Many critics out there think ‘sustainability’ and ‘climate change’ are all a big hoax by ‘green freaks’ trying to push their own agenda.
Responsible Investing (RI) is a balancing act. Investors have to balance positive ambitions for a better world with the practical implications of implementing their investment strategy.
There is no question that everybody wants to make the world a better place, but in the same world investors still require real returns in order to meet their objectives. GraySwan is a PRI signatory and we firmly believe that there is monetary value in RI if you know what you are looking for and follow a step by step approach to incorporate such thinking into your investment process. We’ve already done so successfully for our clients. It’s great to add value in terms of performance and doing good at the same time.
Up to a year ago, we had to make use of theoretical studies and surveys to judge whether companies that perform well on environmental, social and governance (ESG) factors outperform their peers. One such study was the Global 500 Climate Change Report prepared by the Carbon Disclosure Project (CDP) which concluded that “companies that achieve leadership positions in climate change generate superior stock performance”.
Over the last year, a few high profile examples came to the fore that made even the most sceptic of individuals sit up and take notice of the impact of ESG factors on sales and share price. One such company was Volkswagen. In September 2015 the United States Environmental Protection Agency (EPA) found that Volkswagen had installed software in the diesel engines to activate certain emissions controls during laboratory testing. The software caused the nitrogen oxide (NOX) levels to meet regulatory standards but outside of the laboratory these same engines emitted up to 40 times more NOX than permitted. Volkswagen installed this software in 11 million cars over the period of 2009 to 2015.
Was there any reaction from customers and shareholders? The share price dropped 23% within 1 day of the breaking of the news which wiped out EUR15.6 billion in market value. The share price continued to fall during September 015 and ended the month 50% down. Volkswagen also announced plans of recalling all affected vehicles and rectify the software. This will no doubt hurt the bottom line.
Another example is Barclays that announced a reduction in dividends and plans to reduce its stake in its South African unit due to identified money-laundering activities. The share price dropped by 11% in a single day.
These events are Black Swan events and could not have been predicted…or could it? MSCI ESG Research maintains ESG ratings on all listed companies and rate companies on environmental, social and governance factors against their peers. Interestingly, neither Volkswagen nor Barclays compared well against their peers and had very low ratings on especially governance. There is therefore a structural problem in the culture of these companies that were picked up already and just manifested in a particular event. By bringing in ESG factors, the MSCI ESG World Index excluded both these companies and investors tracking this index would have avoided these large losses.
However, not all Sustainable and Responsible indices (referred to as SRI indices) outperform general market indices. One of the reasons being that many of these SRI indices only incorporate disclosure and transparency factors of companies when creating the indices. Albeit that this is already a step in the right direction, many of these indices fail to incorporate the actions taken by companies to improve their current situation. It is good to be transparent, but it’s better to do something about it.
If we think about it, a company that reduces its carbon emissions should outperform its less carbon efficient peers. In order to reduce carbon emissions the company will have to reduce its wastage on fuel consumption, energy usage, water and waste management which in turn mean more efficient use of inputs and therefore reduced costs. If this is such a no-brainer, why aren’t all companies doing it?
The UN Global Compact-Accenture CEO Study on Sustainability shed some light on the issues. This study surveyed 1,000 global CEOs, from 27 industries across 103 countries. Some of the key findings from the report were that 76% of CEOs surveyed believe that embedding sustainability into core business will drive revenue growth and new opportunities and that 93% of CEOs regard sustainability as important to success.
However, the report mentioned that business efforts on sustainability may have reached a plateau. Companies want to keep their main stakeholders happy which include investors and customers. How can efforts plateau if sustainability is important to their stakeholders? The answer might lie in the next two statistics.
81% of CEOs believed that the sustainability reputation of their company is important in customers’ purchasing decisions. However, only 12% of CEOs regarded investor pressure as among their chief motivators on sustainability.
Clearly the investors are not as active and vocal as the customers. Why are the investors lagging behind? One of the questions many investors have asked is, “Is there money in Responsible Investing?”
Asking if there is money in RI is like asking if there is money in investing on the stock exchange. There are most certainly going to be winners and losers. As earlier indicated, bringing ESG factors into the analysis of companies can result not only in outperformance of the market, but also specifically in risk adjusted performance. The inclusion of ESG factors when analysing potential investments should improve the risk adjusted performance of any portfolio and thereby offer investors superior and more robust portfolios.
It is important to note that the exclusion of certain companies from the investment universe will most probably cause potential loss of performance. At the end of the 1800’s slavery was big business and even global best practice. Was there money in slavery? Absolutely! Was it a responsible or sustainable investment? Absolutely not! Today it is globally recognised that slavery is not acceptable, however in the 1800’s it was normal business. We have to look beyond the short term promises and focus on the long term sustainable returns.
We are not saying one should exclude sectors or companies completely. Responsible Investing is a balancing act. In the United States 17 foundations committed to pull their money from companies doing business in fossil fuels. This is wonderful if you are spoilt for choice with thousands of other listed companies to choose from to replace the companies that you exclude. This is much more complicated in South Africa.
If we, for example, focus on the South African mining industry with regards to Environmental and Social factors, should we exclude them from an Responsible Investment portfolio? This sector accounts for about 15% of South Africa’s GDP. If the Government is planning to create jobs and grow the economy, the mining industry will be expected to contribute a large portion of these jobs. Is it therefore responsible to fully exclude this sector from your portfolio? What possible steps can an investor take?
Communication is key to facilitate responsible and sustainable change. The Australasian Centre for Corporate Responsibility (ACCR) says that investors should “put their mouth where their money is”. Investors are already invested in certain companies and these same companies are already listening to customers. The industry needs investors to be more vocal about issues that matter. This does not mean that investors should barge in and try to prove all their personal views, but investors should communicate, raise concerns, ask questions and get involved in the indirect management and operations of these companies. Occasions might appear where the management of a company clearly does not want to listen to their investors, and these situations will require investors to voice their concerns by disinvesting from such companies.