At the heart of an environmental, social and governance (ESG) approach to investing is the belief that it leads to better long-term risk-adjusted investment returns for members.
Increasingly, it’s recognised that an ESG lens is an invaluable tool for managing risk. But ultimately, ESG is about delivering what’s in members’ best interests, and its impact can’t necessarily be assessed in investment terms alone.
Just a decade or two ago, ESG (or sustainable investment or responsible investment) proponents generally – and inside super funds particularly – were viewed as outsiders, fringe-dwellers preoccupied with things that weren’t considered hardcore investment issues. ESG investment decisions, in many cases, bolted on to an existing investment process.
But fast-forward to today, ESG perspectives are hardwired into the investment processes of most significant institutional investors. It’s no longer an overlay or an afterthought; it has led to those processes being redesigned; and today it is integral to how investors create portfolios and act in the best financial interests of fund members.
An Investment Magazine roundtable, sponsored by Northern Trust Asset Management (NTAM), heard that some hurdles remain to ESG investing achieving its full potential inside asset owner organisations, including variability in both the availability and quality of data on which to base investment decisions.
NTAM director of sustainable investing client engagement for EMEA, Valeria Dinershteyn, said ESG has matured as an investment approach, and “there’s definitely been a lot longer of a history than some people give credit for”.
“What we have seen with our long-standing clients is that their SI approach within portfolios is evolving and maturing over time – they might be on their second or third iteration of their ESG approach” she said.
“The starting approach would be very light touch and predominantly exclusions focused. [Then] your toolbox keeps growing. You get to the optimisation, you get to thinking about how stewardship achieves impact, with a little letter ‘i’, not the capital letter ‘I’; and how we think about the interrelation of the ESG integration and stewardship efforts, themes that are emerging and showing up both in your engagement and voting efforts and the way one looks at SI risks and opportunities for portfolio construction.”
Dinershteyn said investment professionals are people who naturally think about risk and return. Initially, thinking about integrating ESG would have been a confronting process because it aimed to broaden their way of thinking about risk.
“When I started in this industry…we had a very limited number of tools, and one of the main tools that we had was exclusions,” she said.
“I was one of those people who’d be coming in and saying, ‘I’m going to make your life more difficult, because you had this universe, now you have this universe, and you need to be making the same sort of returns and thinking about risk in a similar way’.
“Fortunately, that has changed, and I am cautiously optimistic for the industry, [now] that we have a lot more tools in the box.”
Capital market assumptions
Equip Super head of responsible investment Jessie Pettigrew said that over time, ESG factors have been accepted as integral in forming capital market assumptions.
“When I first started doing this analysis…it was, well, it doesn’t move the dial, so why would we include it?” Pettigrew said.
“Now it’s like, well, it might not move the dial, but none of this stuff moves the dial. But the combined aggregate weight of it is what makes up a capital market assumption. It’s just little things like that that I think have shifted. You are seeing things in there that [are] doing tiny little bits, and now ESG or climate is in that conversation.”
REST head of portfolio construction and risk Paul Docherty said that when the fund started building out its internal asset management capabilities it naturally revisited its own capital market assumptions.
“One of the founding principles when we did that was both our baseline assumptions were going to be climate aware, and we were going to work through a process to develop climate scenarios to effectively stress test, like we subject our assumptions to market-based stress tests or liquidity-based stress tests. It’s just another layer of the BAU kind of risk analysis that we do,” Docherty said.
“I think it’s going to be like painting the Harbour Bridge and continue to evolve. But I think, the hardest step to make is the first step. And we’ve made the first step.
“It creates challenging conversations, like when we look…at our scenario analysis, the net-zero scenarios that are actually the worst outcomes for 2030 [are] the best outcomes for 2050. So, you have to sit in the investment committee and have conversations with your investment committee.”
Cbus head of ESG integration Talieh Williams said ESG factors “can’t always drive the investment decision, but understanding ESG risks and opportunities help make sure it’s well informed, and gives you a platform to influence and engage, to drive change”.
“If it is the right thing from an investment perspective, but there are [ESG-related] issues, at least you understand what they are, and then you can use your stewardship capabilities to influence positive change,” she said.
A challenge for ESG investing relates to the availability and quality of data to inform investment decisions, and to help communicate ESG issues to investment teams in terms those teams readily understand.
Even so, Dinershteyn said she is optimistic about the development of ESG-related data.
“I think we are in the business of data, and it needs to be fit for purpose” she said.
“What I’m taking away from this roundtable is ESG data is not something that should be hidden somewhere and not talked about. It should just be front and centre of every investment that we make and treated very, very similarly to [other] data that we have about companies.”
Cbus’ Williams said that “sustainability or ESG factors are sometimes held to a higher standard than other factors that inform investment decisions, such as management quality”.
“Other more traditional factors, which may be also qualitative, are maybe not held to that same evidential standard.”
A starting point
But ultimately, data is only a starting point for making better decisions, and committing capital entails “going to beyond data to actions”.
For example, “what we need is to know where the emissions are coming from and how we’re going to reduce them as quickly as possible”, Williams said.
“We need action plans…to compliment scenario analysis equally important is asking, ‘what does this company do, how is it going to get to zero by 2030?’, and what are the key actions for how it’s going to decarbonise.”
But a conversation with a fund’s investment committee requires confidence in the data for decision making, and Aware Super head of responsible investments Liza McDonald said that right now, “whilst we have some data, there are gaps and questions around credibility”.
“If we’re setting targets on a portfolio, and that’s constraining [the investment team] because they’ve got to meet those targets, but the PCAF [Partnership for Carbon Accounting Financials] score is a 3.8 or a 4.2, you actually can’t give them a target, because you could be so far out that they’re going to make investment decisions that are not actually going to be in our members’ best interest,” McDonald said.
“We’ve just spent a whole heap of time improving data quality versus trying to set targets, because we’d rather have data quality and make sure that’s better for us to make informed decisions. You actually have to spend time on getting data and getting quality data, and that takes up resources and commitment.”
Brighter Super head of listed equities and sustainable investing Fi Mann said that even in just the past three or four years the data available to make good, informed ESG decisions has improved significantly.
“The quality is just so different today,” Mann said.
“You run some numbers today on things you did years ago, and there’s so much improvement. I’m just talking specifically about equities portfolios, let alone other asset classes.
“We did an exercise looking across our unlisted assets and we’re revisiting it, basically getting all of that data again. You need two things. You need to, obviously, have the asset managers help you collect that; and you also have to…make sure it’s reasonable; and those reasonableness checks often need to happen at the investment-team level, because if you don’t understand the assets, you can’t understand the numbers that are coming back to you. It is a team effort.”
The human touch
So, even if the data is good, it still needs a human sense-check.
“We had a situation where numbers came back, and they just didn’t look right,” Mann said.
“If I had just been throwing unscrubbed data into a data warehouse, it may not have been picked up. It’s really important that wherever the data is from, you have to have both sustainable investing and investment oversight.”
Equip’s Pettigrew said that because super funds are universal owners, excluding companies from a portfolio can’t be the only ESG tool they use.
“You can take them out of your portfolio, and that’s fine, and there are clear reasons to do that,” she said.
“But inevitably, if you’re exposed to everything in most economies, you need to be actively in there, trying to change things at every single level, whether that’s the company, the manager, the government, and that is going to bring a better outcome for our members long-term.”
And it’s a collective effort, ultimately: no single investor will necessarily change the world on its own, and they may have different ways of approaching it anyway, but together they can make a big difference.
“It’s hard to say that what I did is bigger than what Liza did,” Pettigrew said.
“But if you think we’re all pushing a giant snowball down the same hill, we’re just trying to make sure that kind of vaguely goes in the same direction and doesn’t knock over any villages on the way.”
McDonald said it is “interesting that we’re being asked to prove what we do benefits members and contributes to member outcomes”.
“I can’t give you a basis point [measure of how] what I do contributes to what my members’ return is going to look like,” she said.
“But I’d ask you the question, if we’re not doing this, and we’re not talking to companies and going, ‘How are you managing this risk, and how are you creating value with what you are doing?’, what our portfolios and what our returns would actually look like.”
Another way to view and measure risk
From a portfolio construction perspective, REST’s Docherty said an ESG focus provides another way to view and measure and therefore manage risk.
“All of us as superannuation funds innately have a long-term investment horizon, and therefore we, as part of our investment processes, should be thinking about these kind of left tail risks that may be realised across multiple decades,” Docherty said.
He said this is a particular focus for a fund like REST, where half of its members are aged under 30 “so they’re going to be retiring into a 2070 world”.
“Considering these kinds of factors and characteristics, we can debate whether or not these risks are going to be realised by 2030, [but] I think the probability of these risks being realised in 2050 or 2070 has got to be quite material,” he said.
“Therefore, when we start to lengthen our investment horizon based on the members’ requirements, it becomes a more pertinent.
“ESG is no longer and should no longer be a cottage industry. It’s part of BAU and it should be integrated into everything that we do as best practice as investors, and best practice risk management.”
Brighter Super’s Mann said that from her perspective a sustainable investing focus benefits members in at least a couple of ways.
“First thing we’re doing is mitigating the financial risk of climate change and any negative implications associated with that in their portfolio,” she said.
“I’d like to think that we are building sustainable portfolios for them going forward, and in the end that should be in their best financial interests.
“I would hope the main thing people who work in superannuation is in the industry for the members’ best financial interest, and really this is just another risk that we’re trying to manage.”
Achieving sustainable investment goals isn’t necessarily a uniform process across all funds, even though all funds might ultimately be aiming to achieve the same thing, namely, maximising risk-adjusted returns for embers to help them accumulate as much as possible on which to retire,
“There is no one-size-fits-all,” McDonald said. “It’s back to the fit-for-purpose [issue], and how I do something is going to be different from how Cbus does it, because we’ve got different members and different objectives. And that’s OK – we should not all be the same. If we were all the same, we’d just need one fund.”
McDonald said funds need to be open-minded about how they approach ESG.
“We need to actually be able to think a little bit differently,” she said.
“The whole way that people invest has to be thought about a little bit differently as well. But I completely agree that responsible investing should not be seen as this standalone industry. We need to get rid the politicisation of ESG; it’s about outcomes for members.”
“We do talk about delivering retirement outcomes for our members, but they need a world within which to retire, [that is] actually going to be sustainable for them.
“They can have all the money in the world, but what’s it all going to look like for them when they’re ready to retire?”