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Episode 16

What On Earth is ESG?

Published on: February 19, 2020 • Duration: 17 minutes

This week we help you to understand the thorny issue of ESG. Most think of it as climate change, when in reality its about corporate change. The market chatter looks at ESG scores and how these will be used by investors and corporate CEOs. Companies with high ESG scores may not be the ones people expect. And the whisper looks at investing trends and performance in ESG.

  • [00:00:04] What on earth is ESG? Twitter is generally less than complimentary with some of the following definitions of an ESG practitioner recently taken off Twitter

    An asset gatherer as opposed to an Alpha producer. 

    Someone who doesn't know how to make a profit. 

    The new feel good requirement to get new fund flows. 

    An online activist with a 4 01 K. scepticism and cynicism about ESG is alive and kicking. 

    But many people think that ESG is about climate change. It's not. It's about corporate change, potentially sweeping corporate change across many different disciplines. And that's the big conversation. 

    [00:00:55] This year, there's a real palpable shift from a rhetoric to an urgent call for action. 

    [00:01:01] The shift is coming. If you're ahead of that trend and you recognise that trend, there are opportunities to make money and the companies that don't measure up are going to suffer financially, in my opinion. 

    [00:01:11] The companies that failed to make that leap, you know, they'll lose on every one of those dimensions. 

    [00:01:16] Finance is gonna be reshaped. 

    So what is ESG and why should we care? ESG environment, social and governance is not quite the same as socially responsible investing or SRI, which really focuses on the social issues regardless of the financial impact to investors. ESG tries to identify measures which reduce a company's and therefore investors exposure to specific risks. For investors, it's been easy to dismiss ESG as yet another fad or marketing gimmick. Ignoring it has not been that hard to do because its not really had many consequences. In fact, until recently, it was fairly difficult to measure the costs and benefits for those who are trying to implement these strategies. At this year's World Economic Forum in Davos, ESG was by far and away the main topic of discussion. And this was not just a discussion about ESG investing, but also about ESG corporate compliance. A vast number of corporate leaders are now committing their company policy to an ESG future, and whether we as investors believe in it or not almost becomes irrelevant. There’s going to be great numbers of opportunities to profit from this trend and potentially lose out if ignored, regardless of whether we emotionally embrace this policy direction or not. But what the hell is ESG? Well, as mentioned earlier, ESG stands for environment, social and corporate governance. For most people, the focus has been resolutely on the E of environment, climate change, global warming, and all those battle lines have been drawn across various forms of social media. Of course, the environment is a key pillar, but ESG is also about much, much more than just the E as Andre Chanavat of Refinitiv explains. 

    [00:02:57] E is environmental. S is Social. G is governance. For example, how we categorise E: we've got environmental innovation, we've got resource usage and we've got emissions. The for social, for example, you'd be looking at human rights, your workforce has a health and safety issue. As well to think about, also what is your corporate social responsibility strategy? And then of course, the G. The governance. So as a shareholder, what are your shareholder rights? What is that? How is the board structured? So when we talk about ESG, we have over 450 individual measures. But, you know, you could go into easily into the thousands. 

    [00:03:33] In 1993, there were only 50 companies who published corporate social responsibility reports or CSRs. By 2015, there were over 7000. ESG data is now collected and collated into an ESG score of which will have more in the next section. But this means that companies can now be compared to each other, i.e. this is not just a flowery discussion about the ethics of ESG. It's a discussion about the metrics. And from that we can make a relative evaluation on individual companies. And the rise of measurable data allows investors, corporate partners and investors like us to make an informed decision about capital allocation. With that comes an opportunity for investors to profit from a corporate change which looks like it's about to take off. Whether you agree with the underlying principles or not, there will be plenty of opportunities for sceptics and evangelists alike. And that's what we should care about as investors, as outlined here by Audrey Choi, who focuses on sustainability for Morgan Stanley. 

    We don't even necessarily have to have the conversation about whether you believe in climate change or not. Let's have a conversation about what are you concerned about in terms of risks and opportunities for your portfolio. I think traditionally you're right, there's been this sort of tension of do I want to be a responsible investor or do I want to make money? Think about it another way. If I said to you. Would you like me to invest your money in a way that ignores a number of factors that could affect your business? I don't know many investors who say please ignore all those macro megatrend of facts. 

    So what does that mean? We may choose not to invest based on personal views of the environment or on ethics, but at the same time, we don't want to invest in stocks that might get penalized by large investors. Personally, I do want to invest in stocks that are receiving beneficial flows as a result of maybe their ESG score. And markets have constantly presented us with opportunities that we didn't have to like, but we still try to embrace in order to make a profit. For instance, although the tech boom of 1999 was at the time, clearly a bubble to many people, though not all, many sceptics still rode that bubble for profit, even though they didn't accept that soaring valuations were going to be a new paradigm. Today, we dont have to believe in Tesla's accounts or its business model in order to participate in the opportunity to make or lose money in the stock. Huge volumes there suggested traders and investors are indeed embracing that bandwagon. Many argue that the current shift towards passive investing itself has been a catalyst for the resurgence in ESG discussions by active managers who are trying to stay relevant in the face of dramatic outflows. But despite that, there are still many investors who continue to profit from that passive trend. Even if they believe that passive investing is ultimately unsustainable, what's key here is that the adoption of ESG is not just by institutional investment managers, it's by a broad cross-section of the corporate world. And 2020 looks like it will be the year when the adoption of ESG policies will reach a critical mass amongst key corporate stakeholders. It's a sort of tipping point onto which actual investment trends will start to exert themselves. We may or may not be individually willing on these changes, and these changes create the sort of uncertainty which we actually prefer to avoid. But if the corporates are willing to act on these policies, then we can either sit back and grumble or we can embrace and profit from these changes. And I guess the important question is, will these changes be fast or slow? And so far, these changes have been somewhat glacial, but it's clearly gathering momentum. Companies like Microsoft and BlackRock have publicly embraced it. More will follow. Now, this might not affect our portfolios this week or even this month, but ESG will increasingly be at the forefront of many investors and particularly CEOs decision making. For investors, forewarned is forearmed. Even if ESG adoption is approaching a tipping point, it won't necessarily be the catalyst for an extreme market move. But it might help investors avoid the worst vagaries of such an event. So, for instance, a discussion is building about the pricing of a potential carbon correction. And what's that, you might say? Well, according to Refinitiv data, last year, around about 20 percent of global emissions were taxed at around about $28 per tonne and that came to a total of about 220 billion. Now, if all emissions were taxed, the number would be about 1.2 trillion dollars higher. So it's a big absolute number. But when spread across all corporate revenues, that's only an additional cost of about one per cent. But if the IMF get their way and impose a $75 per tonne tax, then the carbon gap would widen to 4 trillion. Once again, it may be that policymakers fail to act or don't want to act, but business leaders who are increasingly adopting the ESG narrative will still need to factor in the possibility that policymakers might act. Therefore, monitoring ESG data could help investors avoid the worst drawdowns. And this is why corporate change is key. Within Refinitiv categorization, emissions only make up 12 percent of the total ESG score anyway. So it is that ESG is a lot more than just the E. And the key thing to remember is that ESG is fast becoming a critical new factor to help investors in their decision making process. This is not about embracing climate change. This is about embracing corporate change. 

    [00:09:06] Clearly, there's an increasing amount of chatter about ESG, but how is it gonna be measured and how can people make informed decisions, particularly investment decisions? Companies are now signing up to the ESG protocols. And that means that they're providing increasing amounts of data. Now, this data can be compared and ranked so that each company can be given its own ESG score, which then obviously begs the question, what's an ESG score? There's a number of different methodologies and nothing has been standardized as yet. But we'll look at one that Refinitiv have put together. As outlined in the previous section, environment, social and governance issues are the three main pillars under which there are numerous subcategories. Environment, for instance, is subdivided into resource use, emissions and innovation. Social is subdivided into workforce, human rights, community and product responsibility and governance is subdivided into management, shareholders and corporate social responsibility. By way of example, within the governance pillar, issues such as CEO compensation linked to total shareholder return are also taken into account. For instance, if this has been rising to the detriment of other stakeholders, it would be marked as a negative and I think most people would probably agree with that sentiment. Those 10 ESG themes are then combined across three main categories to provide the ESG score. Refinitiv also include an additional category, the controversies score, which has collated from media sources and is combined across all the 10 themes in order to discount the main ESG score for, as its name suggests, public controversies. Together with the main ESG score, this forms the combined ESG score. These scores can then be ranked, where a score of zero to 0.08333 gets you a D minus, which is the lowest grade whilst a score between 0.9166 and one gets you top marks of A plus. Marks of C plus and B minus are a round about middle of the class. In terms of the ten categories, the weights are not divided equally. For example, emissions have only been allocated 12 percent of the total. The two largest weights go to management within that governance pillar at 19 percent and workforce within the social pillar at 16 percent. And the three pillars environment, social and government social takes a slightly higher weighting at thirty five point five percent. So ESG scores are therefore taking into account a wide variety of factors. And it's not just dominated by climate. Even though this drives the majority of the narrative. And the ESG score then opens up the discussion about comparing companies with peers within and across sectors. Some of the large cap energy stocks may be expected to score badly, but that's actually not necessarily the case. For instance, Royal Dutch Shell scored straight A's across the three pillars of environment, social and governance, scoring a maximum A plus in that environment. Pillar, which, if you recall, has three subdivisions of resource use, emissions and innovation where the company collects an A plus for each of those three themes. Now, whilst the basic ESG score for Shell is an A, the combined grade drops to a C plus, scoring about 44.6 points because of a poor return within the controversies category, where it's polled particularly badly on business ethics and anti-competition. And many other energy companies have a similar score. Exxon also achieves a combined score of C plus with A's across those three pillars of ESG, but another D-minus within the controversies box, where it does score poorly on the environment section. And it may be a surprise that Tesla, the company, scores much lower than Shell and Exxon with a combined score of just under 20 for a D plus grade versus C plus for the energy majors. And Tesla only really scores highly in the innovation category of environment pillar. So Tesla cars may be eco friendly, but the company is struggling with its ESG score. And its rival in the luxury electric car category, Porsche, ranks even worse with combined point score of 9.75 for a D grade, the second lowest category. At the top of the league, with a combined score close to 93 is a US resort stocks, a holiday stock, but also an Italian oil services company, which may be a bit of a surprise. There's only a few companies which score below 10. But yeah, in fact there are a number of chemical companies around those levels. But hopefully it's now clear that ESG scores are not just about jumping on the environmental bandwagon. It's about recording a vast array of data inputs for corporate decision making. ESG scores made up from company filings will increasingly help guide corporate leaders within this evolving framework. Some investors will use these scores, whilst others will care very little about them, at least at first. 

    [00:14:00] But ESG and ESG scores are here to stay. 

    [00:14:10] For ESG investing rather than corporate compliance, the ultimate proof will be in the performance. Refinitiv have identified a number of ESG investment strategies such as ethical and negative screening, to avoid companies involved in unethical activities and positive best in class screening for companies that demonstrate a positive contribution to sustainable development. But are stocks with a high ESG score going to outperform on a regular basis other stocks with lower scores. It's too early to say, although there are now an increasing number of ways in which we can track the performance of ESG factors. But we still have to be aware that stocks with a high ESG score may be outperforming other stocks for non ESG reasons. Indeed, many of the factors followed by pure quantitative strategies will only have a small percentage of a stock’s out or underperformance that is attributable to one single factor. And within a suite of ESG products we are going to see quite a lot of differentiation. Some investors may focus on social aspects, others on governance. One such index is the Refinitiv Global Diversity and Inclusion Index, which ranks over 7000 global companies and identifies the top 100 publicly traded companies with the most diverse and inclusive workplaces, measured by 24 separate metrics. This global index has outperformed MSCI World Index over the last 10 years, though, with names like Accenture, Diageo, BlackRock, Novartis, Allianz in that top 10 by market cap, this may indicate that large international companies, which will often be the beneficiaries of, for instance, passive inflows, are also the ones that have been best placed to address the specific ESG topic. Both the MSCI World Index and the Diversity and Inclusion Index have been lagging the S&P 500. In Australia, the Fossil Fuel Free index has also outperformed the broader Australian market over the last five years. The top 10 holdings of that index, however, lack any of the large cap Australian banks, which have significantly underperformed the broader Australian market. But for those who want to embrace ESG concepts, there are now many ways to track the data to follow some of the investing trends via indices and create personal portfolios that follow the ESG protocols. Now, whether ESG investments begin to outperform or not, it's worth keeping an eye on these concepts and indexes to basically make sure that we're not being left behind by sea change in sentiment.