Responsible investing in 2019: some tipping points and some not
Andrew Canter, Futuregrowth Asset Management's chief investment officer, shares some insights.
The world of responsible investing has seen clear forward movement – at the very least an understanding that the choices about capital deployment have real-world consequences. To overcome the structural barriers to the change, investors should start by recognising that environmental, social and governance (ESG) factors actually do impact risk:return considerations, and that value-adding investment processes can be built around that idea.
Tipping Points: There are some long-standing trends that may be on the cusp of reaching concurrent tipping points:
- The World is Heating Up: Global warming itself could genuinely be approaching the point of no return – with visibly rising temperatures, melting ice, and altered climates. The ability to plan for the future has dropped from decades to mere years. Time for consideration of the necessary changes in humanity’s behaviour is becoming short. "The cost of not acting on the SDGs is becoming higher than the cost of acting.” — Paul Polman (Unilever)
- Investors Know the World is Heating Up: Until now, humans have been willing to trade 'ecology' for 'economy'. Asset owners and fund managers are now embracing a meaningful, large-scale change in the way they view carbon (or pollution) emitting investments. The shift of capital away from carbon emitters will increase those companies’ cost of capital, and hasten those industries’ relative decline. 'Stranded assets', a phrase first coined only a few years ago, has quickly become a real factor in company analyses. Further, the technology revolution is delivering large-scale investment opportunities in a more green economy (e.g. alternative energy production and storage). This is not an argument against jobs, but rather an argument in favour of a different set of jobs and growth drivers: It takes construction to build alternative energy sources, and employees to maintain and operate them. “The sustainability revolution has the magnitude of the industrial revolution but the speed of the digital revolution.” — Al Gore
- Political Risk has Risen: Inequality, slow growth, corruption and mismanagement have created political risk, such as the populist backlash against 'the status quo'. Capital owners (investors) invariably represent the 'status quo', and thus face risks of uncertainty, expropriation, taxation, and protectionism. Investors’ move to channel capital toward development, and to be more responsible, is both appropriate and defensive.
- The Rise of Purpose: The growing trend by industry participants to seek a sense of purpose is a positive development. Once investors move beyond the simplistic goal of “making money” toward “making money and being a positive force in the world”, we take on a wider role and duty, and that demands more varied analyses and better decision processes. Culture is a competitive advantage in building robust decision processes, but also in attracting clients and employees. All investors should seek top returns, but just as a parent must feed, clothe, educate and nurture a child – and do all of them well – so investors must seek returns while being a positive force. “Millennials will be 75% of the workforce by 2025: Demographics is a friend to culture change.”
- Active Ownership Tools: Investors globally are finding new tools to be responsible and engaged investors. This includes such things as proxy voting policies and reporting, direct dialogue with companies, a range of national 'stewardship codes', and improved reporting on sustainability issues.
- The Veneer of ESG: Asset owners and consultants are awakening to asset managers’ using ESG as a sales tool and not necessarily as an investment process. Asset owners are suitably skeptical, but are learning to differentiate between 'ESG on the label' versus 'ESG in the product'.
- ESG Factor Reporting: There is global movement toward requiring more comprehensive and standardised reporting on a range of ESG factors. Companies regularly issue standardised financial accounts for analysts’ interpretation. Likewise, improved information flow on Environmental, Social and Governance (ESG) factors is a vital first step for analysts to do their work. A good example is reporting on a company’s net carbon impact, their own 'internal price of carbon', and their own views of risks arising from ESG issues. However, presently there is a lack of standardised, consistent, high-quality data coming from issuers.
- People Lie, Monopolies Exist: The world is more awake to the reality that people don’t always tell the truth, and are sometimes active and unapologetic liars. Investors have often been willing partners in the stories told by company managers, in favour of rising share prices. Further, it is clearer now that industries are seeking – and winning—market dominance and monopoly powers. Lying, manipulation and self-serving are certainly not new, but our growing awareness of this could lead to backlashes from governments, competitors, regulators and investors. Humans have built complex societies and economies based on trust: But trust is being broken, and we are shifting toward a new equilibrium where we 'trust but verify'. Humans have inherent biases to believe 'everything will be alright' and 'he’s telling me the truth' – but perhaps the scales have fallen from investors’ eyes about the actions, motives and practices which we must more cynically assess.???????
- Deepening Responsible Investing: In South Africa, recent history of both corporate and public sector shenanigans, plus the rising tide of the Principles for Responsible Investment, Code for Responsible Investing in South Africa, and Reg 28, has led retirement funds, consultants and asset managers to contemplate how they can broadly improve governance standards. The King IV Code, for all its merits, is evidently not a panacea. Some ideas to improve investors’ role in corporate behaviour might include:
- Reducing Benchmark Cognisance: Equity managers and their clients tend to fetishize their benchmarks, and seek to maximise returns while minimising 'tracking error' against a broad-market index. This encourages asset managers to be 'closet indexers' or 'benchmark huggers' – reticent to stray too far from benchmark exposures. Thus, a manager with a strong view (either financial or ESG based) has a very difficult time going to 0 percent exposure of a large-cap share. Indices indiscriminately include all issuers with certain size characteristics – without regard to their sustainability. Until asset owners (i.e. clients, investors) expect and encourage more bold positions (relative to benchmarks) – and sometimes accept performance that deviates from flawed benchmarks – asset managers will be reticent to act strongly on their analyses, or listen fully to their inner voices about corporate misbehaviour. For example, even if an equity manager had strong suspicions about Steinhoff, he would have been unlikely to entirely remove such a large cap share from his portfolio. Had he held 0 percent exposure from, say, 2008, then his clients would have felt he’d been 'wrong' for ten years, before finally being 'right' in 2017.
- ESG Ratings: ESG analysis is a complex and expensive process, and there is space in the market for third-party ESG analysis and a rating process. While I would never advocate for an investor to abdicate decision responsibility (e.g. to rely on an ESG rating agency or a credit rating agency), such agents can provide a standardised framework and reporting on ESG issues, and be an input to one’s own analyses and decision processes. “An ESG score is a starting point for a conversation.”
- Analytical Independence: Investment analysts are subject to a range of inappropriate pressures which impair their independence. For example, there are corporate bullies who will exclude analysts who make critical comments or issue 'sell' recommendations on their shares from future conference calls or report backs. There are employers (e.g. banks) or shareholders (e.g. insurers) who are more interested in protecting their corporate relationships than allowing analysts and portfolio managers to work in an unfettered manner. Such interference happens – either overtly or subtly – with some frequency. South Africa has seen strong evidence of the protection offered by a free press, and investment analyst independence is equally vital in maintaining accountability and transparency on issuers in public capital markets. The mindset that “governance begins and ends with the Board of Directors” is well entrenched, despite a more sophisticated view that governance is the duty of the Board, insiders, capital providers (investors and funders), regulators, auditors, journalists, and customers.
Part two of Andrew's article will explore trends in responsible investing that are yet to come.