Triple Bottom Line Investing’s European flagship conference brings together practicing investors and asset managers who control a significant amount of the world’s capital, including representatives from Brazil, Japan, the U.S. and Europe.
The assembled functional expertise is varied, from mutual fund administrators to insurance actuaries to private equity investors, but all attendees trade notes on how they are incorporating environmental, social and governance (ESG) issues into their investment and risk mitigation process, and what outcomes they have seen to date. I traveled to Zürich to participate in the conference in November and to me, three main strategies stood out:
1. Exclude companies that don’t meet ESG criteria.
Investors discussed their strategy of avoiding investment in companies that do not meet certain ESG criteria, in much the same way that many money managers avoid investment in tobacco or gambling.
Pro:
This is a fairly effective way to satisfy increasing client pressure not to support businesses that are inherently unsustainable (such as fossil fuel companies) and to avoid areas with murky corporate governance (such as Nigeria).
Con:
This invites tracking error (namely elevated beta) into the portfolio and forces the exclusion of otherwise worthy businesses. One example noted was a Chinese utility that derives 60 percent of its electricity from coal, which is down from 100 percent just a few years ago. The other 40 percent is renewable, making the utility one of the largest renewable energy companies in the world and possibly worthy of support considering its progressive nature.
Aggregate data can be misleading. Some multinationals that perform well in aggregate on ESG scores have divisions or regions that, when looked at in a more granular way, reveal they are laggard. This was the case for BP pre-Deepwater Horizon disaster: Overall, BP performed well on ESG, but its scores in North America lagged. The story is similar for Petrobras before its major governance scandal.
2. Take a proactive stance.
Attendees discussed supporting companies that, both qualitatively and quantitatively, perform above average on ESG metrics.
Pro:
This strategy adds an additional dimension that can help predict a firm’s future performance. One participant, for example, spoke of a trader who performs fundamental analysis, includes ESG data in his model, and then requests a quarterly investor call to ask the CEO or CFO questions about ESG. If they cannot answer the questions well, the fund manager takes that as a sign of general disarray in the business. Simply stated, CEOs and CFOs who lack awareness of long-term corporate concerns like ESG are a risk.
Con:
Many money managers have a hard time relying on non-quantitative judgments like the example above, and the over/under market rate stock performance data for companies with high ESG scores has not yet been proved on a long enough time horizon to be considered verifiable and trusted.
3. Brace for a bubble.
A final theme among some investors was preparing a strategy for when the “shoe falls” on the fossil fuel bubble. Although the use of fossil fuels may taper slowly, some members believe that the balance sheets of major fossil fuel extraction companies will experience dramatic asset write-downs. This bubble in asset values could force a value reset similar to the financial crisis. One presenter claimed that “$21T of in-the-ground fossil fuel reserves that sit on balance sheets as an asset will need to be written off because it is ‘unburnable’ given what we know about global warming and the likelihood of carbon pricing.”
The logic behind this position is strong if you believe that carbon will eventually be priced or limited in some fashion via international agreements (such as COP 21 in Paris). The math is relatively straightforward, using the amount of carbon that has been emitted since the start of the industrial revolution, then examining the elevated parts per million of carbon in the atmosphere now compared to pre-industrial revolution. Using estimates of temperature rise from continued growth in the carbon parts per million in the atmosphere, it is clear that there are more fossil fuels than can safely be burnt.
However, no one is certain whether, how or when global leaders will come to price carbon, or how this will affect emissions. Timing has always been of critical importance to money managers, but the timing of the asset write-downs is very uncertain.
It was intriguing to see how practitioners from around the world with significant expertise struggle with these issues. There is not one right answer for how to incorporate ESG into a company’s investment process. However, the most important task remains accurate reporting, so that investors and their myriad investment strategies can incorporate that information into their models, selection criteria and investment logic.