There has never been a more important time nor has there been a more problematic time to invest with a focus on sustainability, according to Edward Lees, co-head of BNP Paribas Asset Management‘s Fundamental Active Equities’ Environmental Strategies Group.
On the eve of November’s United Nations Climate Change Conference (COP26) and alongside the passage of the United States President Joe Biden’s Infrastructure Bill – which will see tens of billions of dollars funnelled into clean energy projects – Lees has highlighted the immense opportunities but also the considerable challenges associated with investing and allocating capital in a genuinely sustainable way.
Global pacts and allocation of government capital aside, the continued movement by allocators and investment managers towards integration of ESG into stock selection, portfolio construction and strategic asset allocation decisions makes the interrogation of the ESG measurement all the more critical, Lees said.
“Everybody’s got an ESG score, everybody’s ESG compliant, everybody’s finding a way to sort of bend themselves into it. And people are getting caught out, greenwashing is now widespread and is becoming something that is being called out explicitly… It’s time for investors to move beyond picking companies and allocating capital because of an ESG score,” Lees said in an interview with Investment Magazine.
While there has been some significant progress on the back of global agreements such as the Institutional Investors Group on Climate Change, the UN Principles for Responsible Investment, the Paris Agreement and other initiatives including the European Union taxonomy for sustainable activities designed to standardise and measure progress towards sustainability goals, Lees has pointed out that the flipside to all this progress is growing instances of appropriation and box ticking employed by investors and companies seeking to get benefit from the updraft of the ESG movement.
Throwing out false positives
ESG scores have become a way for companies and investors to gain automatic credibility and benefit from the ESG hype despite lacking genuine sustainability credentials, Lees explained, pointing to the many “false positives” that ESG scoring can throw up.
“How do you tell if a company is doing something that matters? You do it by really paying attention to the company from a bottom-up basis, through detailed revenue segmentation analysis, capex segmentation, understanding where their money is going to and coming from, where their focus is, what they are developing,” Lees said.
False positives are a common outcome of an ESG scoring process that isn’t properly interrogated, Lees highlighted. Companies with a high sustainability impact can end up with low ESG scores because they might not devote the headcount to reporting, while less desirable companies from a sustainability perspective can be highly rated depending on how their scores are weighted.
Many of the companies rated highly under BNP Paribas Asset Management‘s scoring system might not appear as highly rated in more broadly available ESG scoring systems because some of them are smaller companies and they might not have the headcount to devote to their ESG policies.
“If you went today to almost any ESG system out there and you just picked companies with the highest scores, you’d have a very spotty hit rate in terms of real impact. I don’t think impact would correlate with the ESG score as well as you think it might,” Lees said.
Based in BNP Paribas Asset Management’s London headquarters, Lees works with the firm’s sustainability centre which employs 28 people globally alongside a quantitative research group to bring proprietary research and knowledge to the activities of companies in its investing universe. The investment firm has built out its sustainability centre to integrate ESG into its mainstream investment teams over the years. The culmination of this work is one reason that BNP Paribas Asset Management refers to itself as the ‘sustainable investor for a changing world’, Lees noted.
Leading in integration
ESG and sustainable investing in particular has accelerated quickly in recent years and Australia is on par at least with European nations leading the world into mainstream investing integration, according to Kylie Willment, chief investment officer at Mercer Australia.
Willment describes the multiple focuses for CIOs and investment teams at funds today, including generating strong returns while managing risk and navigating a climate transition with a transition pathway that is still uncertain.
“At the moment that really centres on starting to build more sustainably themed strategies at the asset allocation or SAA level so that we’ve got structural components of the portfolio that are very centred on transitioning to a lower carbon future,” Willment described.
“When it comes to manager selection, then it’s really about us being comfortable that the managers that we are bringing into the portfolios are integrating ESG into their own decision making. And then there’s the portfolio construction elements too,” she said.
Aside from (or in addition to) ratings of a manager’s EGS credentials, Willment emphasised the need for investment teams to have key responsibilities or KPIs for ESG.
“It really needs to pervade the investment team all the way up to portfolio managers. What we used to see happen a lot in the past is an ESG team that might pump out a whole lot of interesting research but the portfolio managers never really took any notice of it. If it’s not an embedded belief with your portfolio managers it’s not going to be treated seriously within the portfolio,” she said.
Willment also highlighted the importance for investment firms to demonstrate the outcomes of their ESG integration with case studies and examples of stewardship including voting and other examples where engagement has resulted in behavioural changes with companies.
“For us it’s never been enough for an organisation to have a good policy or good research, we always want to understand how that’s used in the portfolio context,” Kirsten Temple, manager of research at JANA Investment Advisers, said.
“I think once upon a time we might have been a little more… sensitive to a manager’s individual approach as to how they went about ESG integration. Now the expectation is you’ve got to really be able to demonstrate it, irrespective of what your approach is, irrespective of how structured your standard practices are around other non ESG factors,” she continued.
It’s on the issue of engagement where consultants and asset allocators are pushing investment firms to be more accountable, Temple said.
“There’s a very strong expectation that if you’re going to hold that company, and you can see issues, you need to be talking to the companies and really pushing for those issues to be resolved… There’s obviously been a regulatory push and companies have to report now so you’ve actually got the data, now it comes down to how meaningfully you are engaging.”
Proof of engagement
When it comes to engagement, divestment is the lowest hurdle investors and asset allocators should be attempting to get over, BNP Paribas Asset Management’s Lees said.
Firms need to publish the extent to which they’re voting against companies at AGMs, they need to review these proxies every quarter and they need to analyse the data to extract the impact their voting is having on companies they’re invested in and once they have those metrics they need to hold themselves to it, Lees described.
In this 2021 AGM season BNP Paribas Asset Management opposed 34 per cent of the resolutions it voted on at 1,684 AGMs across Europe, North America and Asia according to the firm’s most recent disclosures. It supported 90 per cent of climate-related shareholder resolutions and rejected 37 per cent of resolutions relating to director elections on the grounds of diversity, the data showed.
“But I think proper engagement goes beyond that [shareholder voting and divestment],” Lees continued.
“Engagement is a lot harder for asset management businesses and it more naturally sits with the PMs [portfolio managers] who own the positions and really have that one-on-one time with the CEOs and the CFOs to really push them to change operationally what they’re doing,” he said.
“And those are more like ad hoc situations [where PMs can meaningfully influence operational change], in my experience this doesn’t happen all that frequently, but they are great stories when they do happen… firms that try to imply they do that all the time I would be sceptical of because I just don’t think that the overlap of those genuine opportunities in the market and in your shareholding position are all that frequent.”
Overall Lees said it’s time investment firms got disciplined about segmenting their product range and got more honest about the purpose of their funds in terms of whether they’re focusing on companies that are providing sustainable solutions versus companies that are trying to adapt to an ESG system.
Once ESG might have sat on a different side of the fence to asset selection. Now it’s becoming more integrated it’s time for asset allocators and investors to be clearer about their approach and what they bring to the table, he said.
This story was produced in partnership with BNP Paribas Asset Management.