SHIFTING THE NEEDLE: FROM ESG RISK MANAGEMENT TO ADDITIONALITY

Seldom has an acronym in the investing world elicited such passions. “ESG”, which stands for “environment, social, governance”, has sparked acrimonious debates, most obviously in the US where it has been decried as a “woke agenda” (Florida governor Rod DeSantis coined that term, which has since been widely used on the political right). But even in other markets where political temperatures are lower, ESG is contentious, with fund managers, clients and regulators clashing over just how it should be interpreted, regulated and sold to clients.

Underneath all this hot air, on the trading floors where practical decisions must be made on what to buy and sell, fund managers have been actively integrating ESG into their systems and processes. On one interpretation, ESG is just another way of assessing risk; in this case, the risks that arise from ESG issues. A company whose operations are all near the shoreline and vulnerable to rising oceans, for example, may face greater environmental risks than others less exposed to climate change. Similarly, a company with poor social indicators such as internal wage differentials and poor relations with communities around operations may eventually face an internal or external backlash that would damage profits. ESG, on this reading, is just another way to ensure investors don’t see their returns being compromised.

The amounts of investment that is now being managed in adherence to some or other ESG framework has grown exponentially. Flows into ESG investments reached a pinnacle in 2021 when the market saw an estimated $120bn flow to sustainable investments (against a global investment portfolio of about $100tn). The numbers appear to have been far lower in 2022 when a sustained spike in the oil price saw capital flow to fossil fuel producers. But this is likely a temporary blip in a trend that will continue with public and political pressure on investors to consider ESG factors.

What does this mean for emerging markets like South Africa?

To find answers, we need to understand the practicalities of how investors are turning these intentions into actual investment decisions. Many of the guidelines that investors embrace, like the

United Nations Principles for Responsible Investing (UNPRI), set down principles to apply, rather than specific methods to use. As a result, we have seen a wide range of approaches in practice, from investors who simply select companies that profess to report on ESG outcomes to those who actively investigate companies to determine the difference they are making in the world.

In general, though, we see a trend towards application of a certain type of model. Investment decisions are often driven by models, tools that fund managers develop to identify suitable investments. Traditionally, such models will draw out investments that appear to be worth more than their price, analysing financial information about companies, the economies they operate in and market data on their shares. Models have naturally been extended into the ESG realm. In this case, though, the numbers come not from the vast financial databases that investors subscribe to, but from a wide array of other indicators that investors have found to try and convey the factors represented by the acronym. There are several data providers, including global names like Sustainalytics, MSCI and FTSE Russell, which produce standardised indices and ESG scores on companies (see story on indices). That information can be incorporated into models, alongside other indicators drawn from potentially hundreds of sources such as World Bank data, data produced by non profits like Transparency International and Freedom House, satellite imagery of weather patterns, social media analysis using artificial intelligence, and so on. Investors naturally differ on what particular factors they consider important – many, especially in the developed world, focus on environmental factors such as CO 2 emissions, but will also include others.

The World Bank maintains a sovereign ESG data portal that is assesses governments, which is used by investors into sovereign debt. This looks at 72 different factors. Here are some of them:

• ENVIRONMENT:

- CO 2 emissions (metric tonnes per capita)

- Level of water stress

- Threatened mammal species

• SOCIAL:

- Access to clean fuels and technologies for cooking

- Unemployment, total

- Hospital beds (per 1,000 people)

- Gini index

• GOVERNANCE:

- GDP growth (annual %)

- Patent applications by residents

- Control of corruption

- Rule of law

To get back to how South Africa is affected, it helps to think how such models might score the country relative to others. South Africa is a global outlier in the carbon intensity of the economy. It has among the highest levels of inequality in the world. Its unemployment rate is catastrophic. Corruption perceptions have been deteriorating dramatically. On these it will be judged harshly by most ESG models. But there are also some measures on which it performs relatively well: government expenditure on education and proportion of seats held by women in national parliaments are two examples. Overall, though, if an investor is modelling at the sovereign level and deciding which countries should be upweighted or downweighted on ESG criteria, South Africa may well find itself shifted down compared with other G20 economies.

But while this may be true of sovereigns, what does it mean at company level? It is not easy to answer that, because it depends on the asset management house and portfolio manager. Some will look at companies through a sovereign lens, with the logic being that a company operating in a country with negative ESG features is not going to itself be able to escape these when it comes to ESG risks. Others will ignore the sovereign and focus only on the company.

In practice, fund managers will factor in company scores from various third-party providers like Sustainalytics, MSCI and S&P Global. The Sustainable Development Goals are increasingly used as a way of assessing companies. For example, a primary objective in the South African market given our policy goals of eliminating poverty is SDG 8: Decent work and economic growth. But the narrative dominating the ESG debate globally is firmly linked to SDG 13: Climate action.

There is, we believe, a climate bias in how ESG is interpreted, particularly in developed markets where most of the capital is held. Climate change is clearly a prominent international concern that affects people everywhere, but many social measures are focused within domestic environments and don’t easily translate into the decision frameworks of developed world investors. South Africa has an unemployment crisis, particularly among the youth, but Japan has a crisis of a rapidly aging population – how would investors’ models analyse these very different sources of social distress?

There is also a data problem – environmental measures are typically more straightforward to measure, in tonnes of CO 2 emitted or amount of fresh water consumed. It much harder to measure social factors like how a company affects sanitation or early childhood development. As a result, models tend to factor in data that is readily available, that can result in an environmental bias even if the investor wants to balance social factors in too.

Some of the decisions over models depend on what the investor is aiming to achieve with the ESG strategy. Some fund managers see ESG as a returns-enhancing mechanism. ESG analysis should bring out risks to earnings that can be factored into the investment decision. You may assume that high CO2 emissions, for example, would be perceived as a risk, but we have encountered investors whose ESG analysis identifies the risk of reducing CO2 emissions on the back of public and political pressure, resulting in higher costs for the company. That signal – a reduction in CO2 emissions – counts as a sell signal. So ESG analysis in practice can have the opposite effect to what you may expect: companies which are reducing CO2 emissions are picked out as higher risk because such reductions will increase the cost of production. So, an ESG strategy may result in investments that are high CO2, but harder to regulate.

In contrast, some investors are more focused on risks to their own reputations. They do not want the kind of negative headlines that would follow from being invested in the next Exxon Valdez oil spill or Nike sweatshop labour scandal. As a result they screen out companies where such risks may be present. The concern can be about the reputation of investors, but can also be interpreted as a responsible investment strategy that aims to screen out exposure to any activity deemed to be harmful, or at risk of being harmful. The same strategy applies when “sin stocks” like alcohol, tobacco and gambling companies are excluded as well as climate negative stocks like oil and coal companies.

This objective can be at odds with those investors who intend ESG to maximise returns, though some argue that excluding higher-risk stocks is potentially also positive for returns because such portfolios are more sustainable over the longer run. Such approaches to ESG are common among foundations and endowments and increasingly among pension funds, especially those related to public sector employers.

Both these strategies, returns maximisation and harm minimisation, assess companies on current performance. What is missing is an analysis of how companies are changing. And this leads us to the big gap in ESG investment as it is now practised: any consideration of how an investment can drive change.

ESG investment does often consider the role investors can play in influencing companies to change. This is known as an “engagement” strategy and can become a type of ESG investment strategy on its own. Such investors engage with companies actively, demanding better disclosure, plans to improve environmental performance and adherence to various ESG frameworks. For example, such investors can vote directors onto company boards who have a clear mandate to drive change, or vote against remuneration policies that don’t include ESG indicators as part of the performance assessments of management.

But there is to our minds a further step that is needed: the active steering of capital to support the transition of companies to more sustainable futures. And this is where South Africa has a clear interest: it requires masses of investment to finance the transition of its economy. If investors are trying to simply screen out risks or downweighting regions and companies that perform poorly on standard ESG metrics, then the transition is not going to find the necessary investment. This would be a perverse outcome because many of the wider goals of the ESG movement, such as preventing climate change, would be achieved faster if companies were funded to make the necessary investments to reduce emissions. Many of the same arguments apply in the case of social goals.

We call such an approach “ESG additionality” to focus on adding to the stock of ESG good in the world, rather than merely improving a portfolio’s relative ESG compliance by screening out exposures. A fund that is focused on ESG additionality may well have exposures to issuers that are currently poor ESG performers, but that is actively directing capital to finance transition. Such a fund can only be judged over time, by assessing the shifting ESG features of the investments it holds. Such a fund should be able to report outcomes, like “CO 2 emissions reduced”, rather than only in comparing its performance to a market aggregate and stating it has lower CO 2 exposure.

The Sanlam ESG Barometer aims to examine how such an approach can work in practice. Intellidex (as the research partner) set out to assess approaches and practices relating to ESG additionality among SA’s biggest companies, through a survey of listed companies. The concept of ESG additionality alludes to pushing the boundaries of ESG to generate positive outcomes in society through ESG activities as well as shifting the ESG outcomes of the operations of a company.

A fundamental consideration for ESG integration is financial materiality, a concept which refers to the identification of ESG issues that can have a meaningful impact on an organisation’s financial performance. Because certain ESG issues can have a material effect on a company’s financial performance, these issues must be taken into consideration when the investment decision is made. This notion of materiality is functionally the same as standard financial notions of material risks – any material risk to the earnings of a business, with ESG serving only to pick out those from an environment, social or governance perspective.

But ESG additionality focuses on identifying and pursuing investment opportunities that will achieve positive externalities. This different focus is related to the concept of “double materiality” – an extension of the key accounting concept of materiality of financial information. Simply put, double materiality extends the need for companies to disclose information on issues that could have a material impact on a company’s financial performance but also the organisation’s material impact on particular sustainability issues, for example, climate change. This notion draws apart standard financial risk analysis, that investors should rationally be concerned with, and ESG as a measure of impact on society outside of the firm, of direct concern to the public at large.

The Sanlam ESG Barometer aims to demonstrate how companies in the South African market are already pursuing ESG additionality opportunities through investing in projects that will achieve positive social or environmental outcomes. These initiatives span beyond traditional corporate social investment (CSI) or corporate social responsibility (CSR) activities, both of which are considered interventions that give companies a social licence to operate, to focus on the impact of the company’s core operations. CSR is often measured by the value of money spent on specific initiatives (say, as a percentage of profits) rather than the positive social or environmental outcomes as a result of these interventions. Measuring impact is more complex than simply considering the value spent. Over time, companies will have to become more intentional about this to demonstrate to investors how they are going beyond risk management to achieve positive outcomes.

The ESG Barometer intends to challenge conventional thinking on investor ESG integration. The case studies and analyses it presents aim to show how companies are doing in delivering ESG outcomes. We want to shift investor ideas about what should matter in their decision-making models. Ultimately, we believe it can support the mobilising of capital to fund transition in South Africa.

BY STUART