ESG-momentum matters when it comes to outperformance according to new research by Pictet Asset Management’s head of sustainability Eric Borremans who says investors should sharpen their ESG lens and use active ownership to trigger positive change.

Speaking at Sustainability in Practice at Oxford University he highlighted the new research from the Switzerland-based investor that examines the performance attribution of conventional and ESG indices over long time horizons revealing the importance of governance and engagement.

Borremans said that risk-adjusted returns from ESG fixed income indices are in-line with wider market returns. “That’s good news as it means that investors can build portfolios with stronger ESG credentials without losing money.”

He added that the green economy has had ups and downs but the overall picture remains positive as the sector continues to benefit from supportive policy measures such as the IRA. “Since 2018, companies that derive more than half of their revenue from the green economy, as represented through the FTSE ET 100, have generated superior risk-adjusted returns,” he said.

Still, he noted that the hike in interest rates has had a negative impact on renewable energy projects, contributing to delays and cancellations in offshore wind while other challenges include the outside position of some companies in green indices.

Despite positive returns, Borremans said that investors still question the ESG ratings that underpin the construction of indices with many concerned about the extent to which ratings are a good lens to anticipate investment risks and opportunities.

In 2018 Pictet sharpened its own ESG lens, developing smarter ways to analyse companies that included focusing more on corporate governance. The firm’s analysis explored whether governance was “functional or dysfunctional,” analysed companies’ products and services; operations risk, ESG objectives and whether the footprint it left behind was generated at the expense of society and the environment.

“We asked if the company was facing liabilities because of mismanagement,” he said.

Pictet applied its key questions to thousands of companies and then aggregated the results together. A challenging process that had to unpick multiple issues. “For example, we thought that a weakness in one area could be compensated by strength in another but decided that each issue needed to be looked at in its own right to find outliers.”

The analysis also explored momentum, looking particularly at corporate progress over a 12-month period. It can take years for companies to meaningfully change their products, but governance and the change it can bring can happen quicker, he said. “We found more often than not that incremental changes were triggered by governance.”

Companies with a positive momentum outperformed (about 1 per cent per annum) the universe with lower levels of volatility. In contrast companies with negative momentum underperformed the index (around 1 per cent per annum) with higher volatility. “We came to two conclusions. ESG momentum matters and investors should monitor corporate governance as a key driver to momentum.”

Borremans said that the green economy has performed well despite the 2022 downturn and rising interest rates. “ESG momentum is a critical factor and something we should all be monitoring more closely supported by engagement and active ownership.”

He added that economies and regions will increasingly suffer from extreme weather impacting GDP growth, productivity, resilience and inflation and feeding into sovereign creditworthiness and corporate health.

He said that the growing climate crisis will require a more steady and active governance, especially in asset classes like high yield. High yield is approaching a “maturity wall” with billions of dollars of high yield needing refinancing going forward. Looking at corporate governance as a proxy provides a useful window into how successfully companies are managing this risks.

He also noted the importance of engagement, advising the audience that setting clear targets and incentivizing top management triggers corporate change. “Engagement is not always an easy ride, but it can pay off.”

 

CPP Investments has produced a framework and standardised template to measure the capacity of organisations to remove or abate GHG emissions. Speaking at Sustainability in Practice at the University of Oxford, Richard Manley, the Canadian fund’s chief sustainability officer, managing director and head of sustainable investing, explains how investors can encourage corporate efforts to decarbonize.

Given around one quarter of companies in CPP Investments’ public equity allocation still don’t report Scope 1 and 2 emissions — one of the most fundamental indicators of whether a corporate board is engaging on the climate emergency — there is much to do.

Manley argued that rather than focus on what must be done to reduce emissions, companies should start by looking at what they can do, and what they can do today. He suggested companies look at corners of their business where they have a technically proven ability to decarbonise and told delegates that helping corporates prioritize the highest impact and economic opportunities of decarbonization will give them confidence in their progress on the path to net zero.

Investors can support companies transition by encouraging them to put the details in their business plans, and take possible steps regardless of uncertainties around the carbon price or regulation; unknowns around moonshot technology and offsets.

“It is about the technically feasible stuff. If companies are going to provide forward looking statements they must provide the market with data to show if it is either a slam dunk, or just speculative,” he said.

Manley said  companies have an ability to decarbonize their businesses that many don’t realise. A study by CPP Investments explored transition plans at 12 portfolio companies, and found a playbook from a firm baseline for each. “It’s difficult to chart a course if you don’t know where you are today,” he said. From a firm baseline, it is possible to calculate abatement capacity by, for example, starting with efficiencies and changing the how rather than the what.

“The price on the screen does not reflect the climate risk of businesses we own,” he said, echoing comments shared by other conference delegates that climate risk is systematically undervalued.

Businesses should understand that if they don’t decarbonise, they will lose market share and see their value deteriorate, he continued. Once a company understands it has a value at risk that it can protect through decarbonization, it reframes the discussion.  He urged investors to engage with corporates and their consultants on that basis.

Investors can also add pressure for change by reminding corporates that operate in markets where governments will regulate to decarbonize the economy that executives need to act. “It sits with the responsibility of the director to ensure it gets done.”

Shorter-term goals are more rigorous and provide a more solid foundation. He added that investors can also withhold support for directors if the companies they oversee don’t begin on a journey of identifying and quantifying climate risk.

“We expect boards to provide oversight and counsel to ensure all business risk is covered,” he said. He said investors are frustrated they haven’t seen more action and linked it to poor governance.

Investors can’t control regulation, but he said CPP responds to most public consultations. On another note, he said engagement is easier than divestment. To divest, investors need to believe the company won’t respond to calls for change, and that that if they do, those responses will fail.

Manley added that investment opportunity in so-called grey assets is growing and said the pension will continue to finance the transition. He noted a shortage of potential bids on some grey assets creating an opportunity. “We have an increased conviction in the opportunity to invest in and capitalise on decarbonization.”

Manley concluded with a note on the importance of investors doing themselves what they are asking companies to do. In one initiative, CPP Investments is reducing business travel, aware that not every flight has a business rationale.

Climate risk remains systematically under-priced, the world isn’t on course to meet net zero and investors must prepare for the risks of climate and environmental change.

So warned Nicola Ranger, executive director of the Oxford Martin Programme on Systemic Resilience and a senior research fellow at the Institute for New Economic Thinking at Oxford Martin School, opening the second day of Sustainability in Practice at the University of Oxford. She said that climate risks are coming thick and fast, with a direct impact on assets, labour productivity, patterns in demand, supply chains and markets.

Ranger urged asset owners to re-evaluate climate risk and bring this analysis into their decision-making. For example, few asset owners report on the physical risk of climate change in their portfolio.

“Not managing this risk means the wider economy is not getting the economic signals it needs to create changes. Financial institutions need to price risk properly, and signal to the wider economy that it needs to adapt.”

If governments and countries meet all their pledges, she predicted global warming could be capped at 1.8 degrees, below the threshold for catastrophic tipping points. But she also described a much more pessimistic view based on progress to date and the fact global emissions keep climbing and still haven’t peaked. “We are not on course.”

The risks of climate change are already visible. For example, high temperatures is causing deaths, disrupting transport networks and leading to floods and drought as rainfall patterns change, impacting agricultural systems. She flagged implications for water-dependent industries and big increases in volatility of commodity prices. “Sixty percent of our food comes from five countries,” she said, predicting shocks to supply chains and impact on sovereign credit ratings.

Investors have a role to mobilize finance across geographies, countries, sectors, infrastructure and agriculture. But she warned that many investment decisions are not building resilience. For example, new infrastructure investment doesn’t always consider climate-related risk. “We are still building physical infrastructure that economies depend on, but we are not doing it in a way that is considering climate risk, risking both investors and society,” she said. Similarly, she flagged the much of the estimated annual $6 trillion invested in agriculture doesn’t consider future climate risks.

Ranger urged asset owners to take a holistic approach to managing risk and align their portfolios with resilience. They should ensure they “do no harm” and manage risk in their own portfolio to ensure it doesn’t create risks for society. For example, she said water companies have a significant impact on water scarcity.  Elsewhere she noted that data centres are exposed to climate risk like heat, and they are also water dependent. Adaption can bring returns from investing in new technology, but adaptation also incurs long term costs. For example, retrofitting buildings requires upfront investment.

“We, as a society, are mismanaging climate risk. We are putting insufficient emphasis on our safety and not properly valuing the impact of climate change or logging or exploitation of the soil. Many things doing that are impacting environment that are impacting on us.”

Society can reverse the rapid decline in biodiversity by changing habits, of which reducing meat consumption is the most effective. Trade also helps restore biodiversity because it lets land recover by allocating agricultural production to different areas.

Speaking at Sustainability in Practice at the University of Oxford, Michael Obersteiner, professor of global change and sustainability and director of Oxford’s Environmental Change Institute, sounded a positive note on how investors can help mitigate plunging biodiversity loss.

He said that high-yield agriculture and laboratory-produced foods are key future trends in a modern economy that will support sustainability.

“Plant-based, laboratory meat products hold potential for the planet. If we were to substitute meat products, we could reclaim two thirds of agriculture and give it back to nature.”

Obersteiner detailed a research programme that could support investor analysis of companies doing most to restore nature. Research into palm oil production in Indonesia used satellite images to map the plantations, estimate yields by analysing the age of the plantations, and identify illegal plantations. Continued, detailed research was able to identify the wider ecosystem of supply chains connected to the plantations; trace which multinational corporations own the plantations and calculate profit and loss subject to international policy changes like EU anti-deforestation laws. It was also able to identify the banks (mostly Indonesian) financing the industrial conglomerates.

The technology has also been used to map soy and beef farming in Brazil, gathering information that helps reveal the financial backing of illegal farming. “We can find out which banks are invested in which farms,” he said. Similarly, the research reveals these illegal farms links to the wider supply chains, and export markets in Europe and China.

Obersteiner said the research is accessible to investment teams because it is easy and quick to gather. “Looking to the future, it will be possible to provide this stress-testing analysis on all assets.” He added that the research could also play into forecasting models – the closure of illegal farming and plantations would mean prices could spike – and also provide information on entire supply chains.

The discussion turned to the challenges of investing to protect biodiversity in listed markets. The vast majority of corporate activity harms nature, said fellow panellist Lucian Peppelenbos, climate and biodiversity strategist, at Dutch asset manager Robeco. Rough estimates reveal that only a fraction of the universe of around 40,000 listed companies do no harm to nature. “Finding nature-positive companies to invest in is very difficult,” he told conference delegates.

Not only is channelling capital into wholly nature positive companies close to impossible. It is just as challenging finding companies that will help “bend the curve” on biodiversity.

Peppelenbos advised that investors have a better chance to reduce nature loss by reducing damage and destruction in a pragmatic approach, rather than attempt to become nature positive.

reducing nature loss

Investors need to be ready for the new biodiversity framework from the Taskforce on Nature-related Financial Disclosures (TNFD) that sets out 11 core metrics around risk management and disclosure for business and financial institutions to mitigate nature-related risks and restore damaged ecosystems.

But one of the challenges for investors wanting to integrate biodiversity comes with knowing what is material, as well as the absence of broad based models or a transition models for nature. Those challenges present a contrast with  climate change, where the focus is on reducing emissions.

“How much waste do we still accept from the pharmaceutical industry? How much land conversion from agriculture?” asked Peppelenbos. “We need to reduce the complexity and we can’t wait five years.”

His suggested pragmatic approach involves integrating data at a sector level to give a clear picture of which sectors are putting the environment under most pressure. A second building bloc ascertains the underlying drivers of biodiversity loss.

“Nature can restore [itself] as long as we create the right enabling conditions,” he said.

Different industries have different negative impacts. For example, a key source of biodiversity loss in the paper industry comes from change in land use. “Companies can mitigate here by recycling and sustainable sourcing,” he said. KPIs also help measure progress at a company level and classify companies into leaders to laggards. Similarly, in the chemical sector companies can be split into leaders and laggards regarding water and land use, and their use of renewables to create an investable universe.

Robeco’s research reviews KPIs and sets thresholds. The biodiversity team meet with companies and are creating industry guidance in a research paper that will be open access later next year.

“The long-term direction is clear, and it’s clear politicians need to legislate towards the green economy. With a pragmatic approach we can make biodiversity investible,” he concluded.

Being joined-up is an interesting phrase. Its use grew up in government where it was a beacon to draw on best practices and behaviours in coordination between wings of government, collaboration between key members of government and coherence of thinking in the policy setting process.

All fine aspirations. All devilishly difficult. In the main, joined-up government is an oxymoron.

In this article, we apply those three C’s to the investment industry and specifically the asset owners. We suggest the joined-up term involves getting the fullest benefits from coordination, combinations and coherence across people, teams, organisations and ideas. The investment enterprise at its core has a mission to add value to capital by combining the efforts of separate groups of people in the pursuit of return. Monk and Rook in their investor identity paper put it this way: ‘All investors produce returns in the same general way: they take capital, people, processes and information as inputs and combine them to generate investment returns, which increases financial capital’.

The complexity of the investment industry is clear from just how many groups of people make up the ecosystem of an asset owner – board, executive team, support teams, asset managers, other providers, investee entities, regulators, end investors – these make up most of it, but there are more, the ripples carry on.

So, are there some general conclusions about how to optimise these combinations and bring greater value creation to the asset owner? Essentially, can the asset owner become better joined-up?

It turns out that there are several ways to produce larger combinatorial benefits, but they all involve the deployment of the soft and subtle organisational alpha that is generated from a mosaic of governance, culture, talent, and technology.

The key piece of this mosaic is the alignment of the organisation to one set of specific goals. In this area the approach that secures alignment is one where improvements to the total portfolio is the arbiter of success. This is not the traditional way things are done – the strategic asset allocation (SAA) approach with its policy benchmark introduces biases and the drag from tracking errors. Instead, you need a common framework best described as the total portfolio approach (TPA) that has all investments and groups compete for capital with their best ideas for the total portfolio.

Securing the best organisational alpha for asset owners will depend heavily on four combinations:

  • the board and executive management combination
  • the combination within the asset owner of specialist teams (asset classes, strategy, risk, etc) and support functions working in full alignment
  • the asset owner and asset manager combinations
  • the asset owner and asset manager combination with investee entities employing stewardship and engagement activities.

Each of these areas is difficult. Combinations require significant levels of trust, co-operation, and shared understanding of goals. The organisational incentives may pull in another direction away from the goals. Organisations tend towards one dominant in-group and multiple out-groups and silo behaviours are widespread as a result.

This is accentuated when the out-groups have intrinsic alignment differences as commonly occurs. We also see cognitive errors in how asset owners see collaboration with its merits under-recognised. Some of the blind spots comes from the difficulties in measuring and attributing the outcomes of collaborative actions.

Joined-up in sustainability

But when something is hard it is often very rewarding to do it well. This turns out to be the case with being joined-up, and particularly in how sustainability can be joined-up.

First, there is the rightsizing of sustainability ambition with commitments to the primary goal of maximising returns per unit of risk. Being joined-up here involves the shared vision of the materiality of sustainability factors to financial outcomes.

Secondly, there is the step-up in ambition that some asset owners choose in employing universal ownership strategies where having impact on the wider ecosystem is instrumental to better long-term financial outcomes. We refer to this as 3D investing in which risk, return and real-world impact are joined-up in a competition for capital that integrates sustainability impacts across the SDGs.

The challenge with this is that we have “super wicked” problems needing holistic thinking and cross-agency coordination to tackle the complexity and apparent intractability of the many pressing societal issues captured in the SDGs and most significantly in dealing with climate change.

Joined-up in climate

Notwithstanding this challenge, being joined-up works well with climate.

The first leg is the net zero investing strategy that reduces real-world emissions. Allocation of primary capital to climate solutions plays a part. Stewardship and engagement with higher emissions companies also plays a part in helping accelerate the energy system shift. Systemic stewardship and engagement – across high-emitting industries and on public policy – plays a particular part in guiding collective action.

The second leg is linking the climate impacts with the financial outcomes over time. The returns asset owners need can only come from a system that works and the theory of change thesis is that this allocation and engagement strategy will mitigate the considerable risks to the financial system from a changing climate system. The beauty of this is that this sustainability impact strategy has fiduciary integrity by being instrumental to better financial outcomes.

Climate change is the mother of all super-wicked problems. Finding any decent contributions to a solution is a cause for celebration.

We have an understandable desire in our ecosystem to see simple causes and effects, but the interconnectedness of all things makes that unrealistic. Hence this need to be hyper joined-up in thinking and action. OK, I’ve made things more complicated in seeing our world through an ecosystem lens. But if we can simplify this and progress this to the point where our whole industry frames things using this mindset our anxiety-laden future should not be so chequered after all.

 

PGGM, the €228 billion asset manager for the Netherland’s second-largest pension fund PFZW, is working with US hedge fund manager Bridgewater to help restructure its portfolio to incorporate impact.

The research partnership will integrate a 3D approach incorporating risk, return and impact at PGGM that goes beyond its existing SDG alignment and particular focus on healthcare and climate themes. Still in the early throes of the partnership, the investors are collaborating on analytical detail and wrestling with the tough issues that go into building these new portfolios.

Arjen Pasma, chief fiduciary manager, PGGM, and Carsten Stendevad, CIO, sustainability at Bridgewater, took to the stage at Sustainability in Practice, the University of Oxford, to detail the strategy in action that will ultimately change the look of PGGM’s portfolio, most notably reducing the number of public market stocks.

“We will look very different in five years’ time,” said Pasma, who said the approach applies across public and private markets and the bar for claiming impact is high “There will be fewer names in the portfolio. Research involves a lot more than just buying a company.”

The importance of beliefs

In a catalyst to the new strategy, PGGM recently re-wrote its investment beliefs in a process that has shifted its focus away from exclusions, targets and risk and return optimization. Instead it has begun honing-in on the assets in the portfolio and conducted deep dive analysis on how to make the portfolio more sustainable.

The new approach is already addressing previous challenges – like the fact exclusions “don’t work” in the 30 per cent allocation to private markets. “For every single line in the portfolio, we want to know why it’s there and that we’ve evaluated the risk,” said Pasma.

Carving out beliefs sharpens strategy and helps navigate uncertainties. For example, investors need a strategy on whether or not to finance transition assets. Are they  prepared to invest in high emitting companies if they are reducing their emissions and are on a credible pathway? This type of analysis involves a long journey and comparing notes in a concrete and practical process. Elsewhere, beliefs help decide whether to focus on climate or social issues – or both.

“There is no right way of doing it, but you need to understand all downstream choices,” said Stendevad.

Beliefs also provide a framework to respond to difficult questions around performance. Investing for risk, return and impact requires a more rigorous investment process and frequent trade-offs in contrast to less complex ESG strategies shaped around exclusions.  It also involves having to defend strategies – like a decision to continue to invest in fossil fuels. “How do you measure that trade off? It’s a scary journey that might lose folks,” he continued.

Bridgewater conducts some its research in a top-down approach. This  seeks to analyse the impact of climate policy on markets and economies, for example the IRA and European climate regulation. Elsewhere, the team are looking at how China will balance growth and climate policies.  “Net zero won’t happen by itself. It will happen because policy makers make choices and our job is to try and understand how climate policies help the world and will change how economies work,” said Stendevad.

In a next step, Bridgewater is building out a detailed understanding of sustainability at an industry and company level, exploring how integrating sustainability interacts with impact, risk and return. “We want to take all this understanding and incorporate it into our fundamental investment processes. Any portfolio manager should be able to say this is my return, here is how it fits my risk dynamics, and this is how this company is aligned with sustainability. That is the north star but in practice it is difficult.”

The research partnership also seeks to understand which companies will impact the world most and aims to get under the hood of bank lending to fossil fuels – and to what extent banks are financing the transition.

“It’s not easy to to assess banks’ balance sheets and understand if they are aligned to net zero but only by breaking apart bank balance sheets, will we see if banks are putting money to sustainable outcomes,” said Stendevad.

In another strand, the research also seeks to assess to what extent sustainability endeavour is supported at CIO level. Strategy often flounders without leadership, and sustainability has to come from the top of the house.