Though investors are debating just what counts as an environmental, social and governance factor, their impact is now undeniable.
- David Hickey, investment manager, Lothian Pension Fund
- William Marshall, head of LGPS investment clients, Hymans Robertson
- Richard McIndoe, director, Strathclyde Pension Fund
- Ben Yeoh, senior portfolio manager, RBC Global Asset Management
Early in October the UN warned that the world is heading towards a 3° Celsius rise in temperatures if humanity maintains its current environmental impact.
The scientists behind the Intergovernmental Panel on Climate Change report hope that if governments and companies take drastic but possible action the rise can be limited to 1.5° Celsius – the more ambitious end of targets set in the Paris agreement.
The Local Government Pension Scheme (LGPS) has recently come under pressure for its role in influencing environmental change, particularly through its investment in the energy industry. Campaigners want the funds to divest, with fracking the most recent target.
These developments provided the backdrop for a roundtable at the LGC Investment Seminar Scotland, organised in partnership with RBC Global Asset Management. But environmental, social and governance (ESG) factors have been considered in investment for almost 20 years.
Richard McIndoe, director of the Strathclyde Pension Fund, the largest local authority pension fund in Scotland, said: “In 2000 I think I wrote our first responsible investment policy. I’m pretty sure we used ‘ESG’ back then.”
But there is a sense that demographic changes have upped interest in ESG, reinforced by the dire warnings of climate scientists and growing activism on issues like workplace diversity. “We’re doing a lot of work on ESG recently,” said William Marshall, head of LGPS investment clients at Hymans Robertson. “There’s increased interest around the board.”
Though the roundtable was focused on the Scottish LGPS, Mr Marshall said that, in the private sector, pensions regulations were increasing focus on ESG. “In the last six months or year there’s an unbelievable amount of interest,” he said. “You’ve seen a change to the occupational regulations coming through. Next year they’re going to come into effect.
“On the defined contributions side, I think interest is more genuine because of the millennials’ involvement. On the closed trust, defined benefit side I think it’s more the stick that’s encouraging the interest there as a whole.”
Ben Yeoh, senior portfolio manager at RBC Global Asset Management, agreed that the changing face of pension investment management was key. “Millennials are more interested in this, and actually women are as well. In defined contribution or defined benefit, the committee makeup is changing slightly, where you’ve got a different generation coming in.”
Though there is clearly a public appetite for better behaved businesses as a social good, in the view of Mr Yeoh ESG also translates into material business factors. Although not always shown in financial reports, these impact on how much money businesses make and what they pass on to shareholders.
“We think it’s a source of market inefficiency, because a lot of these ESG items are not reported on cash flow and the balance sheet, but they are fundamental to what drives long-term success for business,” he said.
“If I got paid $1,000 for every time a CEO told me their people are their most important asset, I’d definitely have retired by now. They say it every time. But there’s usually maybe one paragraph in the report and accounts about what supposedly is their most important asset.”
“You allow them to come to a realisation that in fact they are doing ESG.”
David Hickey, investment manager, Lothian Pension Fund
The centrality of ESG to many business models is being recognised by managers in the LGPS. David Hickey, investment manager at Lothian Pension Fund, said his current task was integrating ESG into his fund’s investment processes, aiming for full integration by the end of the year.
“The atomisation of the ESG function in investment management relates to the fact that fund managers tend to have massive egos,” he said. “Speaking as a fund manager, in a team of fund managers, they tend to believe that they know what they’re doing at anything and everything.”
Mr Hickey added that within the investment industry there was a branding issue around ESG. “The only way I was able to integrate it into our processes was to deal with that branding issue,” he added. “I’d go around the fund managers and they’d say ESG is not relevant.
“But I’d ask what they knew about the carbon price and how it was affecting their strategy – well of course they know about that, it’s a material risk. You allow them to come to the realisation that in fact they are doing ESG.”
There were further misgivings about the term ‘ESG’ from around the table. Mr Yeoh said ESG was “a phrase I don’t like very much, but it is our shorthand jargon for it”.
“The fact I have to spend 10-15 minutes explaining what it is to outsiders every single time means the jargon doesn’t work,” he said. “If you’re explaining you’re already losing. Whereas if I talk about the importance of your people, the importance of your environment, or things like that, they instinctively get it.
“Another thing is accountants and chief financial officers don’t instinctively know what you’re talking about either. When you talk to them about supply chain, you talk to them about their people, or those type of things they understand that because that’s material business risk. You talk to them about ‘s’ [as in social] and they ask what it means.”
Within the LGPS in Scotland, England and Wales, many funds consider ESG factors to be a source of downside protection. This is the traditional view. But some are opening up to the idea that ESG can be recast as a source of returns.
“I think you can do both,” said Mr Yeoh. “You can cut the downside as well as up the alpha.
“I always say too many management teams today overborrow from other sources. You can overborrow from the future by cutting R&D. You overborrow from the environment by not cleaning up after yourself. You overborrow from your employees by cutting benefits or staff training.
“Say you cut everyone’s salaries by 20%. Your earnings will go up, but your stock price will probably go down because the market will have acknowledged that you’ve destroyed long-term value.
“If that’s true for cutting corners actually the reverse should also be true. People who are investing in their companies, investing in the future and doing those things right are actually creating assets which you don’t necessarily see on your balance sheet.”
“How unusual do you think you are in seeing ESG as an opportunity and alpha source as opposed to a threat?” Mr McIn-doe asked. “I think within local government we largely see it as a threat because it reveals its head through constant lobbying by every interest group under the sun.”
“The journey on the opportunity side is in its early days,” Mr Yeoh said. “But there are some, even in the local government space, starting to talk about it as an opportunity. Brunel Pension Partnership as a pool has talked about it as an opportunity. LGPS Central has talked about it in part as an opportunity as well as a risk mitigator.”
He added that lobby groups are “very noisy” on risk, shouting over the opportunities being created in some industries. “A lot of the big oil and gas firms have a lot of that R&D which is very much overshadowed by legacy issues and lobbying.”
Said noisy lobby groups have repeatedly called on the LGPS to divest from energy companies felt to be misbehaving. “People talk ESG but 90% want to talk about carbon exposure in relation to BP, Shell and Exxon,” Mr Marshall said. “And they’re not going to be happy with any answer until you say I’m selling. That leaves us with a real challenge.
“I believe in active management. Where I see active management being a challenge is the time horizons of investors – committees, trustees, consultants – and their ability to ride through performance. How do you overcome that, as some of your developing positive changes will take time to come through?”
Mr Hickey said that his approach did not begin with divestment. “We very much believe in engagement as a path forward,” he said.
“But from a fiduciary responsibility point of view, divestment has to stay on the table. If you’re working with a company and you find that company at the end of any engagement is willfully destroying value or does not see the advantage in moving to a transition model, then the chances are that they are going to permanently impair the value of that company. In which case they become a sell.
“That’s the last step in the process, not the first step. And this is what we’re fighting so hard to communicate to our stakeholders. Divestment is a last resort, not a first resort, and if you want to make change, if the CEO is not listening to what you’re saying than the ultimate engagement is saying we’ll put members on your board and we will fire you.
“People talk ESG but 90% want to talk about carbon exposure in relation to BP, Shell and Exxon.”
William Marshall, head of LGPS investment clients, Hymans Robertson
“And we will put in someone that will make these changes, because we own this company, they do not. That is the ultimate engagement. And if you put that pressure on a CEO, they are survivors, and they will change. That’s the way to change, not by walking away from the table.”
“Can you demonstrate that that has happened, that engagement has worked and that it does work?” Mr McIndoe asked. “I understand why it should work, in that sense. But the lobby group says engagement doesn’t work, and you have to divest.”
“If you’re looking at the governance things, they tend to be able to be enacted far quicker and you see results very quickly,” Mr Hickey said. But he said that on the environmental side transitions can take a long time.
“For a company on the scale of Exxon Mobil or Total. you’re talking 50-70 years to make that same sort of transition. Many campaigners can’t see that. They can’t see that Total are doing about 10-15% of their R&D in renewables.
“It’s going to take decades and decades to replace their oil and gas. And those are timescales that the vast majority of people – even the vast majority of fund managers – struggle to deal with.”
For the panel, this struggle is something that must be taken up. “The question is always what we do next,” Mr McIndoe said. “I think one of the most important things in everything we do is actually working at it, as opposed to generating words. It needs to grow and be embedded.”
On this point around embedding, Mr Hickey emphasised that he sees ESG as “a little bit of a misnomer”. He said: “I think it’s terminology that’s probably had its day, because it incorporates so much more about the investment process than the simple acronym ESG. There’s so much that falls outside of those simple siloes that can add to an investment decision.”
“The key for me is getting people thinking about ESG beyond just implementation of what type of mandate and what manager and getting to understand where it sits with the overall objectives,” Mr Marshall said. “Get people to understand what your beliefs are and then think how that is going to come through in strategy.
“It’s going to take time. You always had one or two funds that wanted to talk through it. There seems a genuine level of interest, and the fact we’re having roundtables like this is really positive. I hope we keep that momentum up. But there’s no easy answer.”
“I don’t like the term ESG, but I don’t think it’s going away,” said Mr Yeoh. “I do think it will go across asset classes. In fact, we had a recent survey which shows it’s starting to emerge in a lot of asset classes.
“If you believe in it in the way that I’ve articulated, it will be a risk mitigatory, but I think it will also be a source of opportunity. Because it is such a large part of company’s value today and in the future, you should be able to get return from it.
“And that’s not forgetting the stewardship angle to that, so that if you have a good active ownership mindset then this should be something for good deep fundamental active management.”
This roundtable discussion was sponsored by RBC Global Asset Management. The topic was agreed by LGC and RBC Global Asset Management. The report was commissioned and edited by LGC. See LGCplus.com/Guidelines for more information.