Staying on solid ground

The concept of investing based on ethical, environmental or social factors has gained a strong following in recent years.

Indeed, despite the market volatility of the past two years — which many commentators predicted would damage its credibility — the concept has in fact gained strength and acceptance, with environmental issues in particular gaining importance politically and socially.

Investors increasingly understand that, when assessing a company’s investment potential, taking into account ‘ethical’ considerations such as the environmental or social impact of its activities also enables a better understanding of the company’s long-term plans and, thus, viability and worth.

There is still some confusion between socially responsible investing (SRI) — where the investment philosophy is driven by an ethical overlay (for example, refusing to invest in a tobacco or woodchip company) — and investing on the basis of environmental, social and governance (ESG) principles.

With SRI, depending on the pre-established investment criteria, the investor or fund manager simply refuses to invest in companies that, for example, manufacture weapons, or whose operations cause damage to the environment. One of the problems for fund managers with this approach is that one client will regard certain activity as heinous while another will consider it perfectly acceptable. At the extreme, the selection criterion may become ad-hoc and eventually meaningless.

ESG means investors can still choose to invest in a company that doesn’t meet ‘ethical’ guidelines but, if investing, give due consideration to the influence of these factors on the firm’s worth. Investors who decide to hold shares in companies that fail to meet high ESG standards will seek to enhance the value of their investment through actively trying to influence how the company operates within its challenges.

ESG investors instigate change, rather than sitting on the sidelines. I believe this is a far more constructive approach, which is more likely to see positive changes for the wider economy, improved sustainability of the business, and better long-term portfolio performance.

ESG investors can become signatories of the United Nations Principles for Responsible Investment (UNPRI), which was developed by the United Nations and a group of the world’s largest institutional investors and launched in 2006 by the UN Secretary-General. In Australia, ESG Research Australia (ESGRA) has recently been established to pursue similar aims.

These principles provide a framework for investment professionals to include ESG considerations in their investment philosophies, analysis and decision-making, and disclose such issues to investors.

A key benefit of ESG investing is that it enables shareholding in companies that are currently profitable and successful, without sacrificing ethical considerations.

If the company still seems like a good investment after evaluating all the ESG risks and fundamental analysis, ESG investors will still invest in it. But they will also seek to take steps — through lobbying, voting, discussion and engagement — to find ways to minimise the impact of risk in ways of operating.

It also adds a useful dimension to the analysis of investment opportunities. There is increasing recognition of the ability of ethical considerations to affect the fundamental performance of companies.

Clearly, those companies that integrate ESG aspects into their culture have a long-term outlook and plan for the business, and companies that are concerned with ESG issues place more emphasis on long-term planning across the board.

For ESG investors, no investment decision can be made without assessing the impact of ESG issues on the business’ future prospects, and they must be reviewed in the same way as, for example, the capital expenditure for the business or the quality of management.

Illustrating the importance of these considerations, the three main areas of ESG investing — environment, social and governance issues — have played a role in some of the biggest corporate stories and scandals in recent years.

Environmental issues

Companies that fail to manage their impact on the environment may see a negative financial impact from this, which affects the value of the company.

One example is Orica, which failed to respond to concerns about chemical leakage at its Port Botany operations. The chemicals leaked into the water table under the plant causing a plume of pollution that now extends far beyond the original operations. As a consequence, the company must now undertake an extensive and ongoing environmental clean up operation, and has put in place a $45 million provision to cover future liabilities.

Another good example is Gunns. Looking at just the traditional measures, such as short-term profitability, highlights only half the picture in an ESG investor’s view. Gunns has created controversy with its wood chipping of Australian native trees in Tasmania and its proposed Bell Bay pulp mill.

Such activities have the potential to create disruption to the group’s other operations, as well as generating political risks and decreased customer demand both from its domestic sawn-timber customers and its Japanese woodchip customers.

In effect, a question is raised about whether the company has a “social licence to operate”. These issues should, and do, impact the market’s assessment of value.

Social issues

In Australia, James Hardie is now better associated with its initial failure to provide for the victims of its asbestos operations than for anything else, and this failure has had a significant financial impact — both on the company’s immediate balance sheet through the cost of setting up an adequate fund and its legal costs, and in the long-term, through the reputation it now has of being irresponsible, uncaring and untrustworthy.

The importance of reputation cannot be underestimated by investors, as James Hardie has discovered to its very real cost.

Governance issues

A key area of corporate governance is board composition and remuneration, an issue that has come to the forefront of discussion since the market downturn.

Questions about how directors should be remunerated, how to make sure this remuneration reflects long-term performance outcomes, and what is fair, have been discussed at all levels of business and government, and will need to be dealt with adequately by companies if they are to remain an attractive proposition to shareholders.

Telstra is a good example of a company that has failed to satisfy shareholders — and indeed the regulators — of the appropriateness of its remuneration policy and has suffered reputational as well as financial damage as a result.

The key questions that ESG investors ask are:

• Will the activity decrease cash flows to the business now or at some future date? For instance, could the company be sued, suffer reputational damage, or be unable to get future work?
• Will the activity have to create a contingent liability that should be taken into account for valuation purposes?
• Alternatively, will the activity create a contingent positive benefit if there is a change in legislation, such as those companies that are well prepared for when Australia moves to the carbon pollution reduction scheme?

Depending on the outcomes to these questions, ESG investors can make a decision on whether to invest in a company and, if they do, what action may need to be taken to protect the long-term investment. Such an analysis and investment style will also assist in determining the style and extent of corporate engagement required to preserve and enhance the investments.

As an increasing number of professional investors and fund managers become part of the ESG movement and sign up to the UN Principles, their impact on company behaviour becomes increasingly significant. It is to be hoped that issues such as Orica’s chemical plume will become a thing of the past.

Roger Collison is head of research for the Tyndall intrinsic value Australian equities team.