ESG issues and investment - who cares?

Oil spills, sweatshops in China, dodgy remuneration structures – AMP Capital’s ESG research team explores the 'so what' question around ESG issues.

Milton Friedman, the eminent economist from the last century said: “The business of business is business”.

Some investors might say: “Who cares about environment, social and governance (ESG) issues as long as you are able to make a good return on your equities portfolio? Not all companies will have a giant oil spill in the Mexican Gulf”.

These hard-nosed views of the world suggest there is little room for thinking about or acting on broader ESG issues as a company, let alone an investor.

However, these days smart investors realise that ESG issues can be material. Understanding how companies are managing these issues provides additional insight with which to make better investment decisions.

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While many investors are well-versed in traditional financial analysis, ESG issues are sometimes difficult to analyse. Investors may recognise the importance of the issue too late, when the share price has already reacted to a particular event.

There are no magic steps for looking at ESG issues, and for many investors it is all too hard and often much easier to simply dismiss.

To really see the potential problems, investors need to call on those investment analysts who can marry a strong understanding of ESG issues with an equally strong investment background.

Being bilingual, as we put it, is the key to answering the “so what?” many investors ask when confronted by ESG issues.

Coal-seam methane – environmental and community issues front and centre

The challenges facing the coal-seam methane industry in Australia is a classic example of both environmental and community issues combining to shape this emerging industry.

Our analysis indicates that some of the environmental issues might be overstated – good companies will be able to address these, and therefore meet regulatory and community expectations.

Others may struggle with these same issues taking up valuable management time and costs as they face continued scrutiny from regulators and the community.

It will certainly impact their ability to deliver on their stated strategies.

Technical environmental issues, such as issues of groundwater and surface water, are more challenging. They rely on computer modelling to predict impacts in 10 to 50 years’ time.

However, understanding these issues is important in assessing the investment risks of potential capital expenditure and significant residual liability of these projects.

The success of companies to consult and address community concerns – regardless of whether they are real or perceived – has more immediate investment implications.

Addressing community issues such as compensation, concerns of visual amenity, and the impact on the social and economic character of local communities can have important implications for constraints on exploration or development and timing of approval – important factors when considering the risk-weighted value of potential projects.

While at one level the issues may be similar, the relative importance to each company in the ESG space will depend on location and stage of development – something an investor has to understand if they want to make the best return on their money.

Poor risk/reward ratio for labour exploitation in the supply chain

Sweatshop issues in Asia are nothing new. Why should investors care? Retailers might suffer brand damage and consequential revenue loss, but don’t consumers tend to have a short memory?

Actually, our proprietary research shows that chasing costs in Asia can have a very poor risk/reward ratio – even when you disregard the ‘ethical’ aspects.

Like a swarm of locusts, fashion companies are moving around in Asia to satisfy its appetite for cheap labour.

Last year, plagued by weakening consumer markets and higher cotton prices, many companies started to steer away from old pastures in south-eastern China (eg, Guangdong) to areas with lower unit labour costs.

This process was accelerated by higher costs of living and China’s five-year plan to reduce the economic gap between eastern and inland China. Outside China, the labour unit cost is often even lower.

However, the unit labour cost does not tell the full story.

The labour cost is only a small proportion of the total cost of goods sold.

Also, once differences in productivity and fixed costs have been considered, the elusive savings might be even smaller or gone altogether.

By moving production to remote areas, companies are taking a gamble on poor infrastructure and potentially longer lead times, which can be painful when you rely on fast-moving fashion trends.

Workers’ conditions are often poorer, which can lead to lower productivity and further production disruptions.

So outsourcing to “cheaper” countries is not the panacea that companies and investors might be looking for – the locust may have left your investment looking a bit bare.

Governance – a warning light of a crash ahead

Good governance doesn’t make the nightly news, but bad governance sure does, especially when the reckless behaviour of conflicted boards and management destroys shareholder value.

Corporate collapses have shown there is no point investing in the companies that make great products if no rewards flow to shareholders. But how can shareholders ensure this doesn’t happen?

After two decades of analysing corporate governance, we have learned how to spot the warning signs.

When determining how well a company is governed, an assessment is made of its disclosure, board and pay structure.

For instance, flashing lights appear when companies lack transparency, when boards don’t represent their public shareholders, or when pay structures reward management for risk-taking and achievements contrary to shareholders’ interests.

Companies give great comfort to shareholders by being upfront with them. Clear disclosure of various aspects of the business and its governance helps shareholders make an informed judgment on the risks and rewards of their investment.

Similarly, shareholders take comfort in board structures where directors are not only well-qualified, but are also majority independent, and hence, more likely to be free from potential conflicts of interest.

Finally, thorough analysis of executive remuneration over many years has taught us that poorly structured pay cannot only be costly to shareholders, but in the worst cases can encourage value-destroying behaviours.

Diligent analysis of these aspects can help identify which companies to invest in, and which to avoid.

Although companies perceived as poorly governed can perform well, they will often have fewer investors willing to back them. Most investors only invest in a company where they are confident funds will be used wisely.

ESG analysis can give original insight to equity investments before it is too late

ESG integration is a process of identifying a company’s hidden earnings risks, making a holistic assessment of how a company is managing the risks, and considering these when forming your final investment decision.

Key to that process is to understand that the majority of a company’s value mostly relates to non-financial drivers. Companies face a broad range of different ESG issues, which can be industry or even company specific.

ESG integration into investment decisions is more than ‘ethics’ and carbon emissions – it is about assessing a company’s hidden value drivers and risks.

It is not always what you see, but what you cannot see that drives a company’s earnings and share price. By analysing these drivers to equity investments, you have an opportunity to obtain original insight, which can be the difference between a good and a bad investment. 

By the AMP Capital ESG research team.