The AIQ Podcast: Ethics & Alpha

Hello and welcome to the latest AIQ podcast. My name is Ben Moss and I'm here with Aviva Investors Chief Responsible Investment Officer Steve Waygood. We're going to talk all things ESG and sustainability in the world of investing. And I'll put the question seemingly on the lips of every investor these days. Does incorporating ESG factors into investment process mean sacrificing returns? Steve, welcome to the podcast.

Thank you very much for your time. Thank you. Very, very simple question to start with. Can you make money out of doing good?

Yes, you absolutely can. It is also possible, though, to make money out of doing evil. It would be quite wrong to pretend that by being corrupt or by being fraudulent, by exploiting people, that there are businesses out there that have made more money. There certainly are. But think about how long they make more money for things that will happen to and from. For example, the business doesn't exist anymore. They brought down their auditor. He's heard of Arthur Andersen today. That wasn't also doing business in 2001. So for us, it is purely common sense to say that looking after your customers, treating your employees properly, looking after the local community and not exploiting the environment is a much better, longer term business model. That is all we are saying when we say that ESG enhances long term returns.

Do you need to include businesses in that, though, that maybe don't have the greatest ESG credentials?

So they've been broker studies. There've been loads and loads of academic papers that have looked at the long term evidence now that we've got companies disclosing their sustainability performance. It's possible for the academics, if you like, to do the long term research. And absolutely, it is clearly the case that those companies that have got better long term figures from their ESG perspective, they're reducing risk. They're enhancing long term returns. Now, controversial sectors. It's a different matter as well as there being market inefficiencies that we can exploit, which is essentially what the first set of data are telling us, that it is the case that not all information is immediately reflected in the price. That's market inefficiency. We're trying to exploit that from an environmental, social and governance perspective to enhance Alpha. Now for the controversial sectors, many of the sectors are what I would consider to be the presence of market failure. Now, a market failure is different to market inefficiency. Market failure means that the markets haven't yet been corrected by governments in a way that leads to optimal outcomes for society. Now, that really classic example of that is the tobacco sector.

Tobacco kills more than half of the people who use it in the way it is intended to be used. If you were to bring tobacco to the market today, it would never be approved. Given what we now know in terms of its human health impact yet because it's out there, because governments have approved it, because there is a lot of tax revenue being generated, companies still make cigarettes today and those companies are making money. In the presence of market failure, it's for the end consumers, for the end investor to decide whether they're happy to invest in that way. It is the case to say over the last 10 years, investing in tobacco security has actually generated reasonably good long term returns and a pretty strong dividend because, of course, its customers are addicted. But this isn't what we would consider to be an optimal outcome for society. That's a market failure. So then at what point do you consider divesting from companies? Personally, I don't own it. And my own pay. It's not part of my own personal account.

Institutionally, though, it's not for us to dictate to our clients where their own ethics fall. It's their money, not ours. At the forefront of our minds at all times is that it isn't our money, it's our clients money. So I think what we need to do is have a conversation with institutional clients and explore the boundaries of where they're comfortable and where they're not. To my mind, a product that does kill in the way that it's intended to be used is beyond the pale. But that's only me saying that. What do others feel? Others might feel, actually, they prefer to live in an economy where people are free to choose to be able to smoke as long as they can do so, fully informed of the likely consequences. It's a libertarian view. So each to their right. It's an ethical view and it's up to us as individuals to decide what we believe for ourself.

And your role as chief responsible investment officer. How do you balance that?

Where there's a market inefficiency and there's more money to be made by analyzing environmental, social and governance issues and factoring that into the way that we run money, in the way that we select securities, in the way that we construct portfolios, in the way that we do the risk management. Clearly, we have a duty and our clients have a financial interest to make sure that we've as far as possible factored in all this information and made sure that the pricing that we've got for every security is optimal. We're exploiting the information advantage. We're exploiting the market inefficiency where it comes to matters of personal judgment. As I say, it's up to the individual to make their mind up when it comes to the ethical issues, cluster munitions, landmines, chemical weapons, biological weapons, nuclear weapons, handguns, tobacco. These are amongst the most commonly avoided securities for purely ethical reasons. Now, when you've got an approach to ethical investing that's driven by your conscience, it isn't so much of a financial consideration as it being up to the individual to be free to choose what they wish to own and not own, have a clear conscience. But I think a higher order ethical question is if you want to change the world for the better by avoiding it, by never owning something, by divesting something. How much ongoing influence can you have to improve what they're doing? I think it's better to use your voice first than immediately head for the exit.

And so then from that point of view, how do you ensure that asset managers don't just cherry pick the examples where they have a good story to tell around ESG and engagement and ensure there's actually an honest reflection internally of either the engagement hasn't worked from an integrated standpoint. The investment call ends up hurting overall performance. How do you do that?

That is an absolutely excellent question. It is entirely possible for large numbers of fund managers, as I believe is the case today, to use smoke and mirrors to present what is actually very little engagement, very little stewardship as a great deal. I think it's incumbent on us as an industry to get much better, much clearer and much more transparent, open and honest in how we share what we do with the institutional clients that we have. I think there's a time now for a standard a very, if you like, a kite.

Marcus, it's referred to in the UK where third party institutions can come in and verify that what you say is true. And in the UK, we're the first in the world to create a stewardship code. We're one of a few institutions that get our stewardship statement of eager investors. We get it verified by a third party. We've just passed muster from BWC actually a few weeks ago. There is an approach to stewardship that the government has articulated, which we now respond to, which can be verified. But I think beyond that, it's clearly the case where there is another market failure here. If we spend money engaging with the company, we only own a few percent of it on behalf of our clients. The other 98 percent of the investors also enjoy the benefits. This is the free rider problem, as it's called in economics, and that's why there's a role of government to correct that free rider problem. So we need to make sure that others in the industry are also stepping up. We need to make sure that the end customer, when they're told that engagement is well resourced, that it is well voiced, it is effective, that they've got genuine measures of that and they're in the right place to be able to make that kind of a judgment themselves.

The moment smoke and mirrors prevails, I was going to ask you mentioned that this needs to be an industry sort of led activity push, you know, not just one group doing it on their own. Is the industry doing that and getting there or is that not happening at the moment?

There's different bits of the industry. So I would say if we can point to, for example, the UN principles for responsible investment, which we had a hand in shaping, and we're a founder of back in 2006, that's gone from six trillion to over 80 trillion of assets under management supporting it. It's a set of principles which we report to and they do evaluate our performance. So that's helped us not by any means the whole answer, but it's helped. We've also got the Investment Association in the UK, which provides more of a collaborative forum. John Kay kicked that off after he was commissioned by the then secretary of state, Vince Cable, to look into short termism and see what could be corrected there. That investment association has enabled and encouraged collaborative engagement to take place and be more effective. The last few years hasn't done a huge amount of work, but what it has done has been reasonably high quality. We've also had for a few decades now the International Corporate Governance Network, which enables these things to be shared.

But they're all voluntary. They're all the other side of a wall. Most people can't really see what's going on. And I think that's wrong because it's not our money. And it should be easy for the people whose money it is to see what's being done with their money in their name, on their behalf. And I don't just mean our institutional customers here. I think the end investor, the beneficiary or our retail customer.

They should also be able to see how we're shaping the world they're in today, as well as the world they retire into using the power of their voice, say say you've mentioned engagement already.

What does that actually mean?

Interesting, isn't it, because engagement can mean everything from going to war to a pledge to get married. So what does it mean in this context? Engagement is stewardship. It's perhaps being an active shareholder. Sometimes people think of themselves as shareholder activists, but it's really using the rights that are associated with share ownership. Now, it isn't just about equity shares. It can also be corporate bonds, sovereign debt, infrastructure, real estate and so on. But it's most typically thought of in the area of equities or shares. Now, I think with every right comes responsibility in general, but specifically here. So using the rights of share ownership to responsibly promote good business behavior, being good governance, bear responsible business conduct from a societal perspective, or bear being environmentally friendly, these are all topics that you can be good owners and promote better practice and in the literature. This is thought of as using your voice more than using the exit. And there's a article in ICU which talks all the way through what it means now in the UK. We've got the stewardship code that started to codify what investors should do and we've started to see other countries, for example, Japan in recent years replicate that approach. And it's all there to try and correct that freeride a problem that exists in this space.

If we talk for a moment about the energy sector, because maybe that's one where you can look at them and say, let's say mining companies or whether it's and wind turbines, that kind of thing. There's varying levels of company there which people on the street might say have got different green credentials. Have you got any examples of sort of successful engagement in the energy sector where the UK's biggest owner of rooftop solar?

We own significant proportions of wind farms across Europe.

So from how we're allocating capital perspective, yes, we're financing more of the future that we wish to see as an insurance companies fund manager. Of course, insurers are exposed to flood risk and fire and even crop risk as the climate change. So it's obviously in our interest to do what we can. As well as providing capital, it's also how we use the voice. That was really your question.

How are we engaging with companies and I exon low energy BP shell? These are all examples of companies who we've challenged to either disclose better their climate risk management system or even stop investing new capital in exploration into new fossil fuel reserves, because we believe there is now enough in the system for us to be able to then transition to a lower carbon future. So Exxon is the contemporary example. The church commissioners filed a resolution this year which got 63 percent vote in favour, and now Exxon has to produce a report setting out its climate change strategy. And that's a good outcome. Adele and Glo Energy have been moving away from new capital expenditure in the area of fossil fuel reserves. There's a company called Soko that we engaged with some years ago that was going into Virunga, which is the World Heritage site, the oldest World Heritage site in Africa. And we were successful in being able to stop them going into Virunga. We were one of two fund managers actually, that led the charge there. As it happens, the company has now returned the permit to others that look like they might be about to explore. So the role of engagement doesn't replace the need for government to create the right standards, regulation and the fiscal environment. But regulations fail, too, as well as the market. So it's an ongoing challenge to make sure that the market and the money within it is actually financing a future that everybody wishes to see.

And can engagement deliver benefits in other sectors beyond energy?

Absolutely. It can in every sector.

It can deliver returns or if you like, success, not just in equities either. Of course, with equities, you have the vote at the AGM, which is considered to be the parliament of the company. That's also true. If you think about infrastructure investments, of course you own more of the equity. Sometimes all of it. So you have huge ability to influence. We don't do private equity or venture capital, but that's true there, too.

Real estate, you have an opportunity not just for the real estate investment trusts, but also with the underlying building to make sure that the way it's managed is more socially aware, more environmentally conscious. So this isn't just about equities, but it has principally been about equities. And your question was about other sectors, not just other asset classes. Just last week, we published some work, the corporate human rights benchmark, which ranked beyond the extractive sector. We looked at the apparel sector and the agricultural sector, too, and it's the second time we've done the ranking on human rights in those sectors and added us got another more than 25 percent more this year than it did the previous year. That means it's looking at its human rights risks. And we are able to see that more now as a consequence. So pretty much every sector and almost every asset class, even sovereign debt, incidentally, even when we lend money to governments, I believe it is possible to be effective in your engagement. But it can't be the only answer because engagement, too, has market failures.

The free rider problem I alluded to earlier, welkin institutional investors do to ensure that they actually can be pushing companies to remedy their behavior as well.

First thing is to make sure your votes are being used thoughtfully and actively and that the voting process is well resourced by people who have done good research and can voice the rationale for the way they use your votes. You pay a little bit more for a voting show. It's important to make sure that asset is used on your behalf in a way that you believe is true, is genuine. So, as I say, use the votes. Check that the stewardship statement of the institution that you're asking to run your money is something that you believe in and that if their voting record shows that they, broadly speaking, vote in line with the board 95 percent of the time, which is what some of our peers do, then you got to ask yourself, are they really doing that voting in a thoughtful and effective way?

We withhold our support from a company about a third of the time in general and a bit more than that in the area of board pay. And I'm very proud of our voting record.

So that's a lot. US a third one in three votes, you vote against something a company wants to do with hope means also abstain.

But we by and large vote against more than we abstain. But yes, that's right. That's true.

How does that go down when you win? When that happens with someone who I'm on the inside of, of how this kind of thing works. When you vote against something that company wants to do and you're a shareholder, what's the reaction like?

Depends on the company. A good quality company will want to understand why. They all want to know why they weren't aware of it beforehand.

Sometimes it's the wrong individuals at the institution that we were talking to. They haven't done their job. They haven't in positive but a well-run company. Their board will want to understand why voting of any level was withheld. Obviously, the higher the voting number withhold, the more concern the board should be.

There must be a education now because there's a lot of jargon within investment and there's new jargon springing up around ESG investment as well. So what can we do to help with investor education around this sector to get you to understand what the problems are and how they can help?

I know this is a very long term answer, but honestly, why isn't this stuff in the national curriculum? Every teacher, once every student to become a pensioner at some point and live well in their retirement.

So why aren't they taught? Why aren't we all taught at school how a pension works?

Financial literacy at the moment is considered to be, you understand, a bank account. If you understand what an annual percentage interest rate is, that's absurd. That's clearly absurd. So I think around the UK, certainly, and if not around the world, why don't we change the national curricula so that individuals are taught how their money is invested, how their money flows, if it's a pension, how it flows through trustees who use an investment consultant to choose a former manager who then buys and sells securities. Sometimes they're listed, most often they're listed on a stock exchange. And then those securities are brought to the stock exchange by an investment bank. And it's at that point then when the investment bank gets the money into the company, that flow of money is essentially what creates the world.

You're in your food, your house, your transport, your news, sometimes your holiday, your pension helped shape all of that. Now, why isn't that taught at secondary school?

The first answer, second answer. I think it would be wonderful for the CFA, the chartered financial analysts curriculum, to be significantly updated. They've come a long way in the last 10 years, but they've got a lot further yet to go. So that every analyst and farm manager who becomes a CFA charter holder genuinely understands what it means to have ESG risks and how you offset them. And then beyond that, I think it would be very good news for the trustee training courses to embed ESG at the heart of what it means to be a good fiduciary. After all, we've seen the demand for work and pensions in the second half of 2018 make it very clear that trustees have a fiduciary duty to make sure that they've set out what their stewardship statement is set out, what they're voting approaches, provide an annual report and all of that, and also be clear to the ultimate beneficiaries how their values have been considered now by the end of 2020. All of those things will need to have been done, including one reporting cycle. So I think it's important.

Now, the trustees are better equipped to think of this thing through, and courses, therefore have got to be part of the solution.

Steve Waygood, thank you very much for your time.

Thank you for listening to the AIQ podcast. Do look out for a future episode.