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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.

 

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