Fund managers naturally consider a range of environmental, social and governance (ESG) issues in their investment decisions – much like they have always taken non-financial factors such as corporate culture, geopolitics and regulation into account when considering investments. So ESG is not a new concept… but in recent years it has certainly evolved into a more structured discipline. This has been driven by rising interest from clients, growing pressure from regulators and the advance of investors’ initiatives such as the UN Principles for Responsible Investment. All these are placing greater pressure on asset managers to clearly articulate their approach to ESG.
Another crucial driver has been the advent of specialist ESG service providers, who have improved the quality of information available to investors, enabling them to take a more formalised approach to incorporating these issues in their processes.
Some consider that the first stage in assessing a company’s ESG credentials is to look at the ESG ‘score’. These scores are based on external sources of ESG analysis such as MSCI and Sustainalytics, and aim to assess the ESG risks a company is exposed to. While a useful starting point, our view is that the scores themselves shouldn’t be used in isolation. Sensible investors will take individual scores with a pinch of salt, recognising that they represent just one perspective on an often highly complex set of issues. Research supports this view, signifying there is little agreement between ESG ratings agencies’ scores (Chatterji et al[i]) suggesting it’s not advisable to rely too much on the score alone.
For us, the real value lies in what sits behind a company’s score, i.e. what the data and analysis tell us about the risks the company faces and how well they are managing them. Whether or not the company is improving or deteriorating can be a valuable warning sign and tell us a lot about the quality of the management team.
The analysis will often prompt a discussion with the company to help us better understand their policies and actions. Engaging with senior management of companies on governance and other ESG issues is value-enhancing. Our role in the Corporate Finance and Stewardship team is to provide an advisory sounding board where appropriate, and to challenge management if we feel they are not living up to our expectations. CEOs tend to be highly competitive creatures… raising the spectre of a weak ESG score in a meeting with the chief executive can prompt them to get the ball rolling shortly afterwards.
A crucial ingredient in all this is the ESG data reported by companies. This remains fragmented, inconsistent and of varying quality, while regulators in different countries set different reporting requirements and standards. However, availability is improving (see below charts), and the stars seem to be aligning. Developments such as the recent Task Force for Climate-related Financial Disclosures (TCFD) should result in more consistent disclosure of ESG information across sectors and geographies – a crucial step in the onward development of ESG.
There are other ways in which this ESG information is being used. In a low-return world, there is growing pressure on asset managers to demonstrate that, in addition to delivering long-term financial returns to our customers, we can help our clients achieve other goals through their investments. This is particularly relevant for the next generation of investors, many of whom are increasingly mindful of the origin – and the impact – of the products and services they buy, whether it’s fast-fashion clothing or savings & investment products. We see this scenario gaining momentum, further incentivising asset managers to embed an ESG overlay into their company analysis and broader investment processes so as to better serve the interests of this demographic.
Asset management has long focused on corporate governance as an indicator of company quality and as a mechanism for ensuring companies are run in the interests of their shareholders. Increasing investor focus is requiring corporates to increase their disclosure on Environmental and Social factors as well. We hope that this greater disclosure will encourage positive change by companies and help us, as investors, to make superior decisions. In the end, though, we believe there is no substitute for direct engagement with management teams to really drive corporate improvement.
[i] ‘Do ratings of firms converge? Implications for strategy research’ 2015. Aaron Chatterji, Rodolphe Durand, David Levine, Samuel Touboul