WAY PROCESS

This was not a passive discussion. The audience had a chance to pick the panel up on any topic that they felt had not been covered or covered in enough detail.

A representative from the BP Pension Scheme asked our panel why they could own a company’s equity, but not its debt. Tankwe tackled the question by responding that there are different tools you can use depending on if you are a shareholder or a bondholder. “Engagement is easier to do if you own the equity.”

Another question was how much of a company do you have to own before you can make a difference?

“Even if you have a small asset allocation, you can still make a difference. It depends on the issue,” Tankwe said.

“At Ircantec we favour collaborative engagement, because you are not alone. It is about influencing companies.”

Van Hyfte added that investors need to be realistic in terms of the impact that they can have by engaging with companies. It is also a matter of exchanging information needed to assess the company.

“If you talk about the Apples and Microsofts of this world the impact is minimal on an individual basis,” he added.

“Look at Shell. When it comes to disclosure, it has caught up enormously in the past few years. Is that connected to one asset manager? No. It is because the market is moving and it is being articulated on what oil companies should do.

“The oil majors have a massive impact on climate change and how they allocate capital. Those collaborative initiatives are efficient.

“You are not going to achieve the objective straightaway, but it increases the awareness from a company perspective,” Van Hyfte said. “That is not a short-term game, it is something that evolves. It is also being focused and targeted on what you want to achieve.”

But many final salary pension schemes are approaching their endgame and so will have fewer equities, so credit becomes more important.

“The elephant in the room is fixed income,” Van Hyfte said. “There is a lot to do on that side. The impact it can have is underestimated by the markets. I do not agree that ESG is less material from a fixed income perspective.”

Maturity and duration are important aspects but need to be refinanced. If companies do not meet the agreed objectives then investors could refuse to refinance the debt. “It can be an instrumental part to have impact from the fixed income side,” Van Hyfte said.

This could bring its own problems. Depriving companies of capital could see their cost of capital rise and so they have less capital to invest in renewables.

So another major challenge to implementation is factoring the consequences of your actions into your decisions.

Van Hyfte said that phasing coal out of Candriam’s activities has a social aspect to it because it impacts communities. Poland is exposed to thermal coal, for instance. As an investment community we should not bear sole responsibility of sustainable development.

“We are a player in this and we need to come forward with solutions, but we cannot bear the brunt of all negative side effects of divesting from something,” Van Hyfte said. “If you divest from tobacco they have employees.

“Every scheme is unique and so comes at ESG from different angles,” he added. It sounds like a one-size-fits-all approach will not work, so how do asset managers approach a new ESG mandate?

“We have a philosophy and a framework,” Van Hyfte said.

“You adapt it if you feel the objectives are not being achieved. It is a journey that you assess along the way,” he added.