Environmental, social and governance (ESG) issues have dominated headlines for the last few years and are front of mind for many investors as they start to think more critically about the environmental and social impacts of companies in which they invest and demand more purpose-driven, sustainable and stakeholder-centric behaviour. Although integrating ESG factors into our research has always been an intrinsic part of our investment philosophy, we work on improvements to our ESG approach, research and engagement processes year on year. At the recent Allan Gray Investment Summit, Raine Adams, one of our ESG analysts, explained our approach.
As long-term investors, we spend a lot of time trying to understand what a company’s sustainable free cash flow will be. In our view, companies that operate unethically or do not appropriately manage their social or environmental externalities face a greater risk of cash flow erosion over the long term. This can manifest in multiple ways, including regulatory fines, loss of an environmental permit or social licence to operate, or reduced demand for products due to reputational damage or shifting societal preferences.
Because ESG factors can be material to the investment case, our investment analysts are responsible for ESG research in relation to the stocks they cover. However, we also have three ESG analysts who assist with monitoring individual companies and conduct thematic and detailed company-specific research. We focus our research and engagement efforts on ESG issues that are most material to each company, rather than applying a cookie-cutter approach. Every company research report we write includes an ESG section and, when material, we try to quantify ESG risks or opportunities in our fundamental valuations. We may also limit the size of our holding in a company, or choose not to invest in it, if the ESG risks are significant.
We further integrate ESG into our engagement with company boards and management teams and by making carefully considered proxy voting recommendations to our clients. Our portfolio managers are ultimately accountable for managing the ESG risks in our clients’ portfolios, but we also report to our board of directors biannually.
Of course, it is easy for us, and other managers, to explain how we incorporate ESG factors into our analysis and process; it is harder to apply this consistently over time. We would caution against investors taking undue notice of attention-grabbing headlines, which tend to oversimplify what is a multilayered issue.
There are many ways in which ESG, as a growing global theme, could impact future stockpicking and our clients’ portfolios. As outlined above, an accelerated global energy transition could increase the demand for certain metals, while single-use plastic bans could dampen demand for oil and alter demand for certain packaging materials. In addition, the ESG theme has the potential to materially impact investment flows. For example, the Net Zero Asset Managers initiative – recently launched internationally to commit to investment portfolios aligned with net-zero greenhouse gas emissions by 2050 or sooner – could impact flows into both low- and high-carbon emitting industries.
In this debate, however, the intersection of the environmental and social pillars should be appropriately weighed up. So far, environmental considerations have been in the driving seat; however, reducing the E has an impact on the S, and the COVID-19 pandemic has further accentuated deep inequalities in many countries, with potentially severe consequences, as the July riots and looting in South Africa showed. Overlooking the social aspect of ESG is as much of a global risk as failure to act on environmental issues.
The role of the investment industry and overcoming challenges
As an investment industry, we must be honest about what we are and what we are not. For example, we are not experienced policymakers. Many of these complex problems require coherent policy and regulatory development and enforcement, far above investor engagement, to be effectively addressed. This would also avoid unintended consequences.
An example here has been the growth in asset owners announcing divestments from fossil fuels, particularly thermal coal. As a result, many listed companies have rushed to unbundle or privatise these assets. But once sold, they remain in operation and in fact often increase production. The climate is no better off, while lesser disclosure requirements mean that society generally has less insight into the site’s environmental management than before.
ESG factors are also often still lightly or inconsistently reported by issuers, particularly in less developed stock markets, making meaningful evaluation and comparability difficult. At Allan Gray, we try to address this by engaging with issuers on a case-by-case basis to improve their disclosures and by using multiple sources for ESG research: Apart from company reporting, we look at non-governmental organisations and academic, regulatory and news reports.
ESG is further complicated by the fact that we tend to view these matters through the lens of our own personal value set. The EU is leading the way in regulation attempting to address some of the interpretation issues, and regulators elsewhere, including here in South Africa, are watching closely.
At Allan Gray, we participate proactively in industry initiatives that bring more regulatory clarity to ESG. This includes providing detailed feedback to industry consultations, such as on National Treasury’s draft Green Finance Taxonomy and the revised Code for Responsible Investing in South Africa (CRISA) earlier this year.
Don’t forget about the G
Finally, we pay particularly close attention to the governance pillar. This is because, as shareholders on behalf of our clients, we are not involved in the day-to-day running of companies and therefore rely on executive management and boards to act responsibly. We assess management’s alignment with long-term shareholders by evaluating how they are incentivised through executive remuneration schemes. We also consider the board’s expertise and independence to be able to provide effective oversight. Finally, studies show that stronger governance is generally associated with stronger company environmental and social performance.
You can view Raine’s presentation at the 2021 Allan Gray Investment Summit here.