ESG Integration

ESG – What Is It?

The term ESG Investing refers to an investment approach that integrates non-financial factors – environmental impacts (E), social concerns (S) and governance issues (G) – with financial analysis when evaluating a company, for the purpose of identifying material risks and opportunities. The terms Responsible Investing and Sustainable Investing are often used interchangeably with ESG Investing.

There are several other investment approaches that consider ESG factors, but are not ESG Investing as described above, including:

• Socially Responsible Investing (SRI) is a values-based approach to investing that incorporates ethical and moral considerations, often through the use of negative screening, such as no tobacco and no alcohol. The origins of SRI date back to the 18th century, when certain church groups forbade investing in producers of alcohol and tobacco products.
• Impact Investing is an approach that seeks to generate meaningful social or environmental impacts alongside a financial return, such as in the areas of sustainable agriculture and renewable energy.
• ESG Thematic Investing is a top-down approach that focuses on identifying industries and companies which stand to benefit from ESG factors, such as water management. Green Investing is a subset of thematic investing.

Before investing in a company, an investor, ourselves included, will typically evaluate the company’s financial statements, calculating any number of financial metrics while looking to identify material risks and opportunities. While many risks (i.e. excessive leverage) and opportunities (i.e. the introduction of a new business or product line) can be found in the financial statements, not all are found there. As example, a company’s carbon emissions or its employee safety record may not be found in its financial reports and, when they are disclosed, they are often not in a manner that allows for comparison to other companies.

Efforts are being made to address this lack of standardized reporting. The Sustainability Accounting Standards Board (SASB), an independent, standard-setting organization, published industry-specific standards to help companies identify material sustainability issues and set out how to report on these issues in a meaningful, standardized manner. As example, firms which have greenhouse gas (GHG) emissions as a material risk are encouraged to report their emissions as “metric tons of carbon dioxide equivalent (CO2-e)”. It’s still early days, but we hope to see more and more companies begin reporting using the SASB standards. When this happens, comparison across firms will become more meaningful and will inform better investment decisions.

ESG – Why Is It Important?

Identifying risks has always been an integral part of the role of an investor. As example, an investor may calculate a company’s leverage (measured as Net Debt/EBITDA) and, all else being equal, will likely demand a risk premium for a company with higher leverage. When the risks facing a company are non-financial, such as repeated safety violations or water usage in a water scarce region, an investor cannot ignore them. These risks could ultimately manifest themselves as material financial consequences for the firm.

Here are two examples where known non-financial factors, not captured by financial analysis, led to meaningful losses for investors:

• In 2017, Equifax, a firm providing credit monitoring and fraud-prevention services, announced a data breach that had exposed the personal information of over 145 million people. In the week following the announcement, the market value of Equifax shares fell by more than 30%. One year before the data breach, an ESG rating firm had downgraded Equifax to their lowest possible rating, citing the inadequacy of Equifax’s security measures.
• Another example of a non-financial early warning sign relates to the explosion at BP’s Gulf of Mexico Deepwater Horizon oil rig in 2010, which resulted in the tragic death of 11 crew members and one of the world’s largest marine oil spills. Ahead of this incident, BP’s safety track record had been lacking that of its peers. In the three years prior to the Deepwater incident, regulators had fined BP more than 750 times for “egregious, willful” safety violations, many, many times more than for its larger peers. In the months following the explosion, BP’s share price fell by more than 50%.

While these events were not inevitable, a consideration of the non-financial risks related to each could have led an investor to a different investment decision than would have been arrived at through financial analysis alone.

While we won’t delve into these items further here, the list of reasons why ESG is important includes:

• Growing proportion of companies’ assets being (less transparent) intangible assets, such as brand name, goodwill and intellectual property, calls for consideration of ESG factors to evaluate the risks to the value of these assets.
• Climate change and the transition to a lower-carbon economy are becoming increasingly important to investors. How a company is responding to these issues is often not found in its financial reporting and cannot be evaluated with financial analysis alone.
• Effectiveness of a company’s Board of Directors not always readily determinable from a company’s financial reporting.

ESG – Negative Screening or Engagement?

There are differing approaches to implementing ESG Investing. A common approach is negative screening, where an investor eliminates all companies involved in industries that it has identified as inappropriate. Industries commonly excluded include controversial weapons (cluster munitions), tobacco, gambling and pornography.

Another approach is engagement, where an investor does not screen out companies based solely on their industry. With this approach, the investor believes that change can be better effected through engagement with the company.

We support a hybrid of these two. There are several industries, which by their very nature present abnormal risks or benefit certain stakeholders at the expense of others, which we will not invest in, such as tobacco, gambling and thermal coal. We are strong believers in engaging with the companies in which we invest. Our engagement is not limited to financial matters; ESG is often a topic we discuss with these companies. Through our engagement, we have had success in contributing to change related to employee safety, board-level governance, particularly in the area of executive compensation, and reporting of ESG metrics, including carbon emissions.

How is the ESG Landscape Evolving?

One can see the growth in ESG awareness and support by looking at the United Nations’ Principles for Responsible Investment (PRI). The PRI has as its foundation six Principles for Responsible Investment, the first of which is “We will incorporate ESG issues into investment analysis and decision-making processes”. Since its launch in 2006, over 2,500 investment managers, asset owners and service providers have signed on as a signatory to the PRI. We support the PRI’s mission and are a signatory to the PRI.

With a focus on climate change, the Financial Stability Board (FSB) Task Force on Climate-related Financial Disclosures (TCFD) was established in 2015 to develop climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers and other stakeholders.

And as we mentioned earlier, SASB published guidelines for the reporting of standardized, meaningful environmental and social-related information.

Can You Do Good While Doing Well?

ESG has gone mainstream as topics such as climate change and the social impacts of a company’s operations have become top-of-mind for an ever-increasing number of asset owners and managers. Supporting this growth in ESG awareness and adoption is a belief by investors that it is possible to do good while doing well. Research has shown that an investment in a portfolio of stocks with strong ESG scores has often outperformed both the market and a portfolio of stocks with poor ESG scores. Perhaps not surprisingly, investments in stocks with high ESG scores may also be less risky.

Our Commitment to ESG Investing

An investor evaluates and measures many aspects of a business before taking a decision to invest, including items such as a company’s strategy, operations, industry, customers and suppliers, in addition to financial analysis. ESG refers to additional items to be evaluated and measured.

We are fully committed to ESG Investing – the integration of ESG factors with financial analysis and the many other aspects of the business that we consider when evaluating companies. This is not something new for us; we’ve been doing this for years. For us, ESG Investing includes ongoing engagement with companies concerning financial matters, as well as ESG risks and opportunities. When dialogue fails, we often reflect our concerns through our proxy voting.

While ESG Investing, by definition, concerns the integration of ESG factors in evaluating companies, investing in companies with good ESG performance can have long-term positive impacts on the environment and society. We are delighted and encouraged that our approach to ESG Investing, including engagement with companies, may be contributing to these positive outcomes.