Three topics investors should not hide away from

Introduction

There are lots of words that I try to avoid saying in front of my two-year-old daughter - namely “sweets”, “chocolate” and “ice cream”! At work, I’ve been part of several discussions covering different ESG matters, and it struck me that there too, we’ve topics that we focus lots of attention on and others that we don’t. Thankfully talking about any of these lesser-trodden topics doesn’t have quite the same effect as when I say the word “chocolate” to my daughter… although maybe the immediate sparked interest wouldn’t be a terrible thing either. In this blog I explore three topics I think are worth a greater spotlight within ESG.

1. The limitations of climate scenario analysis

This topic has had some airtime recently with papers published such as by the Institute and Faculty of Actuaries and Carbon Tracker Initiative. The message essentially being that climate scenario analysis used in financial modelling is hugely underestimating the actual risks at play (particularly by underestimating the financial costs of physical risks, assuming they will occur in the future so the “present value” of the costs is very small). Therefore, some in the market have argued that making investment decisions based on the results of this modelling is flawed. 

I agree that there are limitations in the modelling, which is something that should be recognised and understood by decision-makers.  In time we also expect that the models will improve to better reflect the scientific viewpoint.  However, all models have limitations.  This analysis can initiate and facilitate a very important conversation for decision-makers and the analysis can be a useful component in an overall decision/formulation of next steps, particularly when considered alongside other portfolio data points. Therefore, having the conversation is more important than not having it.

2. The “S” in ESG

The impacts of social factors in investing are trickier to measure than the environmental and governance aspects, this being primarily driven by a lack of standard data and measurement. Issues that fall under the “S” umbrella are also wide-ranging - so that it’s difficult to aggregate meaningful data over an entire portfolio. We see certain sectors placing greater emphasis on factors such as safety or human rights, we also see investor preferences varying by geography too - with US investors/sponsors having Diversity and Inclusion (“D&I”) higher on their agenda than perhaps in Europe.

If we focus on D&I, we often jump to gender equality.  I’m personally a huge advocate for gender equality (with XPS doing some great work in this area), this metric also tends to be the most tangible measure when looking around a meeting room table.  However, there are lots of other factors that should be considered, for example, social mobility.  A globally accepted metric when looking at social mobility is parental occupation at the age of 14 - this is shown to be closely related to an individual’s future occupation (in the case of low social mobility). Here comes the tricky part for this example - lots of companies don’t currently collect this data, it’s also quite a personal detail so some people may not wish to disclose it and in certain countries, D&I data such as this is actually illegal to disclose on behalf of your workforce.

There is more education and discussion around this topic coming to fruition with some fantastic initiatives such as the Asset Owner Diversity Charter (“AODC”) rallying the industry to do better, and a new framework being launched by the Taskforce on Inequality and Social-related Financial Disclosures (“TISFD”). In our research we try to look for quality engagements which cover social aspects, on an annual basis we will be reviewing the AODC questionnaire from our researched managers and we also have impact funds that not only reach the “E” in ESG but help to address “S” as well.

3. Divestment - a signal to a bigger problem

Simply divesting from high emitters is now widely regarded in ESG circles as being flawed - whilst this action might help to improve portfolio stats, it doesn’t encourage engagement with companies to achieve a real-world impact.

That said, as a final escalation point, following a structured engagement period, disinvestment is absolutely an option where the company/management strategy is not consistent with the climate objectives of the investor, or seemingly at odds with the policy direction of travel.  We have seen some big players divest from oil and gas companies - most recently this was undertaken by a large Dutch pension scheme, PFZW (€200bn in AUM), and closer to home we saw the Church of England Pension Board undertake this action last year.

On a related note, an article by the Climate Change Committee last year outlined that in the UK, for most sectors, the rate of emissions reduction needs to accelerate two or three times the current rate to meet the 2030 target. Engagement can play an important role but it’s clear there’s still lots to be done, across different sectors.

To wrap up

There is a fiduciary responsibility to consider ESG factors - even if your involvement is for a short period of time - you could be making asset decisions on behalf of long-term beneficiaries. Therefore appreciating the detail, including the lesser discussed areas outlined in this blog, is important.

Climate is the area with the most understanding given the wider political focus over past years and the progression of standard data and metrics, however even within this space there is detail to appreciate.  Social factors have had relatively lesser focus previously, there is plenty of scope to spend time here too and to think about whether you have any aligned priorities to help impact change.

Taking a leaf out of the book of a two-year-old, sometimes less words and more action can have the biggest effect - in investment decision-making, having an action plan is key to being part of the change and should be supported by solid understanding and clear priorities to make a real-world impact.