Warming to ESG investment

With climate change at the forefront of many investors’ minds, now may be the time to get started with an environmental, social and governance approach to investing. Ashleigh McIntyre reports.

But a recent study by Deutsche Bank found that throughout Europe, the countries that are closer to the North Pole have greater levels of investment in funds with an environmental, social and governance (ESG) approach.

As a country that does not experience the obvious effects of climate change, it often becomes difficult for Australians to care about investing responsibly.

Stephen O’Brien, chief executive of Deutsche Asset Management (DAM) in Australia and New Zealand, jokes that witnessing the real effects of pollution and climate change – like acid rain and melting ice caps – makes responsible investing hard to ignore.

“The Nordics are doing more and the Spanish are doing less. If that doesn’t say something, I don’t know what does,” he says.

While the science of climate change is not questioned in Europe, he says Australia’s debate has become extremely politicised, which has not helped investor sentiment towards ESG approaches.

But O’Brien sees this as a temporary phase, and in the meantime DAM has committed to investing in ESG funds for investors to turn to regardless of how the debate pans out.

“We expect that there will hopefully be investors out there who do want to employ capital in a way that is consistent with their value framework and so we think it is only logical to provide solutions in that space,” O’Brien says.

DAM is considering setting up an Australian bond fund with an ESG focus, which it is talking about getting seeded from its parent company Deutsche Bank.

While ESG strategies have traditionally been thought of as venture capital for investments in clean technology companies, O’Brien says it does not have to be a ‘boom or bust’ approach.

“That’s the way people have thought about approaching it. Either you are in it in a big and potentially risky way, or you are not, and I think that’s where some people have become stuck doing nothing,” he says.

Getting started

There is building pressure on both institutional and retail investors to invest ethically, but there is also a lot of caution surrounding the risks involved, O’Brien says.

“This is a potential way of putting your toe in the water, getting some exposure, but it’s not like either it all goes brilliantly or terribly – it’s just slowly working into the real economy through fixed income as a defensive component of the portfolio,” he says.

DAM has had an ESG approach for the fixed income asset class for more than two years.

The process starts with 700 investment grade issues worldwide, as provided by ESG research company Sustainalytics, which is then distilled down to between 70 and 100 names with both strong ESG ratings and investment ideas.

If DAM’s Australian bond fund were to go ahead, it would be run by Andrew Canobi, fixed income portfolio manager.

Canobi says the defensive nature of fixed income goes hand-in-hand with an ESG approach, as it comes down to issues of trust.

“Fundamentally, what we do is lend money to corporations. We have seen many high profile examples over the last 10 to 20 years of companies that run on poor ethical principles and with poor governance structures.

"These tend to be the ones that you just don’t want to have in a portfolio,” Canobi says.

Companies that run on sound governance principles, have strong management frameworks and are cognisant of their impact on the society around them tend to produce good investment outcomes over the medium-to-long term, he says.

As for the environmental aspect of ESG, Canobi says companies that are positioning themselves now for future changes to government carbon pricing policies will be the beneficiaries when and if these policies are revealed over time.

Companies that are actively dealing with climate change now, in a real way, will be better positioned in the coming years and will experience a lower cost of capital and less abrupt change when policies are introduced, he says.

While this approach sounds appealing, O’Brien concedes there are a number of retail managers who have had products available in the market for a long time that have not attracted large amounts of money.

Championing ESG

But with the backing of the global head of asset management, Kevin Parker – whose ‘hobby horse’ is ESG – and much debate surrounding the issues of a carbon tax and climate change, O’Brien believes there will eventually be a tipping point in public opinion.

“What we are seeing is a lot more of the general population interested in something being done,” he says.

“It’s proven and tested with big portfolios that we have in Europe that have been going for more than two years.

“I don’t think it is something that is going to get 20 per cent of portfolios here next week, but over time, I think people will get fed up with what is happening on a policy level and will want to make decisions on their own,” he says.

“We’ll be there and ready when they do decide to come aboard.”

One of the biggest struggles ESG approaches face is giving investors a compelling reason to change their investment strategy, which often involves proving investors will not forego returns for the sake of being ethically responsible.

Canobi says this is an area he struggles with, as it is difficult to prove in a fixed income environment.

But being well-resourced makes it possible to generate strong portfolios that have a good chance of excess return performance versus the benchmark, he says.

“Because our investment universe is so large, even when we invest along ESG principles, I don’t believe we necessarily give up or sacrifice a lot of excess returns just because we are investing in that framework.”

Despite this, Canobi says it will always be difficult for fixed income approaches, ESG or not, to compete in the retail market if they are judged solely on performance.

“I feel very strongly, as does Deutsche Asset Management, that within the fixed income component of a retail investors’ portfolio, what is paramount are those defensive characteristics – those offsetting, uncorrelated characteristics,” he says.

“Clearly throughout the crisis we saw a number of high-achieving fixed income solutions that suffered horrendous returns because it came to pass that the risks embedded in those portfolios were quite high.”

Canobi says that he feels very strongly that what is delivered to retail investors needs to be robust from a risk perspective.

“I doubt we’ll ever compete with high-yield more risky style solutions purely head to head in the retail space.

“The way we differentiate ourselves is we are in the business of building solutions that stand up in volatile conditions – and frankly that’s when you need your fixed income portfolio to stand up,” he says.

Another question Canobi says he hears a lot is: ‘What difference will it really make on a global scale if little old Australia adopts a framework to mitigate carbon emissions?’

“I think the obvious answer is that someone has to begin somewhere in taking responsibility for these sorts of issues and that is also true at the investment level,” he says.

“It may not change the world overnight, but the point is: let’s begin. Let’s begin to actually apply what are good principles to our investment portfolios.”