ESG Issues in Investing: A Guide for Investment Professionals PDF

2. Application: The Six Methods for Considering ESG Issues In Chapter 1, we discussed background information on ESG considerations in investing. In Chapter 2, we explain how ESG considerations in investing are being implemented. Investors use six methods for bringing ESG considerations into their d...

2. Application: The Six Methods for Considering ESG Issues In Chapter 1, we discussed background information on ESG considerations in investing. In Chapter 2, we explain how ESG considerations in investing are being implemented. Investors use six methods for bringing ESG considerations into their decision making: exclusionary screening, best-in-class selection, thematic investing, active ownership, impact investing, and ESG integration. These methods are not mutually exclusive and are often used in combinations. They are used by both value- and values-motivated investors. 2.1. Exclusionary Screening Exclusionary screening refers to avoiding securities of companies or countries on the basis of traditional moral values (e.g., products or services involving alcohol, tobacco, or gambling) and standards and norms (e.g., those pertaining to human rights and environmental protection). In values-based exclusions, the focus is on the business of the company, and entire sectors are excluded. In norms-based screening, the focus is on the company’s behavior regarding internationally accepted norms in such areas as human rights and labor standards. Where such values-based avoidance is built into the governing legislation (e.g., a ban on financing controversial weapons), exclusionary screening can also become a legal obligation. Exclusionary screening is the oldest ESG method. An important point to note regarding exclusionary screening based on values and norms is that the particular security will not be invested in regardless of how economically attractive it may become. The remainder of this section is derived from the descriptions provided by MSCI in 2014 in explaining the valuesbased and norms-based exclusions for its ACWI Select Global Norms and Criteria Index. Exclusions for the ACWI Select Global Norms and Criteria Index Companies involved in (1) serious violations of widely accepted international norms of responsible corporate behavior and (2) certain controversial business activities are excluded. The norms‐based exclusions are defined as violations of standards related to human rights, working conditions, the environment, anti‐corruption, and control of weapons. The business activities exclusions are for involvement in alcohol, gambling, tobacco, military weapons, and adult entertainment. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 17 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals Examples of Violations of International Norms Human rights: Companies involved in serious violations of internationally accepted norms concerning fundamental human rights, as defined in Principles 1 and 2 of the UN Global Compact, are excluded. Such violations include involvement in abuses concerning civil and political liberties, the deleterious impact of a firm’s operations on freedom of expression and free speech, and infractions concerning the rights of indigenous peoples. Companies assessed as being involved in “very severe” controversies concerning the following key performance issues are excluded: human rights abuses, support for controversial regimes, freedom of expression and censorship, and impact on local communities. Working conditions: Companies involved in serious violations of internationally accepted norms concerning fundamental labor rights, as defined in Principles 3, 4, 5, and 6 of the UN Global Compact, are excluded from the index. Such violations include involvement in forced labor, child labor, employment discrimination, and failure to respect employee rights of freedom of association and collective bargaining. Examples of Involvement in Controversial Businesses Alcohol: Companies earning greater than 5% of revenues from the manufacture, distribution, or sale of alcoholic beverages are excluded. Gambling: Companies earning greater than 5% of revenues from (1) owning and/or operating gambling establishments and/or (2) the manufacture or sale of products necessary for the gambling industry are excluded. 2.2. Best-in-Class Selection Best-in-class selection refers to preferring companies with better or improving ESG performance relative to sector peers. It could be implemented on either the level or the change in ESG performance—that is, investing more in companies with better ESG performance levels or momentum relative to sector peers. Best-in-class methodology is sometimes referred to as positive selection or positive alignment. In the remainder of this section, we discuss the application of best-in-class selection by NN Investment Partners.7 7 Formerly, ING Investment Management; our thanks to Nina Hodzic and Jeroen Bos for contributing information for this section. 18 WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues Approach to Best-in-Class Selection NN Investment Partners determines the relative position of companies in their respective industry by using ESG scores, which are based on both the opportunities and the risks that companies face. ESG criteria comprise around 150 factors, partly depending on the industry. Analysts look at whether a company has ESG policies and management systems in place, whether it has signed up for international initiatives, and what the actual conduct of the company is. For each industry, analysts at NN Investment Partners initially focus on the top 50% of companies in terms of ESG scores in each sector. Selection of companies that are close to the sector average depends on overall portfolio construction features, such as sector and regional risk characteristics and restrictions. Belief regarding Best in Class NN Investment Partners believes that the best-in-class method can improve the risk and/ or return characteristics of a portfolio. A strong ESG policy makes companies more aware of the various risks they face and increases overall transparency. Companies that score well on ESG issues are often more efficient with lower environmental costs—for example, a lower electricity or water bill. In addition, these companies are expected to have empowered human capital, resulting in higher productivity and a stronger reputation among clients, other stakeholders, and society itself. A strong governance framework secures the legal position of a (minority) shareholder in many ways, which starts to matter in difficult times. A best-in-class methodology needs to be combined with a check on ESG controversies in order to avoid potentially misleading claims, or “greenwashing.” Also, momentum in ESG performance is a strong signal of a change in the market’s perception of a company. Therefore, both the level of ESG scores and the change in ESG scores over time need to be considered. Two examples of best-in-class companies, included in NN Investment Partners’ sustainable equity strategies, follow. Best in Class: ASICS ASICS, together with its subsidiaries, manufactures and sells sporting goods. The company is headquartered in Japan. Through constant research and innovation, the company creates products and services that help people enjoy the physical and mental benefits of sports, contributing to a healthy society. ASICS seeks to integrate sustainability as a basic consideration in the design of its processes and products and to improve sustainability throughout the entire value chain. ASICS regularly checks working conditions in its supply chain. ASICS’ rating system scores each factory on a range of criteria, such as working hours and health and safety. ASICS’ ESG score, as determined by NN Investment Partners on the basis of data from Sustainalytics, is 68.4 versus the industry average of © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 19 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 57.2. The company scores well above average in all three areas (environmental, social, and governance) and shows positive momentum over the years. The company exhibits strong ESG policies, reflecting a commitment to mitigate related risks and impacts. There is significant evidence that corporate behavior at ASICS is in line with its strong ESG policies. Best in Class: Linde Linde is a global gas and engineering company headquartered in Germany. The company offers a wide range of compressed and liquefied gases as well as chemicals. Linde develops new applications in close collaboration with its customers, taking into account their specific needs. The company pays particular attention to the environmental impact of its production processes and focuses on making its technical processes and plants more energy efficient. In this way, the company can reduce carbon emissions of its own operations as well as those of its customers. The company has clear targets in the energy efficiency area. An improvement of 0.8% was reached between 2008 and 2012, and a further 0.86% a year is required to meet the 2017 target. The company’s water intensity is well below the industry average. Linde’s ESG score is 74.7 versus the industry average of 63.3 and shows positive momentum. The company scores well above average in all three areas (environmental, social, and governance). Linde has strong ESG policies and management systems and systematically identifies and controls risks along the product value chain. There is significant evidence that Linde is “walking the talk” with its strong ESG policies. 2.3. Active Ownership Active ownership refers to the practice of entering into a dialogue with companies on ESG issues and exercising both ownership rights and voice to effect change. Engagement with a company could be for monitoring or influencing outcomes and practices regarding ESG issues. Active ownership is in sharp contrast to the idea that investors should vote with their feet—that is, simply sell off the investments with questionable practices. Activism varies in terms of aggressiveness of the approach. Some investors may use publicized and confrontational measures, whereas others may prefer a more discreet approach. Note that “active ownership” is not necessarily the same as “activist investing,” which may rely more on aggressive measures commonly associated with hedge funds. The following actions are part of active ownership: 20 ■■ Vote in shareholder general meetings. ■■ Write a letter to the company. WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues ■■ Meet with company representatives. ■■ Raise a question at a general meeting of the shareholders. ■■ File a shareholder resolution. ■■ Attempt to gain a seat on the board. ■■ Call for an extraordinary/special meeting of the shareholders. ■■ File a complaint with the regulator/authority. ■■ Issue a statement to the news media. Achieving the desired results of active ownership takes time and is not without cost— most notably, staff time—thus, some investors prefer to pool resources and outsource some of the activities related to engagement. Next, we look at case examples of active ownership directly relevant to ESG issues. JP Morgan Chase’s Say-on-Pay Vote In the United States, say-on-pay votes are mandated by the Dodd–Frank Act. Under the statute, shareholders can endorse or object to executive compensation. Most companies can get majority support for proposed executive compensation. In 2014, according to Towers Watson, the average support for company pay practices was 91%, and only 2% of companies failed to get majority support. In 2015, in the say-on-pay vote at JP Morgan Chase, a record low percentage of shareholders approved the company’s pay packages for its executives. This compensation proposal also faced criticism from proxy adviser Institutional Shareholder Services. In total, 61% voted in favor of the measure at the annual meeting—down from 79% in 2014 and 94% in 2013. After the vote, it was reported that JP Morgan’s board would consider changes to compensation policies for top executives. The Church of England and Environmental Standards In 2013, the Church Investors Group (of the Church of England) continued its engagement program of encouraging companies that operate in carbon-intensive sectors, or that could be considered laggards in comparison with their peers, to report their greenhouse gas emissions to the CDP (formerly, Carbon Disclosure Project) and to adopt emissionsreduction measures. To enable engagement across the whole market, the initiative was based on sending tailored letters to the targeted companies. The program resulted in a © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 21 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals 72% improvement in the environmental performance of the 53 companies targeted. An academic assessment of the initiative showed, with 90% confidence, that Church Investors Group members were responsible for the most improvement among the FTSE 250 companies.8 Mitigating Governance Risk through Engagement During 2013–2015, Sparinvest, an asset management firm in Denmark, held a dialogue with the management of a telecom company headquartered in Japan to improve both the substance and the transparency of the latter’s anti-corruption strategies, policies, and systems. This engagement between Sparinvest and the telecom company was part of a wider engagement coordinated by PRI. Through meetings and regular communications with management, Sparinvest encouraged the company to improve in a number of indicators, including greater disclosure around whistleblower policies and incidents; the application of anti-corruption policies to contractors, subcontractors, and suppliers; and internal risk assessments and regular monitoring of the internal anti-corruption program. During the period of engagement, the company issued its first annual report with information on the integration of its sustainability and corporate social responsibility practices as well as its first anti-bribery handbook for its increasingly global workforce, covering such risks as facilitation payments. Most significantly, the company issued a clear statement of zero tolerance of corruption. At the beginning of the engagement, in 2013, a thirdparty provider scored the company—on the basis of public disclosure and a binary scoring method—25% against a series of 18 governance-related indicators. After the engagement with Sparinvest, the company’s score rose to 81%.9 2.4. Thematic Investing Thematic investing refers to investing that is based on trends, such as social, industrial, and demographic trends. A number of investment themes are based on ESG issues, including clean tech, green real estate, sustainable forestry, agriculture, education, and health. Although thematic investing is not confined to ESG issues, here we focus on examples of thematic investing that pertain to ESG issues. 8Church Investors Group, “Being Good Stewards: Church Investors and Corporate Engagement” (www. churchinvestorsgroup.org.uk/system/files/documents/JamesCorah/CIG-GoodStewards.pdf). 9Olivia Mooney, Principles for Responsible Investment; information courtesy of David Orr, Sparinvest. 22 WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues Profile of a Water- and Air-Themed Fund This fund is for investors who (1) wish to invest in the shares of companies focused on the water-related sector worldwide, (2) are willing to bear significant variations in market value and thus have a low aversion to risk, and (3) have a long-term investment horizon (at least seven years). It aims to invest in equities issued by companies operating in the water and air sectors worldwide. The companies targeted in the water sector include water production companies; water conditioning and desalination companies; water suppliers; water bottling, transport, and dispatching companies; companies specializing in the treatment of waste water, sewage, and solid, liquid, and chemical waste; companies operating sewage treatment plants; and companies providing equipment, consulting, and engineering services in connection with these activities. The companies targeted in the air sector include those responsible for inspecting air quality, suppliers of air-filtration equipment, and manufacturers of catalytic converters for vehicles. The fund invests at least two-thirds of its total assets in equities issued by companies operating in the water sector. Profile of an Alternative Energy–Themed Fund The investment objective of this fund is to provide investors with long-term capital. To achieve this objective, the fund intends to invest at least 80% of its net assets in equity securities of globally based companies involved in the alternative energy or energy technology sectors. Alternative energy includes energy derived from such sources as solar and wind power, hydro-electricity, tidal flow, wave movements, geothermal heat, and biomass/biofuels. Energy technology includes technologies that enable these sources to be harnessed; various kinds of storage and transportation of energy, including hydrogen and other types of fuel cells, batteries, and flywheels; and technologies that conserve energy or enable more efficient use of energy. Fund managers believe that over the next 20 years, the alternative energy sector will benefit from the combined effects of higher energy prices driven by population growth, developing world industrialization, and diminishing fossil fuel supplies; falling costs of alternative energy assets as the technology improves; energy security concerns; and climate change and environmental issues. The fund is a long-only equity portfolio of 30 equally weighted positions. Profile of a Food- and Agriculture-Themed Fund This fund seeks to achieve capital appreciation. To achieve this investment objective, it invests in a global and diversified portfolio of investments that provide exposure to the food and agriculture sectors. The fund is permitted to invest in a broad range of instruments, including transferable securities, units in collective investment schemes, exchangetraded funds, and exchange-traded commodities. It intends to take full advantage of the © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 23 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals ability to invest directly in derivatives in order to achieve the objective. In particular, the fund is expected to combine core conventional long-only holdings with synthetic equity swaps, contracts for differences for long and short equity positions, stock indexes or stock index options, and equity derivatives and equity derivatives baskets. 2.5. Impact Investing Impact investing refers to investing with the disclosed intention to generate and measure social and environmental benefits alongside a financial return. According to Global Impact Investing Network, the practice of impact investing has four core characteristics: (1) investors intend to have a social and/or an environmental impact, (2) investments are expected to generate a financial return on capital and, at a minimum, a return of capital, (3) investments are to generate returns that range from below market to risk-adjusted market rate, and (4) investors are committed to measuring and reporting the social and environmental impacts. The following examples concern Bridges Ventures, an impact investing specialist firm founded in 2002 in the United Kingdom. Investment Strategy According to the firm, its investment strategy is to focus on opportunities where investments can generate investor returns through helping meet pressing social or environmental challenges—be it backing businesses that generate jobs in underserved markets, or building environmentally friendly care homes for the elderly to sustain an ageing population, or providing flexible financing for innovative community transport models. The Gym The Gym pioneered the concept of low-cost gyms in the United Kingdom, opening its first site in 2008. It provides fitness facilities in purpose-built gyms that are open 24 hours and located mainly in underserved areas. The transaction represents a 50% internal rate of return (IRR) and a 3.7× multiple for investors in Bridges funds, of which a minority were rolled over to retain a 25% stake going forward, enabling these investors to benefit from the future growth in the business. 24 WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues The Hoxton The investment in the hotel The Hoxton produced employment for one of the bottom 3% of deprived wards in England. More than 70% of The Hoxton staff live in underserved areas. The hotel has won praise and awards from different publications, including GQ, the Guardian, and Observer Travel Awards. It has consistently achieved 90% or greater occupancy rates for its 208 rooms. The exit delivered a return of £13.3 million to Sustainable Growth Fund I, representing an IRR of 47% and 8.8× the total investment, and £1.9 million to Sustainable Growth Fund II, representing an IRR of 35% and 3.4× the total investment. SimplySwitch SimplySwitch is an independent and free online and telephone-based price comparison and switching service that offers consumers immediate, impartial information on the most economical and appropriate gas, electricity, home phone, broadband, and mobile phone suppliers. It was also the first service of its kind to be accessible by telephone as well as the web, making it easier for those who lack the resources or know-how to go online to save money on their household bills. SimplySwitch was sold for £22 million. The exit returned £7.5 million, which represented a money multiple of 22× for investors.10 2.6. ESG Integration ESG integration refers to systematic and explicit inclusion of ESG risks and opportunities in investment analysis. Unlike the best-in-class method, ESG integration does not necessarily require peer group benchmarking or overweighting (underweighting) the leaders (laggards). Similarly, ESG integration does not require any ex ante criteria for inclusion or exclusion. The integration of ESG risks and opportunities into investment analysis is relevant for most, if not all, investors. The following are examples of ESG integration. Valuation of Mining Companies and ESG Risks When valuing stocks in the mining sector, analysts at Citi Research analyze the management of the relevant ESG issues by the mining companies. In particular, analysts carry out environmental and social impact assessments and closure planning to gauge the quality of the process that mining companies use to assess and manage the environmental and social impacts of a mine throughout its life and beyond. As part of these assessments, 10 See www.bridgesventures.com/exits. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 25 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals analysts use environmental indicators (e.g., the ISO 14001, a family of standards that provide practical tools to manage environmental responsibilities) as well as health and safety indicators (e.g., lost production time due to labor injury frequency), along with an analysis of government relations and local economic and community engagement. These analysts are of the view that effective management of ESG risks can significantly reduce mine development lead times, which they see as critical to future earnings capacity. Exercising their judgment, the analysts appropriately adjust the discount rate for mining companies that have lower ESG risks. For example, in one case, the discount rate of a mining company with better ESG management was adjusted from 10.7% to 7.5%, which increased the estimated intrinsic value of its stock by 29%.11 Valuation of a Mining Stock and ESG Issues Anglo American, a mining company with operations spread across a number of countries, has received mixed assessments of its ESG performance. Although some analysts have taken a favorable view of the company’s ESG performance for such reasons as its risk mitigation processes and track record on environmental management, others have taken a different view. In 2015, analysts at Robeco, an asset management company, stated that Anglo American scores low on some of its most material ESG issues, such as occupational health and safety and management of local stakeholders. These analysts believe that in platinum mining, Anglo American’s profitability is affected by wage inflation and labor strikes. Accordingly, these analysts revised their forecasts of costs upward by 400 bps, which reduced margins by 80 bps and the target price by –7%. In addition, reflecting several ESG factors, analysts at Robeco adjusted the weighted average cost of capital upward by 50 bps, which reduced the target price by –12%. The total impact of integrating ESG risk analysis into the Robeco analysts’ estimate of Anglo American’s target price is –19%.12 Valuation of Utilities and ESG Risks and Opportunities In the United States, the Environmental Protection Agency’s emission and carbon regulations are expected to have a material impact on valuing the power sector. Analysts at ClearBridge Investments believe that these regulations will increase the operational costs of the power plants with higher emission levels (e.g., older, less efficient coal plants) and require additional environmental spending. According to these analysts, incremental expenditures on environmental retrofits should make smaller, older coal plants uncompetitive and lead to their retirement. Implementation of mercury regulations alone could 11Justin Sloggett, Principles for Responsible Investment, email message to one of the authors. Sloggett, Principles for Responsible Investment, email message to one of the authors; our thanks to Willem Schramade, Robeco Asset Management, for permission to use the Robeco information. 12Justin 26 WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues lead to retirement of an estimated 17% of the country’s coal-fired capacity by 2017. Thus, the companies owning newer plants with lower emissions (consisting of renewables, efficient coal, combined cycle gas plants, and nuclear plants) will be relative winners. The increasing penetration of distributed solar power generation and utility-scale energy storage will have a disruptive effect on utilities over the longer term. For example, NextEra Energy (NEE), the largest wind and solar energy producer in the United States, will see a higher output growth and a more efficient cost structure than some of its peers as it drives earnings growth with these low-carbon energy sources. ClearBridge analysts believe that NEE has an attractive above-average earnings growth rate of 6%–8% and an attractive relative valuation.13 Deepwater Horizon and BP Credit Default Swap Spreads Poor management of ESG factors can contribute to corporate default, price volatility of credit securities, credit rating downgrades, and widening credit default swap (CDS) spreads. Consider the example of BP. On 20 April 2010, the Deepwater Horizon oil-drilling platform exploded, killing 11 workers and resulting in a large oil spill, the results of which cost BP several billion dollars. Prior to the catastrophe, some of the ESG research on BP had shown that the company had significant safety and environmental violations at its US operations, including fines. For example, in March 2005, 15 people died and 180 were injured in an explosion at BP’s Texas City refinery; in March 2006, there was a massive spill from a BP pipeline at Prudhoe Bay, Alaska. Most investors were not paying attention to the concerns that some ESG research reports had raised. In 2010, as news of the oil spill hit the markets, the BP five-year CDS spread jumped from under 100 bps to as high as 600 bps. Only then did market participants start to pay attention to BP’s unenviable record on health and safety. Not only BP’s shareowners but also its creditors were affected. Had investors paid attention to ESG research, they could have taken a number of actions to manage BP’s higher-risk profile—for example, by underweighting BP in their portfolios or by engaging with BP to improve its health and safety standards.14 ESG in Private Equity: Apax Partners Apax Partners adopted the Private Equity Council’s guidelines for responsible investment in 2009 and became a signatory to the Principles for Responsible Investment in 2011. According to Apax Partners, it considers sustainability issues in the early stages of 13According to Tatiana Thibodeau, senior analyst at ClearBridge Investments (http://www.clearbridge.com). 14Presentation by Christoph Klein on ESG integration in fixed income at the 2015 CFA Institute Annual Conference. © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 27 Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals any potential investment opportunity and monitors them throughout its stewardship of the investee company. Apax Partners has a number of initiatives in place in its portfolio companies to reduce complexity, waste, and energy consumption. Two examples, the first pertaining to energy and the second to waste management, follow. Plantasjen: This company has improved its energy performance by increasing insulation in all newly built stores and by installing heat pumps in six stores in the last 12 months. The increased insulation has reduced the energy consumption of the newly built stores by approximately one-third compared with older stores, and the newly installed heat pumps have reduced energy consumption by approximately 20%. KCI: This company offers a recycling program for facilities and patients that allows the safe disposal of certain single-patient negative pressure wound therapy (NPWT) devices. KCI provides this recycling program free of charge to the customer. KCI has partnered with Sharps Compliance Inc. to convert customer-recycled KCI single-patient NPWT devices into PELLA-DRX, an industrial resource with a BTU content greater than or equal to that of coal. Therefore, none of the Sharps Compliance–processed medical waste ends up in a landfill; instead, it is repurposed into an industrial resource capable of powering homes and businesses.15 2.7. ESG Integration Used More Widely Our survey responses indicate that ESG integration is the most used (57%) of the six methods available. This finding contrasts sharply with the perception that ESG issues are only about the exclusionary screening of “sin stocks” (alcohol, tobacco, and gambling). With the signatories of PRI, which emphasizes ESG integration, having nearly $60 trillion (as of April 2015) in AUM, it makes intuitive sense that ESG integration is becoming more common among investment professionals (Figure 6). 15The case study on Apax Partners was adapted from INSEAD, “ESG in Private Equity: A Fast-Evolving Standard” (2014): http://centres.insead.edu/global-private-equity-initiative/research-publications/documents/ ESG-in-private-equity.pdf. 28 WWW.CFAINSTITUTE.ORG Application: The Six Methods for Considering ESG Issues Figure 6. Methods of Considering ESG Issues A. How do you take ESG issues into consideration in your investment analysis/decisions? 57% 38% 36% 26% 23% 21% 4% ESG integration Best-in-class into the whole investing/ investment positive analysis and alignment decision-making process Exclusionary screening Active ownership Thematic investing Impact investing Other © 2015 CFA INSTITUTE. ALL RIGHTS RESERVED. 29