ESG investing: sustainability becomes systemic

In 2018, the world saw clear evidence that we’re beginning to run past the limits of natural capital—of the availability of fresh water resources, which could shrink in cities to a third of 2015 levels by 2050¹; of the resilience of ecosystems to declining biodiversity; and of the earth’s radically diminished ability to absorb our collectively expanding carbon footprint.² As these limits of natural capital become more and more apparent, we believe we must teach ourselves to look beyond short-term risks to financial capital.

Environmental, social, and governance (ESG) analysis is now being looked to for its ability to help map opportunities for sustainable growth. As large asset owners become more conscious of their own social license to operate, we think they’ll seek investment outcomes that not only deliver long-term wealth, but also leave behind a desirable world for beneficiaries. Defining the contours of that sustainable future is where we think ESG research, analysis, and integration will play an increasingly important role in 2019 and beyond.

ESG research, analysis, and integration efforts have done much to transform contemporary practices of asset management around the globe, and they’re now widely recognized as one of the keys to pursuing attractive risk-adjusted returns.

This trend has been fueled by the rapid proliferation of third-party ESG data, benchmarks, and company ESG disclosure: What’s the potential impact of a carbon price shock, labor stoppage, or product recall on specific companies in my portfolio? How should we alter our corporate earnings outlook for a particular bank if it has another data breach? How seriously would a major pollution incident affect the magnitude of liabilities at a given utility? These are real questions about the implications of ESG factors for company valuations. However, to tether ESG analysis to a short-term perspective limits the larger message that ESG factors can tell us about the long-term sustainable outcomes of business as usual.

New methods for modeling portfolio-level risk

Asset managers are beginning to see more clearly that the risk mitigation measures we use to benchmark companies can be inadequate for giving true insight into how prepared companies are to deal with the systemic nature of several key ESG issues. Therefore, a problem our industry must grapple with is how to define what sustainable economic outcomes look like in global, absolute terms. Asset managers are working toward evaluating how aligned specific companies are to long-term sustainable development goals—such as using science-based company targets for carbon emissions reduction in accordance with the concept of a global carbon budget. 

A potent example of recent work that attempts to achieve and promulgate such a broader view is the global investor consortium convened by the United Nations Environment Programme-Finance Initiative’s pilot project on climate change scenario reporting for investment managers, of which Manulife Investment Management is a member.³ The outcome of this work will enable a set of climate-related portfolio-level disclosures that align with the recommendations of the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD).⁴ In 2019, we’ll help shepherd the release of this important new landmark in reporting on how various climate change scenarios will parse out winners and losers at the portfolio level.

We’re confident that this groundbreaking work will greatly assist the 1,900+ signatories of the Principles for Responsible Investment (PRI) and the dozens of investors who’ve already publicly supported the TCFD.⁵ We further hope that this will enhance the transparency of asset managers’ climate change exposures against the backdrop of growing urgency to move the world toward more sustainable development outcomes.

Off the back of the PRI’s recent research that suggests that engaging with companies on sustainability issues enhances investor returns,⁶ interest in and the practice of ESG engagement continue to gather rapid momentum in the investment industry. We see two trends in this area. First, as the practice of collaborative engagement among different investors matures, the influence we exert on companies in our collective orbit of impact is strengthening. The second trend concerns thematic ESG engagement across value chains, which deemphasizes less efficient, ad hoc interventions in favor of more holistic methods of seeing and acting on the systemic nature of sustainability.

Collaborative engagement by investors

Although some asset managers now have decades of experience with ESG integration supported by bilateral company engagement, in 2019 the industry will continue to learn how best to conduct collaborative engagement to achieve sustainability outcomes in the collective interest of both companies and the  investment community. One such collaborative effort is Climate Action 100+, for which Manulife Investment Management serves on the steering committee. This growing group of 310 asset managers from around the globe represents US$32 trillion in investor capital and is the largest investor-led collaborative engagement initiative of its kind ever assembled.⁷

One of the chief objectives of Climate Action 100+ is to set new norms for engaging with the world’s largest greenhouse gas emitters. A consistent message from such a large and influential group of investors helps to ensure that  companies take more ambitious action to curb emissions, strengthen climate-related financial disclosures, and improve their governance of climate change issues. Climate Action 100+ has already logged notable success—for example, in late 2018, Royal Dutch Shell announced its intention to implement short-term targets and incentives to help realize its net carbon footprint plan to reduce carbon emissions, citing support from the Climate Action 100+ engagement group in a decision that sets a new standard of best practice for the oil and gas industry. 

In light of such examples, we anticipate the aggregate impact of other collaborative engagements to accelerate in 2019, and for the lessons learned from the Climate Action 100+ initiative to disseminate to other collaborative projects focused on ESG issues beyond climate change. This type of collaborative work can even help companies that seek clarity from the confusion generated by many voices weighing in with varied expectations about  appropriate corporate sustainability practices.

Thematic ESG engagement across value chains

In the year ahead, we expect to see more instances of systematic engagement across value chains on specific sustainability themes. This is similarly driven by a process of maturation in the industry around the importance of engagement and the hunt for more efficient ways to engage to enhance both investment and sustainable development outcomes. 

We have seen this in the case of palm oil, a long-standing engagement concern for ESG-oriented investors for its association with deforestation, forest fires, and poor labor conditions. Our experience has shown that by expanding the scope of engagement activity from producers and traders to the banking sector in Asia, value chain engagement can help raise awareness with parts of the value chain about their shared responsibility for solving difficult economic issues with significant sustainability impacts. Improved ESG disclosure from these banks, and more open dialogue with investors about disclosure expectations, has been the result. 

"In the year ahead, we expect to see more instances of systematic engagement across value chains on specific sustainability themes."

In 2019, we see two new issues on the horizon for value chain engagement. First, the problem of plastic waste has garnered global attention as the public has become more aware of the mountainous whirlpools of plastic waste that are gradually poisoning massive segments of the world’s oceans. Moving the dial on this problem requires more than just influencing the product manufacturers who use plastic packaging. Investors must also speak with the packaging manufacturers, with the chemical companies that provide the high-carbon feedstock to make plastics, and with the retailers who distribute consumer products. The essence of the challenge is how to work with the various business models across a value chain to foster greater circularity in the use of natural resources and to do so in a way that shifts incentives for companies that have historically relied on plastic’s ubiquitous availability and use.

Further, engaging more intelligently through value chains isn’t limited to physical assets such as palm oil or plastic. It also pertains to more abstract assets, such as data—how it’s produced, stored, and used—across virtually every sector of the economy. Less than a decade ago, cybersecurity issues were generally considered an area of risk among information technology companies. But after major data breaches at Equifax, Target, Sony, Wells Fargo, and Facebook, it’s easy to see that cybersecurity issues are germane to the entire global economy. In 2019, we think investors—through collaborative initiatives and more informed  perspectives on cyber issues—will become stronger advocates of enhanced  transparency in cyber risk disclosures and greater cyber competence among company boards. 

As we head into 2019, a question of ongoing relevance concerns how active managers can continue to add value when the systematization of financial data and analysis is increasingly the norm. If active management is based on intangible knowledge adding tangible value over time, we believe ESG integration efforts that systematically incorporate ESG factors into all aspects of the investment process may be an especially fertile area for carving out an enduring niche for active managers. 

ESG analysis of prefinancial data

ESG is a shorthand acronym concerned with analysis of everything that’s relevant but isn’t on a company’s balance sheet or income statement today. While ESG data is often termed nonfinancial data among investment industry professionals, we would posit that ESG is more correctly understood as the practice of interpreting pre-financial data—factors that may eventually express themselves in terms of financial value, whether that implies a cost or an accretive addition to a company’s balance sheet. 

One example of prefinancial data can be found in rates of employee turnover. Currently, such turnover doesn’t qualify as a financial data point. But if a company consistently has a higher turnover rate than industry peers, then eventually—in our world of limited talent resources—this may take on an actual financial dimension and go so far as to change a fundamental company valuation. As a company churns through its available employees, the salaries it pays will tend to rise, both for the capital required to attract new hires and to retain its (likely unhappy) current employees. This in turn makes it more difficult for such a company to keep employee productivity high, if measured using a variety of ratios (e.g., aggregate employee income relative to revenues earned). Consequently, we view employee turnover as one potential prefinancial  indicator of the efficiency of a company’s human capital utilization. 

"In a world where financial data is increasingly commoditized into passive investment applications, high-quality ESG analysis remains a key area in which active managers can differentiate themselves."

The complementarity of active and passive

ESG approaches ESG integration supplies structured frameworks to assess prefinancial data. But the frameworks—because they  deal with subjective ideas and target deeply contingent, idiosyncratically human areas of knowledge—must be operated by a human intelligence and constantly refinded  as the world evolves. ESG data remains noisy and requires context to effectively harness the insight implicit in it.

Active managers can supplement ESG third-party data or company-disclosed data with engagement to inform a holistic view of risk and opportunity. In a world where financial data is increasingly commoditized into passive investment applications, high-quality ESG analysis remains a key area in which active managers can differentiate themselves.

However, the growth of ESG practices in passive investing can be regarded as complementary to the evolution of ESG application in active management. First, ESG indexes provide new benchmarks that enable asset managers to focus on the companies with the strongest sustainability strategies and outcomes and to manage and report on the sustainability impact of their investments in parallel to financial performance. Second, from the perspective of engagement, passive investors must own the index, and so have a stake in reducing absolute risk evenly across it. In the case of active management, there’s the advantage of deeper interventions and engagements with more concentrated portfolios and the discretion to allocate capital in response to a company’s ESG risk and value drivers. The flourishing of both approaches in our capital markets can make a powerful contribution toward advancing sustainable economic outcomes. 

1 “High and Dry: Climate Change, Water, and the Economy,” World Bank, 2016, http://www.worldbank.org/en/topic/water/publication/high-and-dry-climate-change-water-and-the-economy. 2 See, in particular, the United Nations’ Intergovernmental Panel on Climate Change (IPCC) October 2018 special report on the impacts of global warming, https://www.ipcc.ch; and the U.S. government’s interagency-authored National Climate Assessment, November 2018, https://www.globalchange.gov/nca4. 3 http://www.unepfi.org/investment/tcfd/, March 25, 2018. 4 The TCFD works to develop voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders, https://www.fsb-tcfd.org/, December 4, 2015. 5 TCFD supporters, as of the One Planet Summit, September 2018, https://www.fsb-tcfd.org/tcfd-supporters/. 6 “How ESG Engagement Creates Value for Investors and Companies,” April, 2018, https://www.unpri.org/download?ac=4637. 7 Climate Action 100+, http://www.climateaction100.org/, as of December 2018.