Taking an equal approach to ESG

The times when advisers had an option to take into account the environmental, social, governance (ESG) considerations are over and those who are lacking in this department may actually be risking losing clients.  

Research from behavioural finance experts Oxford Risk found that more than 60% of retail investors were ready to move their investments to new advisers if they were unhappy about the ESG focus from their current wealth manager.

What is more, the focus on the ESG factors has become even more important for those clients who are now considering deploying cash into new investments. 

The same study found that only around 30% of current clients rated their adviser commitment to ESG highly or very highly, while 7% were of opinion that their adviser’s ESG focus was poor or very poor.

On the other hand, the Perennial Better Future Survey Report, which surveyed the Australian Securities Exchange (ASX) listed companies on how they are moving with all things ESG, found that 2020 and 2021 became watershed years for sustainable investment, with significant inflows into sustainable investment products, intensified focus on climate change and net zero emissions and governments paying more attention to ESG and introducing legislation offshore.

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Also, it meant that the increasing ESG engagement by investors with listed entities had led to improved disclosure and increased company willingness to engage on ESG topics.

The study also identified the three top areas of ESG which had the most material impact to the businesses and would be of focus for their managements in the next 12 to 18 months, with GHG emissions, including alignment with the Paris Agreement, coming in as the number one priority for companies for the second year in a row. This was followed by diversity, which moved up as a priority, while Modern Slavery and cyber security issues came in equal third.

Perennial’s head of institutional and retail, George Whiting, said that ESG considerations were definitely a growing trend among the advisers, although there was still room for growth.

“Asset owners were certainly the first to move on ESG as it becomes a criteria in almost every mandate but if you look at the wholesale small institutional market, particularly charities, ESG considerations have been embedded in their mandates for years and years,” he said.

“But as far as the adviser market goes, we are seeing it has become increasingly more important for ESG to be considered on the fund level, although there is still a lot of room to go there before it is properly engrained in the thinking of every adviser.”

When asked which component resonated the most with advisers and investors, Emilie O’Neill, co-head of ESG and equities analyst at Perennial, said that the environment part was “overwhelmingly most important criteria”.

“We definitely see the environment tops minds for clients, with more countries signing the Paris Agreement.

“For investors it’s about moving capital to help and support environmental outcomes. “Investors no longer want their money in things that are detrimental to the environment like fossil fuels, and they are willing to move their money in order to do so. So that’s been a really interesting shift.”

O’Neill further stressed that as far as other components were concerned, the small-cap companies were often involved in positive things from the environmental or social perspective but were slightly lagging behind in the governance space.

“Because they are small or they are newly listed on the ASX they don’t tend to have all the governance that we would expect normally in the large cap space. Governance is one bit that is lagging in small caps, but luckily this is one thing that we can work with companies to improve.”

According to her, the governance issues in the small-cap space often included gender diversity and board composition due to their size and the fact that those firms were also run, in some cases, by families.

“So, I guess a board composition is something that they typically perform on less strongly than large cap.”

Whiting also stressed that environmental factors in Australia were also one of the most tangible for everyone.

“That [environmental factor] is also the most obvious one where investors can see whether it is the cost reduction or future costs so that’s the one that is the ‘S’ and the ‘G’ for investors investing in a fund is not in plain sight for them so they could see that there are benefits. We understand that there are benefits in the ‘G’ and the ‘S’ but investors are probably more focused on the ‘E’.”

ESG IN INFRASTRUCTURE

However, for Sarah Shaw, global portfolio manager, chief executive and chief investment officer at 4D Infrastructure, when it comes to the investment process it is all about sustainability and the responsible investments rather than general ideas.

“We see the ‘E’, ‘S’ and ‘G’ as equally important as so we don’t just focus on one but we see them as quite integrated and we believe that you cannot have one without consideration of the other three elements of this acronym.

“We really ultimately looking to do due diligence around of all aspects of that in order to make sure that the investment proposition that we look at is sustainable and has that responsible investment strategy.

Following this, Shaw said that during the investment process there would be certain stocks completely screened out from the infrastructure opportunity set based on the ESG elements.

“This [screening out] process could be too much fossil fuel exposure, or this could be sanctions against social misconduct or it could be the case that companies do not report enough in English sources for us to be comfortable that we are getting the same information as domestic sources,” she added.

According to Shaw, one other important criteria when it came to infrastructure investments would be a country review.

“By that I mean we need to be comfortable with that country that this company is operating in before we even look at the company itself. If we do not believe that a country is an acceptable investment destination then we will not even bother looking at the stocks or those assets within that company,” Shaw said.

“We do invest in emerging markets as well and that assessment is done exactly the same way as every country that we look at. 

“The way we do that is we look at four elements at the country level: one is financial risk, one is economic risk, one is political risk and the other one is ESG. Now, those four factors together dictate whether we believe that a country is an acceptable investment destination or whether it is completely unacceptable or whether it is sort of transitioning. And every country is looked at on the individual basis.

“Once we look at the company level, we construct a portfolio based on those country reviews, based on company assessments, and we are looking at the combination of the quality and value and then we measure our portfolio on key and ESG metrics such as carbon emissions, board independence, shareholder alignments, social goals. And we make sure that what we are presenting to clients is offering a better track record on those metrics, than what we could get from the broad universe as a whole.”

Shaw also stressed that although the ESG considerations are integrated in the process through the outset, the infrastructure sector had earned a bad reputation from the environmental standpoint which was, according to Shaw, quite unjustified.

“We need huge investments in infrastructure and technology. Infrastructure as we know it, technology to improve that infrastructure, and infrastructure to improve the congestion. All of those things need to happen if the world is planning to meet our carbon goals by 2050 or whenever it may be,” she said.

“The reality is that infrastructure is probably part of the problem we are now facing in terms of decarbonisation needs.

“We’ve had globalisation, industrialisation, population growth, emergence of the middle class and a shift in demographic trends around the world, and that has created the emissions and environmental situation that needs rectification. 

“But if you take it from where carbon emission or environmental issues are stemming from then the biggest part is the energy sector, with over 25% of carbon emissions, and the second biggest sector is transport that is over 15% of carbon emissions.

“So unless we can build the infrastructure that can address those emissions, there is no chance of the world decarbonising or getting to net zero or however you are going to measure the goal.”

SCORING ESG

For Jack Nelson, portfolio manager at Stewart Investors, there are two reasons why sustainability and ESG considerations matter so much and both of them relate to long-term returns. These two reasons are the fact the world will not continue on the same developmental path while the second thing to consider is the quality of investors.

“The reality is that the whole world cannot follow the same developmental path which is carbon and resources-intensive particularly in the emerging markets which is where we are focused.

“In those countries, we see great opportunities to take a different developmental path and great risk if they do not. 

“So when we are looking at the companies in that context we care about sustainability simply because we are a long-term investor and we’ve held many companies for 25 years in our funds. You certainly need to think what is the development path that a society we are investing in is taking?”

The quality of investors criteria pertained to the “people behind the business”, their reputations and how they behaved in the past, he said.

According to Nelson, there were a number of companies which offered data-based approaches solutions which attempted to score and rank companies on these sustainability criteria and their performance.

“What we find sometimes is there is a lot of inconsistency between those quantitative approaches so you can find the same company having scored very well on one data provider on the sustainability efforts and scoring very poorly on different providers’ metrics,” he said.

“But we don’t really use those quantitative approaches and we don’t assign scores on sustainability and try to quantify something that is unquantifiable.

“You cannot put the number on the integrity of a manager but also you have to build it subjectively using face-to-face conversations rather than using a spreadsheet and you can’t take a shortcut of using a provider. You have to go out and do that active management and spend years getting to know companies.

“For us it’s much more fundamental, it’s not about ESG and scoring, it’s simply about saying how well is that company positioned to the future as there are many businesses out there which score incredibly well on ESG metrics but, to us, they fall out on the sustainability.”