Is ESG Investing Just About Climate Change?
The ESG Alphabet Soup Series #2. A look at the "E" in ESG and how to identify environmental risks and opportunities.
Hi there,
Climate change is just the tip of the ESG iceberg. It’s about much more than environmental issues. One way of thinking about it would be that compared to traditional equity research, it’s just a more exhaustive list of non-financial factors to evaluate that can impact the performance, valuation, and risk profile of a company.
All of those principles still apply, and many analysts incorporated them into their work long before ESG became a thing. Yesterday, I kicked off my Alphabet Soup series with a look at what ESG investing is and how it is best defined. Today, I’m going to write about the “E” in ESG – the environmental factors. Please let me know what you think by replying to this note, commenting or messaging me on Twitter.
Regards,
Brennan
What Are Environmental Factors?
I’ll briefly revisit my preferred definition for ESG investing:
“ESG investing is the research and investment strategy framework that evaluates environmental, social, and governance factors as non-financial dimensions of a security’s valuation, performance, and risk profile.” Sherwood & Pollard (2019)
As we’re building up this approach to ESG investing, we know we have to explore each of the three pillars of the framework – the environmental, social, and governance dimensions. We can assess how a company performs on any of the three ESG pillars using this approach:
Identify the risks
Assess what the company is doing to manage them
Explore opportunities for value creation
The most exhaustive list of ESG factors I’ve seen so far is in an article in Sustainability called “Rating the Raters: Evaluating how ESG Rating Agencies Integrate Sustainability Principles”. Their exhaustive list of positive environmental factors measured by ESG rating agencies looks like this:
It’s exhaustive. There are so many issues to consider that identifying the material risks and opportunities that each company faces manually would take quite some time. Because of the time constraints faced by many asset managers, the ESG rating agencies have developed rating models that summarise how a company scores on each of these underlying areas.
For example, a positive mark means they do well, whereas a negative score means they do poorly. The inspiration for these models comes from credit rating models where you’d recognise the concept of a “AAA” rating, for example. They are quick summaries of vast amounts of underlying data. However, they are expensive to purchase and use in your investment process.
Each ESG rating firm has its unique methodology, and asset managers can use the brand imprimatur of the ESG rating to support an investment decision without necessarily understanding in depth what is underneath that rating. Here is what sits under the MSCI ESG Ratings Methodology for the environmental factors. As you can see, their methodology considers both risks and opportunities for firms.
I think that something valuable is lost when there is too much reliance on 3rd party ratings, reports and quantitative screens of primarily qualitative factors. Reading primary documents, talking to the company and visiting their operations yourself is critical.
Primary research tasks still need to be done in the ESG investing era. However, there are some amazing ESG analysis tools built on large datasets and taking advantage of machine learning and AI that will enable assessment of ESG performance at scale. An example of something in this space would be Arabesque S-Ray or Verisk Maplecroft.
Understanding the context the company is operating in from an industry and jurisdiction level is vital too. Comparing the environmental risk profile to peers through visual observation of their physical operations can be a valuable exercise.
Where Are The Environmental Risks?
The three key questions when looking at environmental factors are what are the risks, how is the company managing them, and where are the opportunities for value creation?
The way to identify these risks is to start with understanding the operating model of the company you’re researching. I want to know why they exist as a company, what their strategy is, and how they have built capabilities to deliver value to their customers. You can’t assess the ESG factors in isolation from understanding how they do business and what they do for their customers.
The environmental risks generally pop up where the operating model touches the physical world. If a value stream delivered to a customer involves a physical product, there will be many touchpoints along that production line that have environmental risks to manage appropriately.
For example, a sporting goods manufacturer will have environmental risks across its entire value chain from sourcing raw materials through to the amount of packaging the product has. The ability to recycle the product once the customer has used it is a recent development that many analysts want to understand when thinking through how sustainable a product is.
That doesn’t mean that non-physical products or services don’t have environmental factors in their value streams. For example, expanding the understanding of a value chain upstream to suppliers and downstream to customers is a key part of understanding the extent of greenhouse gas emissions a company has to report under the Greenhouse Gas Protocol.
This extra step means that reducing a company’s greenhouse gas emissions over time would imply the need to reduce its broader value chain emissions. Many publicly listed companies are yet to report these 3rd party emissions in their sustainability reporting. Despite the difficulty of putting Scope 3 emission numbers together, if they’re published, then management has made an effort to make that happen, and that speaks to their capability around the management of environmental risks.
The environmental risks of customers are part of this assessment. For example, the banks have reduced their financing of thermal coal mines over the past few years. Many banks still have exposures to loans, but they disclose this in their sustainability reporting. They have made public statements that they will reduce this exposure over time and not enter into new lending arrangements. However, there will always be questions about the classification of loans – does asset finance to a contractor whose only customer is a mine count as exposure to mining?
Earlier in the year, Germany giant Siemens AG came under fire because it will supply a small piece railway signalling technology to the Adani coal mine. The environmental performance of a firm’s customers and suppliers is now a key part of assessing these risks. They ended up putting a sustainability committee together:
Generally, and as a consequence of this issue, we will for the first time in Siemens history establish a Sustainability Committee with external members to give environmental concerns even more priority and attention in the future. I will also open the doors to the youth, and the concerns young people have taken to the streets around the world, to sit at the table. This committee will have the power to stop and escalate projects of critical nature to sustainability, no matter whether we are directly or indirectly participating, like in the current example, with our rail infrastructure.
How Are The Risks Being Managed?
The good thing about the rise of ESG investing is that many firms are trying to standardise how they describe the risks they face and how they’re managing them. They can use their three lines of defence risk management frameworks to ensure that environmental risks are identified, managed and reported on through to board level.
Every publicly listed company will have a few pages in their annual report dedicated to explaining their risk management framework and how they manage risks. If they have a sustainability report, they will also have extensive explanations of how the company assesses its environmental threats and how they’re handling them.
For example, ASX-listed telecommunications and data centre provider Vocus (who settled a shareholder class action late last year ) has this brief environmental risk commentary in their annual report.
Their FY19 sustainability report has a lot more detail. For example, they’ve identified their cable landing sites where telecommunications cables exit the sea as their biggest physical climate risk. They note that recent site selection decisions included 100-year flood studies and that their cable landing sites are either on a cliff-top, headland or greater than 3 metres above ground level. At the end of their sustainability report, they note that they use the Global Reporting GRI standards, and make the required disclosures.
Vocus has identified and reported on 11 environmental risks and opportunities:
Cable landing stations
Energy consumption at their offices and data centres
Their retail electricity and gas operations
Off-grid fibre optic communication shelters powered by solar panels
Their motor vehicle fleet
Carbon emissions from business travel
Submarine telecommunication cables
Native title or cultural heritage issues
Hardware and packaging waste
Paper bills to customers
Environmental laws and regulations
As you can see, there is much disclosure of relevant environmental factors in this example. However, company disclosures are only the beginning of your research journey. If you are doing due diligence on a company, you need to build your understanding of the operating model and where the environmental risk factors could lie when viewed through a value stream lens. One of the key questions is derived from your understanding of the value streams the company provides customers - are there any environmental risks that haven’t been mentioned?
Other potential sources of environmental risk and opportunity information include books about the industry, regulatory actions, court judgments, news articles, industry body reports, speeches in Parliament, or activist group research. You need to verify the source of information and analyse it in the context of what else you’ve learned about the company.
Other sources of information include press releases, sales literature and media commentary about suppliers and customers. Analysing all of this content with machine learning tools is how some firms are choosing to deal with the information deluge, but designing, testing and deploying these models still requires skilled people.
The question of how you can monitor ongoing environmental risks and opportunities for each company in your portfolio is a topic for a future article. Building a technology capability that enables efficient, accurate and comprehensive research and portfolio management is critical.
However, ESG investing as a framework can only be automated up to a point. The opportunity to use tools to identify controversies or potential environmental issues in your portfolio is augmenting the portfolio manager or research analyst’s capability. But judgment calls on position sizing or sector preferences will still end up being subjective.
Data-driven decision making still requires a judgment call from someone with the delegated authority to do so or an investment committee. For example, the S&P 500 index is still governed by a committee. The ESG variants will be too, obviously on top of a complex quantitative index construction process.
What Opportunities Are There?
An often overlooked part of ESG investing is the identification of opportunities. The ability to create value for a broader group of stakeholders, help achieve societal level goals like the UN Sustainable Development Goals or reduce emissions to reach the Paris Agreement targets are all opportunities.
If you understand the value stream of a firm, where its environmental risks are, and how they’re managing those risks, this can become a source of investment insight. The better companies in each sector will outperform over time because the financial and non-financial impact on these risks will be reduced compared to firms who just produce sustainability reporting without changing their operating model.
For example, a data centre provider that has already sorted out renewable sources of energy to supply its data centres can build on that capability to invest in energy efficiency and further reduce operating costs over time.
Ultimately, all of the ESG factors become good business sense when you include a broad range of benefits and mark them against the costs incurred. Other commercial opportunities that could arise include being eligible for tenders where competitors are not because of compliance with higher sustainability criteria imposed by potential client’s procurement policies.
This is how our ESG investing framework will evolve in this Alphabet Soup series over the coming weeks. It’s basically an investment process with more non-financial factors explicitly considered, researched, analysed and documented to support an investment decision.
Many of the non-financial factors we will explore have been documented by research analysts for decades - starting with corporate governance factors primarily. Now, the incorporation of ESG investing in investment processes is basically just an uplift in capability for active portfolio managers and research analysts where they may have explicitly focused on financial valuation only.
Financial factors are still critical. A company has to have a business model that delivers value to customers, makes a profit, produces free cash flow and stacks up relative to its peers.
I sometimes worry that many ESG activists sometimes get lost in the weeds of climate change financial disclosure and forget that this is still about reducing risk and enhancing returns in relation to investments in securities either publicly listed or privately held. It’s not about forgetting the first principles.
For boards and management, a key part of ESG investing is managing their environmental risks, reporting regularly and pre-empting investor action by transforming their operating model so that outcomes in line with increasing expectations of stakeholders becomes the way they choose to do business.
What Will We Learn Next?
Thanks for reading this article. Tomorrow, I’m going to continue the Alphabet Soup series. The next topic is the “S” in ESG – the social factors. I’ll explore what risks and opportunities are in this pillar of the ESG investing framework. It’s certainly gathered a lot of focus during the COVID-19 pandemic, particularly on worker health & safety issues.
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The ESG Alphabet Soup Series
Is ESG Investing Just About Climate Change?