Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 298

ESG by new means, to new ends

As shareholders question ESG (Environmental, Social and Governance) practices more than ever, we spoke to some institutional clients about how they are thinking about ESG when managing their funds. From reducing emissions to corporate culture and ESG risk assessments, the conversation highlighted the industry’s approach is not uniform but we are all grappling with the same issues.

Carbon production dominated client discussions

Depending on how you measure carbon, especially emissions versus intensity, a portfolio can yield different results. When it comes to portfolio construction there are two schools of thought: exclusion and inclusion.

On the one hand, excluding carbon producing companies in a smart beta portfolio lowers the environmental impact of the overall portfolio but may create an unintended sector bias. Allocating more funds to low carbon sectors can result in unintended tracking errors.

On the other hand, an actively-managed portfolio might invest in carbon-producing companies that have sensible action plans in place. Once these companies have achieved an emissions reduction, or steered their operations towards a more sustainable future, they generate long-term value and good returns for their investors.

As fund managers, we have a clear responsibility to avoid the worst impacts of poor ESG management to minimise the risk of losing client capital. As seen in the starkly different approaches to carbon emissions, there is not necessarily a single or correct way of mitigating ESG risks.

Credit risk analysis should focus on ESG as well as default risk

Identifying ESG risks requires a constant scrutiny of past and present decisions. Our analysis shows a strong relationship between our ESG analysis and our internal credit ratings. In 2018, 40% of our internal credit ratings were lower than those of credit rating agencies S&P and Moody’s*, with 60% of these being rated high or very high ESG risk. This highlights a potential underweighting of ESG issues by the market.

However, 30% of our internal credit ratings were higher than S&P and Moody’s ratings in 2018*, which again is partly a result of companies taking steps to address ESG risk and implement safeguards. ESG in fixed income has mostly been focused on the risk of default, however a company’s ESG practices can also give investors greater confidence in the quality of management and the business, positively shifting the risk versus return ratio.

We believe our strong ESG processes have contributed to our global credit income strategy having an average BBB security rating but delivering below AA default outcomes.

Research should scrutinise each issuer on a case-by-case basis against a range of ESG metrics. The risks are different in every sector. Warning signs range from safety lapses, regulatory fines and environmental breaches. In the electronics industry, investors should look for any signs of exploitation in a factory's supply chain, while the biggest area of scrutiny for banking is lending policies.

If it appears a company is managing any of these visible risks poorly, then we don’t have confidence in other risks being well managed. This interactive case study map includes over 100 examples from across our business.

One recent example was our raising Woolworth’s ESG risk assessment from low risk to moderate risk. While Woolworths has commendably exceeded its target to reduce carbon emissions and has partnered with Replast to address plastic waste, we hold concerns over the risks associated with allegations of underpaying employees found by the Fair Work Ombudsman. We anticipate that ongoing legal action from the Retail and Fast Food Workers Union, which is seeking damages of over $1 billion in back pay, could trigger a structural change.

Ethical sourcing of products such as palm oil and seafood also remains a concern, but due to investor pressure and the Modern Slavery Act, policies are being adopted by Woolworths to improve the social supply chain standard. We believe governance could be enhanced by aligning compensation with ESG factors.

Corporate culture often needs addressing to support successful ESG practices. ESG is more than making a statement about carbon reduction or unveiling a new social policy. ESG should be at the heart of everything that a company does and its corporate culture should serve as an incubator for lasting change.

These examples show that regardless of whether it is a smart beta strategy investing in thousands of companies or through bottom-up company analysis in a credit fund, ESG factors can be a powerful investment consideration that can deliver sustainable long-term returns and better social and environmental outcomes.

* Source: CFSGAM, Investment Opinion Network as at 31 Dec 2018. Moody's and S&P annual default studies, based on number of issuer defaults.  Averaged cumulative defaults since 1983.

 

Pablo Berrutti is Head of Responsible Investment, Asia Pacific and Mark Nieuwoudt is a Business Development Strategist at Colonial First State Global Asset Management, a sponsor of Cuffelinks. This article is for general information purposes only and does not consider the circumstances of any individual (view full disclaimer here).

For more articles and papers from CFSGAM, please click here.

 

RELATED ARTICLES

Top 10 ESG issues for 2019

UNPRI ready to go to the next level

Beyond the acronym, navigating important ESG choices

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.