Devastating events such as the recent bushfires, which impacted approximately 80% of Australians in some way and charred ~20% of total forest cover in our nation, have thrust environmental, social and governance (ESG) issues both at a societal and investor level.
The term ESG was first coined in 2005 in a landmark study titled “Who Cares Wins.” In 2019, ESG investing was estimated at over US$20 trillion in assets under management, or around a quarter of all professionally managed assets around the world.
But what's the relevance for retail investors? Danielle Welsh-Rose, ESG Investment Director Asia-Pacific at Aberdeen Standard Investments says anyone interested in generating solid investment returns and protecting their capital should be putting an ESG lens over their portfolio. Furthermore, the world is entering a period where capital will be needed to solve some of the biggest environmental and social challenges facing the planet.
Here, she goes into detail about the risks of overlooking ESG as an investment consideration and busts myths around a topic perceived to be a matter only for "greenies".
Image: Danielle Welsh-Rose
Q: How would you explain environmental, social and governance (ESG) investing to someone?
I always find that question a bit tough to answer in social settings – depending on my mood, and on whether I sense my poor unsuspecting dinner partner is interested or is robust enough to cope, I either brush over it very lightly in 10 seconds or less, or bore them senseless with a full 20-minute impassioned monologue!
A sensible mid-point might be to explain that I work for a global fund manager, helping them to integrate environmental, social and governance considerations into investment analysis, into the way we manage our investments, and into investment product development. I would explain that we do this in order to deliver better outcomes for clients. If my unsuspecting friend seems interested, I would then go on to use climate change as an example.
I would say that climate change is both an existential threat and a threat multiplier – the physical impacts of climate change such as bushfires, water scarcity, sea-level rise and crop failure exacerbates existing problems like poverty, forced migration, increased risk of political instability and even terrorism.
These physical impacts will be felt in different ways by the companies and assets that people invest in through their retirement and other savings. The policies that have been and will be put in place by various governments to shift the world to a low-carbon economy will also have impacts on companies and investors, and therefore on peoples’ savings.
This means, that in order to ensure the best outcomes for clients, investors like Aberdeen Standard Investments (ASI) need to ensure that the companies and assets that we invest clients’ money in are adequately addressing their exposure to climate change risk. For example:
- By understanding the physical impacts on assets (e.g. are their agricultural supply chains at high risk of bushfires?), and
- Understanding the impacts on markets for their products (for example, will there be a market for single-use plastics in a carbon-constrained future?).
If my dinner companion is still awake at this point, I would wrap it up by saying that investors like ASI integrated ESG considerations in company analysis, when engaging with company management, in deciding how to vote at company AGMs, and when engaging with regulators on ESG-related public policy issues.
Q: What do you like to do outside of work?
Turns out I’m a bit of a glutton for punishment, so I generally like to have several things on the go… I’m also a bit of an endurance sports addict. This means that I’ve completed iron-distance triathlons, a handful of other ultra-endurance events, travelled to some interesting and far-flung places (although now with two small children, travel has definitely become less adventurous!), and have just completed the last subject of my Juris Doctor. I think I’m now at least done with the study…. probably…
Q: Thinking back to when you first started, how much more has ESG been integrated into the investment process over that time?
When I first started my career, beyond specialist ethical investment managers, there was not really any explicit recognition that investment processes needed to cover issues outside traditional financial considerations. Since then, ESG has definitely moved from the niche to the mainstream, and this has really accelerated over the past couple of years.
Most large super funds and fund managers in developed markets employ ESG specialists, and the understanding of what ESG is has become more sophisticated. In the last few years we have also seen central banks and regulators discussing ESG risks as financially material, particularly in the case of climate change. However, in some quarters there is still a tendency towards ‘greenwash’ or more recently sustainable development goals ‘rainbow washing’. I expect this to change in the next few years as there is increased scrutiny on funds, increased regulatory requirements, and an increased demand for quality disclosure of ESG metrics and targets.
When I first started my career I spent an inordinate amount of time explaining to people what ESG investing was, and why it was important. I’m very happy to say that this aspect of my role has rapidly diminished in the past few years, and since starting at ASI in September last year I’m ecstatic to say that I haven’t had a single conversation on either aspect of the what or the why of ESG!
Q: Where is ESG adoption at in Australia among asset managers and listed entities? Are we leaders or laggards?
Australian asset owners are often viewed as leaders in ESG. Our super funds were some of the first signatories to the UN Principles for Responsible Investment (PRI), and Australian signatories remain a large and active group within the PRI. Alongside this leadership, and perhaps in many cases because of this leadership, Australian asset managers are also showing increased commitment in ESG integration.
Active ownership through company engagement on material ESG issues such as climate change, actively utilising proxy voting, as well as long-standing and active collaborative efforts through groups like the Australian Council of Superannuation Investors (ACSI), the Investor Group on Climate Change (IGCC) and the Responsible Investment Association of Australasia (RIAA) has been a focus of Australian investors for a long time now, and this has really put pressure on Australian listed entities to lift their ESG performance. As a result, we have seen some listed entities at the larger end of the Australian market take a global leadership position on ESG, particularly around reporting and transparency.
We are now entering a period in ESG investing where a combination of increasing regulation around disclosure of material ESG risks for companies and investors, and increasing pressure from stakeholders to not only integrate ESG considerations but to provide proof points of this integration, is leading to rapid improvements in disclosure and transparency, particularly around climate change, diversity and human rights.
Q: How would you explain to an investor the importance of ESG in a strategic asset allocation (SAA) context?
ASI believes that SAA and ESG are closely linked. Environmental and social change should shape the way we allocate capital to generate long-term returns. The relationship works the other way too: SAA can direct private capital to where it’s most needed to help alleviate the most pressing social or environmental problems. Our thought leadership paper Strategic Asset Allocation: ESG’s new frontier is a really interesting read on this topic.
If investors are serious about ESG integration, they need to consider how ESG factors are among the most important drivers of long-term returns and therefore deserve to be incorporated into the SAA process. Asset allocation analysis that integrates ESG effectively ought to deliver better risk-adjusted returns than that that does not.
But ESG-integrated SAA offers investors an even more intriguing opportunity. Many of the world’s biggest problems are a result of a failure to invest enough capital. The SAA process provides a way to begin to remedy this: for investors to channel their capital to increase its real-world impact. SAA also allows investors to do so in a disciplined way that avoids compromising expected returns.
Q: What factors do you consider from an ESG perspective when assessing individual companies? Why are these important?
We consider a variety of factors, which will differ according to what is material for the sector and individual security.
From a top-down perspective, we use the UN Global Compact’s four areas of focus as a basis of our work, which feeds into research pillars of:
- Climate Change
- Human rights & Community
- Labour & Employment
- Business Ethics and Governance
We analyse what is changing in these areas, how these changes will affect different sectors and the triggers that may make these matters material for our investments. This thematic and sector work feeds into the asset classes and bottom-up analysis.
The issue of single-use plastics is a good example, where we researched the topic a couple of years ago. We highlighted that our high yield bond funds were most exposed, so we engaged with exposed companies on this topic, and adjusted the portfolio accordingly.
From a bottom-up perspective, we focus on what is material to each company, where the risks are for the business and the potential strategic opportunities to create solutions to problems. So for media companies, for example, it can be issues like energy use from data storage, how content is produced and shared, and customer privacy.
Q: Can you provide an example of when applying an ESG lens contributed to a great investment decision?
ASI made a decision to avoid investing in a corporate bond from an Indonesian textile company due to high ESG risks. Our analysis of the company showed that there were risks across the ESG aspects of company operations. The company was facing increased production costs due to stricter regulations on waste and wastewater, there were risks around poor labour practices and a lack of disclosure on labour policies and practices, and there were red flags raised around audit quality, related party transactions and other governance issues. Governance disclosures were insufficient to provide adequate comfort around lending to the company, and the risk of default was high.
Q: What ESG red flags would make you decide to not invest in a company?
There is not generally one specific ESG red flag that will prevent us from investing in a company. Often when a company is exposed to a highly material ESG issue, and it becomes clear that management of this issue is poor, it is an indicator of poor management of other issues. So, a ‘red flag’ material ESG issue may indirectly result in a decision not to invest in a company where it leads to the discovery of poor overall governance.
Q: Has the focus on ESG opened up new investment opportunities for ASI?
The landscape on responsible investing has changed. It used to be about excluding ‘sin’ stocks, moving into understanding ESG matters as risks, and now there is a growing realisation that the world faces a number of huge social and environmental challenges, encapsulated by the UN Sustainable Development Goals (SDGs). This has led to a rise in the belief that you can invest your money in companies that are focused on creating solutions to some of these challenges, with investors beginning to actively select stocks that meet the needs of the SDGs.
For ASI, this has translated into the development of new products that invest to create value for clients as well as to create positive impacts on society and the environment. It has also led us to develop climate change products that align with a transition to a clean economy.
The world is entering a period where massive amounts of capital will need to be allocated to solving some widespread environmental and social challenges – this will translate to some exciting investment opportunities.
Q: Complete this sentence: The one myth I’d bust about ESG investing is…
… that consideration of ESG issues is ‘additional’ to the investment process. The language of ‘ESG’ can be problematic as it suggests, firstly, that these issues sit outside of the investment process, and secondly that each issue can be neatly categorised as ‘environmental’, ‘social’ or ‘governance’, with no interrelations between each other or with other investment factors.
Q: What was the last report, book or documentary that really stunned you?
It is not a single report, but I have been floored by some of the early data on the impacts of the Australian bushfires over the summer of 2019/2020. The word ‘unprecedented’ has been thrown around a lot to describe this summer, but research is now suggesting that over 20% of Australia’s total forest cover, excluding Tasmania, was burnt. This figure does not capture the entire season or the entire country, so the figure could be even higher. When you contrast this with the background burn rate of 4-5% on any continent in any fire season in the past 20 years, you can see how unprecedented our fires really were.
I was also astounded by research by the Australian National University that estimated almost 80% of all Australians were impacted either indirectly or directly by the fires. This really does show the enormous scale of the situation.
Scientists have been telling us for a long time that these types of natural disasters would become more frequent and more intense under a warming climate, and we are already starting to see this play out in Australia, where average warming is ‘only’ 1 degree Celsius more than during pre-industrial times.
I have also been horrified, but admittedly not surprised, by recent industry reporting on the proportion of female fund managers globally. Twenty years ago, 14% of all fund managers globally were women, and today this figure stands at …. 14%! No change in 20 years should really have the industry closely examining the barriers that remain.
In Australia, the proportion is even lower, and in the UK there are more fund managers called David or Dave than there are women! I feel very lucky to be working with an organisation that is seriously tackling this issue, but there is no doubt that the wider investment industry has a gender problem. We need to be a lot more focused on treating the underlying issues, putting in place hard targets, being transparent about progress, and tying it all to remuneration.
ESG considerations underpin all investment activities at Aberdeen Standard. Their goal is to make a difference – for clients, society and the wider world. ESG investment is about doing the right thing, while aiming to achieve investors long-term financial goals. For further insights from Aberdeen Standard, please visit their website