DON’T CALL IT A JOURNEY

ESG doesn’t even need to be spelled out anymore. Everyone knows what it stands for. But the worst cliché surrounding the movement is that it’s a journey. The reality is those who have yet to make any meaningful progress stand to be left behind. Elizabeth McArthur writes.

Last year was the first year that the United Nations Principles of Responsible Investment (PRI) delisted companies that signed up with big promises of investing in a responsible manner. Ten signatories were kicked out in 2019, and69 are currently on the watch list.

The baseline that the PRI expects from signatories is to have a policy covering their responsible investment approach for the majority of their assets, a staff member to implement it and someone senior to oversee it.

So if signatories couldn’t, or wouldn’t, meet those basic requirements why did they sign up in the first place?

“We are on the edge of a fundamental reshaping of finance,” BlackRock chief executive and chair Larry Fink wrote in his annual letter to chief executives earlier this year.

“In the near future – and sooner than most anticipate – there will be a significant reallocation of capital.”

Fink used the letter to outline BlackRock’s plans to place sustainability at the centre of its investment approach and to exit thermal coal while launching new investment products to screen out fossil fuels entirely.

The investment giant aims to divest all companies that generate more than 25% of their revenue from thermal coal by the middle of 2020.

However, the letter was not clear about the fact that the exit of thermal coal would only apply to BlackRock’s active mandates – 73% of its US$7.4 trillion in assets under management is in indexed strategies.

The E in ESG – for environment – seems to be most commonly grabbing headlines.

According to Rainmaker analysis, there are 165 ESG options offered by 41 super funds in Australia. Ten years ago there were next to zero.

In the US there were just 65 investment funds (excluding unit trusts) with the words ESG, clean, environmental, impact, responsible, social, or sustainable in their names as of 31 December 2007. By 31 December 2019, that number sat at 291. This extraordinary growth is not without scrutiny.

The US Securities and Exchange Commission is calling for public comment on how funds are named, in an effort to reduce misleading fund names – with funds labelled as ESG, ethical, responsible, sustainable or impact an area of concern.

Fidelity International, with US $2.4 trillion in assets under management, made waves when it introduced a system for rating the ESG qualities a company possesses and said it would integrate that score into investment decisions.

Fidelity International global head of stewardship and sustainable investing Jenn-Hui Tan 01 apologises for using the “worst cliché in ESG” when he says, “it’s a journey”.

Alphinity IM portfolio manager Bruce Smith is blunt on where he thinks ESG stands right now.

“ESG has become pretty much universally adopted by investors in the last decade, although with varying degrees of rigour. You wouldn’t be taken seriously if you didn’t say you thought about ESG,” he says.

“It really is a licence to operate; just like we expect companies to do the right thing, investors expect fund managers to do the right thing.”

Recognising this, MSCI executive director and head of climate policy and strategy David Lunsford 02 co-founded a start-up called Carbon Delta, which was acquired by MSCI in 2019. Carbon Delta developed new ways to produce data around climate change risk.

Its acquisition by one of the most respected research houses in the world was a clear indication that investors want data on climate change and that ESG research capabilities are worth investing in.

Meanwhile, Schroders head of sustainable research Andrew Howard 03 and his team have integrated ESG considerations across every investment desk at the $992 billion global asset manager.

“Climate change has become not just an environmental consideration but a business issue, a financial issue and an investment issue,” he says.

The growth in the number of ESG options is an indication that public opinion has swung in favour of ESG investing and Australian super funds are feeling the pressure from all directions.

Again, climate is front of mind.

Earlier this year, $85 billion industry fund UniSuper was hit with a divestment campaign organised by Market Forces.

The campaign has so far seen more than 10,000 people sign a petition requesting UniSuper divest from all fossil fuel companies.

Will van de Pol 04 , asset management campaigner at Market Forces, explains the campaign against UniSuper was driven by members, not by the fund’s investment strategy.

“We did this campaign in response to really clear demand for it,” he says.

“But I think there are other funds with similarly engaged membership bases and we are already getting outreach from people saying ‘what about my super fund?’”

In the same week Market Forces ran full page ads in Australian newspapers requesting Uni- Super divest, protesters gathered outside the offices of $50 billion industry fund HESTA.

This time the activist group in question was Healthy Futures, a group of health professionals concerned about the impact of climate change on the health of the population. As HESTA is the industry fund for health professionals, the group feels the fund should be more concerned about climate change, taking into consideration things we currently take for granted like clean air and water and safe food.

First State Super is also in Healthy Futures’ crosshairs.

And it’s not just the public putting pressure on funds, APRA is calling on all entities it regulates to consider climate change risk.

It wrote to super funds saying climate change will be firmly on the agenda as part of its efforts to increase industry resilience.

Market Forces and those who support its campaigns are clear on what they want – divestment.

Divest or don’t

J.P. Morgan global pensions executive Benjie Fraser 05 talks to the world’s biggest pension funds.

Of the total US$40-$50 trillion in defined benefit and defined contribution systems, 300 pension funds in the world are responsible for almost half that money.

It really is a licence to operate; just like we expect companies to do the right thing, investors expect fund managers to do the right thing.

Ninety of those 300 rely on Fraser and his team at J.P. Morgan.

He says his clients care deeply about ESG and their concerns have only increased over the years.

“These funds are considering how they conduct themselves in terms of investments. They are forming a continued view of what it means to be an owner of assets, how you link with your asset manager and the underlying investee company,” Fraser says.

While signing up for the UNPRI has been an option for decades, Fraser sees a series of forces accelerating how seriously pension funds take ESG.

“There are a lot of headlines around climate all over the world. But ESG is not only about the environment or climate,” Fraser says.

Regulatory pressures are another factor. Fraser has seen ESG integration accelerate since the Paris Agreement in 2015, particularly in Europe.

Europe has been something of a hub for forward-thinking on ESG, he says, with Article 173 mandating climate change related reporting for institutional investors in France and the European Union requiring occupational pension providers to evaluate ESG risk.

“The most systematic development of ESG goals has been in Europe but a number of the Australian funds have been early developers of negative screening,” he says.

Australia was one of the first markets in the world to move on tobacco divestment.

Local Government Super (LGS) first dipped its toes into ESG when it screened tobacco out of its Australian equities portfolio around 20 years ago.

The fund has a sustainability policy that informs all its investment decisions and a carbon neutral property portfolio which it prides itself on.

It also has a list of excluded stocks that is reviewed and sent to managers on a quarterly basis.

LGS head of responsible investment Moya Yip 06 says that while the funds negative screens include things like gambling, weapons and some of what it views as the worst fossil fuel stocks alongside tobacco – the issue members overwhelmingly care about is the environment.

“We get member enquiries, often around voting time, and around 95% of the enquiries we get are about climate change risk,” she says.

Even for Equipsuper financial planner Cara Sloshberg 07 , environmental factors are the number one ESG enquiry from clients.

“Equipsuper’s heritage is in the electricity sector so we tend to have a lot of people who work in electricity, gas and mining as members. I guess in some ways they tend to be less focussed on ESG just by virtue of the industries they work in,” she explains.

“I tend to find there is a group that are really engaged though, and they want to divest away from fossil fuels. It’s hard for them because there aren’t that many options.”

But negative screens and divestment aren’t the answer for everyone.

Mans Carlsson-Sweeny 08 , head of ESG research at Ausbil has seen a shift away from divestment to engagement.

And he agrues it makes sense, particularly if you’re an Australian equities manager.

“In a market like Australia, we’re a small country with a limited investment universe and we have good corporate access so investors are naturally incentivised to engage with companies,” Carlsson-Sweeny says.

“It’s not activism, it’s engaging in a consultative manner to improve companies and thereby improve their sustainability.”

Measuring success

Carlsson-Sweeny and his team at Ausbil conduct their own proprietary ESG research.

“We don’t buy any ratings; we don’t get any third party data on ESG research. We think the Australian market is quite small and we can do it ourselves,” he says.

His issue with third party data and ratings is that they are often based on public disclosures by companies and, as an investor, it’s obviously desirable to be one step ahead.

Bottom-up, original ESG research pays off, Carlsson-Sweeny says.

“A few years ago, I was trawling through social media and I found some information about employees being underpaid at a particular franchise,” he says.

Not one to name and shame, Carlsson-Sweeny declines to point out which company he is referring to but says the stock was rather expensive at the time.

“We actually took a short position on that stock in one of our long/short funds because we thought that information would eventually come out in the media. Sure enough, it took about a year and then the media started to write about it and that stock tanked.”

Relying on company disclosures would not have produced that result as a company is pretty unlikely to disclose the underpayment of staff unless its hand is forced, he says. Tan agrees. “A couple of years ago we had a model where the ESG team did ESG research and then we went to the portfolio managers and we said, ‘look at our piece on climate change or supply chain or whatever, isn’t this interesting?’” he explains.

“We were reaching them only after they had made their stock selection decisions, only after they constructed their portfolios. So they had already come up with a view of how they want to buy the stocks.”

Fidelity’s proprietary ESG rating system asks companies between five to seven questions, which are unique to the sector and sub-sector.

The questions vary greatly from sector to sector, analysts looking at oil for example might be asked to look at how the company is prepared for

future climate change regulation and how they are minimising health and safety risks.

Meanwhile, banks might be asked about their social license to operate, their corporate culture and how ESG is integrated into their lending practices.

“The main thing we try to do, and the reason we think this is the right direction, is it’s done by the investment team not by the ESG team,” Tan says.

“So our role changes, we are more consultants to other parts of the firm to help them integrate ESG.”

Fidelity introduced its rating system in July 2019 with a goal to rate every company it has under coverage by the end of the year. That goal was met and Fidelity now has 3700 companies rated.

Fraser and his team at J.P. Morgan are also taking ESG more seriously as time goes on.

“We’re building on the data that we provide to asset owners to include ESG factors. In the end, our clients want better data on this to further assist a positive engagement with their fund managers,” Fraser says.

“We are quite excited about being able to give data to our clients with additional factors relating to ESG.”

Fraser sees ESG as having well and truly moved to being something that should, at bare minimum, be integrated into the risk management process.

And as ESG grows, so too does the number of proprietary research systems. Howard and his team at Schroders call theirs SustainEx.

“Companies are increasingly being held to account for the impact they have on society,” Howard says.

“Really, all we’re doing with SustainEx is asking if companies were handed a bill at the end of the year, or a credit note, that said ‘here is the impact you’ve had on society that you haven’t paid for’, how big would the bill be?”

SustainEx applies a dollar amount to the costs or benefits of ESG practices.

“What we’ve done is turn everything into dollars, which means we can compare across companies and integrate that analysis into investment decisions in a way that’s traditionally not that easy,” Howards says.

Still, Howard does see a place for off the shelf, third party research on ESG.

“It would be a lot easier for us if we could use an off the shelf solution, we might have been able to go home a bit earlier,” he says.

“The problem we run into is there is no such thing as definitively good or bad ESG for companies or portfolios or sectors. There’s no consistent view of a company’s ESG profile.”

Tan agrees, saying Fidelity still looks at third party ratings alongside its own.

“We didn’t do this rating because it would save us costs. If anything it’s the other way around,” Tan says.

There are a lot of headlines around climate all over the world. But ESG is not only about the environment or climate.

“We still use third party ratings but we think they don’t give a full picture for a lot of reasons. One is, there’s not a lot of agreement between the different rating providers.”

J.P. Morgan too uses data from many sources to assess complex ESG factors.

“Taking in vendor feeds to support our performance and risk analytics service is our bread and butter as a custodian,” Fraser explains.

“But, in addition, we’ll now introduce ESG factors.”

The interest in ESG saw MSCI ESG Research make 2800 of it’s ratings public as part of a campaign to increase ESG transparency and data for investors.

MSCI ESG Research rates companies on an AAA to CCC scale according to their exposure to ESG risks, using 1000 data points from company disclosures and alternative data sets, across 37 key ESG issues.

A separate rating, the MSCI Climate Valueat-Risk (Climate VaR) measure was developed by Lunsford and his team.

“MSCI is putting an emphasis on climate change for a number of reasons,” he says.

For an idea of the scale of Lunsford’s project, Climate VaR uses a database of 600,000 company facilities and maps the climate risk to each facility.

The tool can even align a company’s behaviour to a degree of global warming.

The next big thing

In her role, Mercer principal – responsible investment Jillian Reid 09 takes a bird’s eye view of ESG integration.

She assesses the ways fund managers are integrating ESG into the investment process in order to feed that information back to institutional clients.

“When we research those strategies we need to maintain a focus on all the fundamentals

we would ordinarily be looking at,” Reid explains.

“We differentiate by asking the portfolio manager for company examples, how it’s affecting their investment decision making and how it’s changing their investment process.”

She says she has to be wary of greenwash, having experienced incidents where someone in marketing at a fund could speak about ESG but the portfolio manager couldn’t.

“You have to be careful about what’s measurement and what’s marketing,” Reid says.

Reid points to Alphinity as an example of a fund manager with research that integrates the UN Sustainable Development Goals (SDGs) into its investment approach – but they are far from alone.

For Smith at Alphinity, ESG is a nuanced issue.

“There is no single correct way to think about ESG,” he says.

“For instance, is AGL a good ESG performer because it is planning to roll out a large amount of renewable energy? Or a bad performer because even in 2030 it will still be generating a significant proportion of its electricity by burning coal?”

The UN SDGs come up a lot in discussions about ESG investing. They are 13 goals with 169 metrics underneath them.

They have proven not only worthy global ambitions but a useful framework for super funds, asset consultants, fund managers and consumers when it comes to measuring the impact money can have.

Tan agrees that many are looking to the SDGs for a framework, and measuring impact is in Fidelity’s sights.

“I think the whole industry is looking for a standardised solution, or at least a set of metrics to start to quantify the non-financial

impact of some of the stuff that we’re doing,” he says.

“I’m not really sure that we’ve found the answer and that there’s consistency of data out there.”

At LGS, Yip is busy developing an impact measure that will speak to the fund’s members.

LGS already provides members with regular updates on how its investments align with the SDGs.

For a super fund with many managers across many asset classes, it’s an ambitious undertaking.

“Our members care about sustainability, but they care more about returns,” she says. But this, of course, isn’t a choice. Fraser says his clients, some of the biggest pension funds in the world, are overwhelmingly of the view that ESG integration promotes better performance.

And, Fraser explains there is an additional factor in the Australian market that is applying pressure to the need to speed up ESG integration – choice.

Because Australia has a mandatory superannuation system but individuals can still largely choose their own funds, the factors that differentiate funds become very important.

“Because of the way the funds need to compete for members it will be interesting to see how ESG plays in the marketing to members and how members or member groups influence how boards now operate,” he says.

“That’s an additional factor among Australian super funds that I’m not seeing anywhere else at the moment.”

Sloshberg thinks Australia is “light years behind” the European pension funds that have led the way on ESG issues.

As an adviser, she often struggles to find the right solution for clients who care about the environment or any other ESG issues.

“I think there should be a rating system or a screening process that’s easy for members to be able to see and then everyone knows what that means,” she says.

So far, Sloshberg hasn’t found a solution that she can pass on to her clients.

Going forward, Reid says artificial intelligence and the ability to process data sets that are larger and messier than the kind of data the finance industry is used to will be key.

When it comes to climate change, MSCI’s Lunsford admits he remains an optimist.

In Lunsford’s opinion, it is absolutely essential that financial services get on board with the solutions to avoid climate catastrophe.

“The more that we increase the finance of global climate action, the more ambition that everyone will be able to take,” he says.

“The more finance that’s put on the table the more likely we will be to hit the two degree or one and a half degree target. We will not be able to increase ambition until the financial sector steps in and starts taking action.”

DON’T CALL IT A JOURNEY