Environmental, Social and Governance (ESG) – An investment framework

Defining the scope of ESG

Outside of economic and company analysis, environmental, social and governance (ESG) issues have become an increasing component in judging the merit of any investment. This is differentiated from ethical investments, which incorporate moral aspects such as screening out weapons, tobacco or gambling, though in some cases the two work hand in hand. An extension of ESG is sustainability and impact investing which focus on positive measurable outcomes. An example is a company investing in products that reduce health risks or greenhouse emissions.

The most common factors assessed in an ESG framework are set out below.

– Environmental, for example land degradation, pollution and climate change.

– Social including health and safety, racial and gender issues and labour practices, particularly in the developing world.

– Governance extends to executive remuneration, board structure, accounting treatments and financial oversight.

Many now differentiate between environmental (E) and social (S), versus governance (G). They are linked, but require a different lens and approach. It is likely they are complementary and companies with an ethos of ‘E’ and ‘S’’ will also be cognisant of ‘G’.

Fund managers and investors can approach the implementation of ESG from different angles, all of which are valid. Top down starts at the headline level such as an overarching theme including broad economic parameters, while bottom up examines company behaviour and financial data. Performance has to be considered versus the benefits that are achieved.

From an investment stance, the greatest impact of an ESG overlay will come from assessing negative issues and therefore screening out problematic companies. Direct costs can clearly come from transgression of any of these factors, whereas indirectly investors many apply a valuation discount to any security if it is judged to be weak on ESG standards.

The positive aspects include employee engagement and transparency. Some suggest that companies with high ESG scores do outperform low scoring organisations, though this is not a uniform outcome and may be due to other reasons.

The implementation is based on a judgment made on set criteria. There are a range of organisations which provide independent ESG screens for fund managers and industry superannunation funds. Each undertakes their own screening and questionnaires. Funds use these for voting recommendations on board matters, as well as a basis for questions that can be put to management. Invariably a structured ranking or screening process requires another level of scrutiny. For example, large cap equities tend to rank higher than small cap due to the level of information they are able to provide.

The case is made that ESG investing takes a longer time horizon than many investors are prepared to consider. Environmental issues may take decades to become transparent, social problems can be difficult to verify and governance requires a forensic analysis of company accounts which can be influenced by short term fluctuations.

Environmental

To illustrate the complexity of EGS investing, a number of different examples are useful.

Environmental

Three large companies loom in the public’s mind in recent times.

– The Mexican oil spill for BP. In 2010, one of the company’s deep-sea wells blew out off the coast of Louisiana, leading to the sinking of the Deepwater Horizon drilling rig. Eleven rig workers were killed in the explosions and millions of gallons of oil seeped into the Gulf of Mexico. The company states the eventual cost will be US$61.6bn.

– The emission scandal for Volkswagen. To date, this has cost the company US$20bn and is likely to rise as countries outside the US seek reparations.

– The collapse of BHP’s Samarco tailings dam, at this stage provisioned at US$3bn. Further direct and indirect costs should be expected.

The secondary costs are clearly higher. Management time, loss of reputation, allocation of capital and uncertainty undermine investment returns for a number of years.

Many investors remain reluctant to participate in some sectors such as coal mining companies or those with remediation risk (for example petrol stations or chemical sites) and equities with such assets can be valued below their peers.

A common issue is the treatment and payment of labour which is regularly highlighted across south east Asia. On the other hand, social investing can encourage better outcomes such as illustrated below. Many can overlap with environmental themes, but also have social benefits.

As is inevitably the case, social investments have to pass the test of practical judgement and financial returns. More recently there have been regrettable examples in areas such as education and drug pricing.

Governance has the greatest potential for hard rules. Application of standards on board structure, remuneration and accounting offer the capacity to be judged on specific criteria. Even so, this will not always influence stock price performance especially in the short to medium term. That said, companies that score poorly over a range of issues and over time tend to underperform.

A well regarded group, Ownership Matters with which Escala Partners has an informal alliance, provides analysis and advice to local funds on governance risk.

Companies are ranked based on the list below:

The largest contribution to weak performance within the ASX100 from the issues highlighted above is from accounting risk. The bottom quartile of stocks ranked on accounting issues has underperformed the top three quartiles by 4% p.a. over the past 4 years.

Current examples of governance issues:

– Recently, Wells Fargo was found to have pushed its ‘cross selling’ strategy, where staff created fictional accounts to meet management expectations. The bank had been held in high regard due to its stable retail customer base and distinction from other US banks caught up in the repercussions from the financial crisis. Consequently it had a competitive advantage in its cost of funding. With the exposure of its business methods, not only has the share price come under pressure but the cost of funding has risen.

– Locally, at the completion of the 2015 AGM season, 14 companies out of the 221 with remuneration reports, received a ‘strike’ where more than 25% of shareholders voted against the adoption of the resolution. This pattern looks set to repeat itself this year with a high profile vote of 37.2% against the AGL remuneration report. The bulk of the issues for companies with a ‘strike’ relate to weak benchmarks for long term bonus incentives, exclusion of certain costs, particularly write-offs and high base pay often reliant on global rather than local comparisons.

– The interaction between the board and executive management can be one of the most important features of a company. Selecting a CEO and succession planning has become even more critical with the average tenure of an ASX200 CEO falling from 5.7 years in 2006 to 4.4 years in 2015. The turnover of CEO’s in Australia is some 35% higher than global comparisons, according to a study by PwC.

The challenge in the practical implementation of ESG cannot be underestimated. Everyone has to address their own judgement and many times the data is far from transparent. Further, many companies assessed as weak on ESG can outperform the underlying index. Would an investor be prepared to accept a period of underperformance if it can be attributed to stock selections based on ESG standards? A specific example has been the substantial outperformance of tobacco stocks over the long term.

Below we note a few of the current debates in ESG.

Industries such as gaming or alcohol are regularly under scrutiny. Investors themselves may choose to participate in such activities, yet they are generally judged as inappropriate for social good. Then where does one draw the line; should a retailer or provider of alcohol also be excluded?

Fossil fuels have recently been subject to heated debate in the industry super sector. Does that require applying a blanket ban on both mining and generation at any level? Is that contradictory to the reliance of many industries on this source of energy and should they too be judged on the way they use fossil fuel, albeit indirect?

In property, an energy rating is generally required for government tenants. Buildings with a NAPERs (National Australia Bank Built Environment Rating System) above the benchmark can have a lower capitalisation rate. Is the potential of higher income attractive to an investor where the valuation may be suppressed by a low energy rating?

Retailers adhere to standards on labour conditions, even though tracking the compliance within their suppliers can be challenging.  Does the desire to offer competitively priced product stand at odds with best practice?

Governance is the aspect of ESG where investors can take a direct stance. Locally, voting on remuneration, board elections and capital management is within investor’s ambit if there is a direct shareholding.

While funds are the decision makers in unit structures, many do discuss ESG issues in their consideration.

– One of our preferred global managers, MFS, believed the provision of education services was an attractive investment theme.  A major consideration was the use of cash reserves on the balance sheet of these companies, given pre payments are commonplace. In a number of circumstances the cash had found its way into investments unrelated to the strategy of the corporation and MFS excludes such stocks from its universe even though the potential share price performance was supportive of inclusion.

It may be the behaviour of funds themselves that can be problematic. This includes trading for their own interest rather than their investors, inappropriate fees, insider information, or not adhering to the product disclosure statement. Unfortunately, regulatory bodies often do not pick up on these issues. Where we believe there is any doubt on a fund managers’ ethos and alignment with investor interest, we prefer not to support such a fund, even if the performance of the fund merits consideration.

We are also somewhat sceptical on some funds that banner themselves as ‘sustainable, green or ethical’. A number are true to label, but some take a lenient view on interpretation, as well as chose to price up their product which is no more costly to manage than others without that label.

Credit funds are unable to vote and therefore rarely can take a position. That said, they are highly sensitive to the movement in credit spreads should any company come under negative scrutiny.