Growth of ESG Integration Sparked by Risk Mitigation and Client Demand
ESG PANEL EVENT HIGHLIGHTS
Leveraging environmental, social and governance (ESG) ”screens” as part of the investment process is gaining momentum among active investors seeking to mitigate risk and gain alpha.
To delve deeper into the rationale behind this trend, Clermont Partners recently co-hosted a panel discussion featuring ESG experts at Northern Trust in Chicago on May 18, 2018. Participants included:
- Dan Nielsen, Senior Portfolio Specialist at Great Lakes Advisors, a full-service investment management firm. Dan oversees the firm’s ESG integration initiatives across fundamental equity, quantitative equity, and fixed income strategies.
- John Hoeppner, an Advisor at Arabesque Asset Management, a global asset management firm that uses self-learning quant models and big data to assess the performance and sustainability of companies. John focuses on the connection between ESG considerations and clients’ investment returns. He previously concentrated on ESG integration at UBS, Northern Trust, and Cambridge Associates.
- Victoria Sivrais, Founding Partner of Clermont Partners, a strategic communications firm, moderated the panel.
The key insights from the discussion are summarized below.
ESG Integration is Increasingly Going Mainstream
Client demand has fueled a growing interest in ESG investing. Given this catalyst, investors have taken a more sophisticated view of analyzing ESG factors. Mainstream portfolio managers weren’t typically looking at it from a social responsibility “do-gooder” angle. Instead, they had vague fears that the lack of ESG focus within portfolio companies might actually pose increased business risk. As a result, attention has shifted to using ESG screens to enhance the investment process, otherwise known as “ESG integration,” to mitigate investment risk.
One of the panelists compared ESG factors to debt loads. Clients generally believe higher debt levels make portfolio companies riskier amidst business fluctuations. They realize lower debt means less risk, and they leave it in the hands of the portfolio manager to evaluate.
Client preferences have impacted the following trends:
- First, there is an explicit marketing angle tied to client interest. Institutions are now creating ESG-branded products either by creating new funds or rebranding old ones.
- Second, as client demand has pushed PMs to consider ESG in their investment decisions, they are finding ESG integration is a beneficial discipline to add to the decision process. It has impacted their thinking and improved their own analytical capabilities. As a result, they are expanding internal resources to handle ESG, asking more questions, and setting more standards for portfolio companies.
Many CEOs mistakenly view ESG as a new development, according to the panelists. But in fact, it’s been a theme for the past decade and is now gaining more mainstream recognition.
Top ESG Factors
1. Culture. Simply put, culture affects the cost of doing business.
As an example, compare industry behemoths Costco and Walmart. Costco is viewed as having a more supportive and employee friendly culture. It pays its employees more than Walmart and offers better benefits and scheduling. On a cost basis, Costco employees are more expensive. However, at Costco, employee productivity is higher, turnover is significantly lower, and customers have a more positive experience interacting with Costco employees than they do with Walmart employees. Walmart ultimately spends more money on employees due to turnover and lower productivity.
One way institutions look at culture is employee turnover rates. For example, Merck’s aggressive recruiting and investing in researchers – not simply staffing up ahead of major scientific discoveries – is viewed by the panelists as a competitive advantage. The consistent application of this hiring approach will reduce Merck’s costs by reducing employee turnover. Merck’s CEO identified this as a critical element of its strategy, described why it’s important, and further explained actions the company is taking to promote a stronger corporate culture.
Another panelist mentioned that before he makes an investment, he looks at Glassdoor to read company reviews.
Important factors such as these are evaluated under the ESG “culture” umbrella.
2. Data Security. This issue continues to surge in importance.
Companies need to proactively address data security since it represents a major risk to many industries. As an example, panelists called out Wells Fargo. Despite having faced several highly visible data breaches over the past six years, Well Fargo’s CEO failed to address data security in an ESG presentation to investors. It was only after being asked during the Q&A session that he spoke for three to four minutes about all the different steps the company is taking to strengthen data security. As one example, the Board of Directors recently formed a subcommittee to focus solely on data security. In fact, the newest Wells Fargo Board member has expertise in data security, which was a key reason why she was invited to join the Board. While the CEO’s response was well received because it reduced the panelist’s perceived risk of investment around that topic, it would have been far better to include these points in his prepared remarks.
3. Environmental. PMs widely view this as a source of potential future cost and liability for all companies.
Reconsider Costco and Walmart. Walmart has done a tremendous job improving the fuel efficiency of its transportation fleet and making long-term renewable energy purchase agreements to reduce cost and improve its environmental footprint. On the flip side, Costco has lagged in these efforts.
The focus on “environmental” is not just for marketing purposes. On the contrary – it’s good management. If CFOs rely on electricity generated from fossil fuels, the cost could be volatile and uncertain. However, by securing a long-term renewable energy purchase agreement, the price of electricity can be locked in for those next three or five years, thereby reducing the manageable risk. For investors, this is a positive step.
Where Do Investors Get Their Information on ESG?
Panelists look at company filings, websites, sustainability reports and any other sources that provide ESG-related data. If a company does not disclose ESG information, investors will turn to other channels – namely rating agencies – to piece together the company’s ESG story. In this case, companies lose their own ESG narrative if they allow a third-party research vendor to evaluate its performance in these critical ESG areas.
For example, panelists discussed the many outside firms that gather data from 50,000 releases and categorize them as environmental, social, or governance issues. These groups will consolidate and aggregate all available information and generate ratings that shape perceptions of a company’s ESG performance. Some of this information is dictated by SASB, the Sustainability and Accounting Standards Board, which puts a lot of thought into determining the material issues in each industry. However, some of these sources will be idiosyncratic to individual companies.
Panelists stressed the importance of understanding the ESG issues that investors care most about and being able to report definitively that “these are the issues we feel are important to our success – our financial success – and these are the things that we’re doing.” It’s easier for mega-cap companies to invest in this effort because they have more internal resources and a longer history of publishing corporate social responsibility reports. But it’s not all-or-nothing. As a start, a small- or mid-cap company can disclose some initial information on its website about an issue they’re focusing on and build from there.
How Pervasive and Important are ESG Rating Agencies?
There are now approximately 650 rating agencies. Panelists believe there will be a few thousand in a year or two. Each agency has a different methodology for how they rate all the underlying ESG metrics. While there may be some disagreements, there are commonalities among the top agencies. As such, companies in the top quartile for one vendor are typically in the top quartile for all of them.
The two dominant ESG data providers, MSCI and Sustainalytics, are estimated to have at least 70% of the market, while Bloomberg and Morningstar’s fund ratings are on the rise. One of the panelists comes from Arabesque, an up-and-comer in this space.
Panelists believe company inclusion in ESG indices matters less for active investors, since most of them do their own fundamental analysis. Being included in a sustainability index can garner more publicity for a company, but the real benefit for investors is those companies tend to disclose more ESG information. However, a company being part of the Dow Jones Sustainability Index is not going to influence panelists’ decision to buy the stock .
Panelists stressed that it’s important to understand the focus of each index, such as disclosure, culture, or other specific topics. Indices can be very different – and a company may have vastly different scores depending on the underlying factors measured. Regardless, panelists advised companies to stay out of the bottom quartile.
When asked how they would counsel companies on ESG strategy, panelists said they would advise management to focus on near-term and long-term priorities. For example, if a company is doing well at disclosure and poor in some of the environmental areas, management may want to shoot for being competitive with its peers in the short-term, and reach the top quartile of more categories in the long run. Panelists agreed that some of these issues can’t be solved immediately. However, management acknowledgement and articulated steps towards improvement is expected by investors in the short term.
The panel also noted that ratings firms say companies rarely respond to them. Instead of ignoring these requests, panelists urged companies to evaluate the reports, see what these firms are getting right and wrong, and provide relevant feedback. To the extent investment managers use that topline rating, this is a company’s chance to influence its score. At a minimum, make sure research vendors have accurate and complete information.
It’s Ok to Be “In Process” Rather Than All the Way There
A company’s communications strategy should include being vocal and transparent about its ESG agenda and related progress.
While ESG communications are still somewhat new, the panelists said it’s a strong indicator to see what a company is conveying on its own. They look for what a company identifies as its most material ESG factors and how it’s managing those issues. Panelists evaluate whether those efforts are credible, effective, and will benefit the bottom line. Corporate governance and leadership are very strong components of the mix.
Will ESG Emerge as the Next Major Activism Topic?
Panelists believe activism within this area is still in its infancy, but people are getting more connected and data is becoming more transparent. They recommend companies focus on ESG topics in the context of value creation. For example, raising the issue of children being addicted to smart phones – is that really tied to value creation? It depends if there’s a belief it will impact brand strength of smart phone manufacturers. If so, then companies should have a strategy to address such threats. Panelists mentioned research that found in the 1990s, 20% of a stock’s value was tied to brand value, whereas today that figure is 80%. If the company’s action – or lack thereof – has a potentially long-term impact on brand value and brand strength, expect activism to rise.Back To Blog