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The evolution of ESG

More than just a risk mitigator

Once dismissed as a virtuous endeavour that compromised investment returns, the ability to gain a more holistic view of risk by considering environmental, social and governance factors is increasingly appreciated by investors. We assess the evolution of ESG across asset classes, as well as its role as a risk mitigator and opportunity spotter.

With money pouring into the responsible investment sector, or funds closely tied to it through environmental, social and governance (ESG) integration, investors are making a clear statement with their money. They either want to do some good with it, think that by doing so they will be rewarded, or both.

Since the term ‘ESG’ was coined 16 years ago in Who Cares Wins, published by the United Nations Global Compact and the Swiss Federal Department of Foreign Affairs,1 sustainable investing assets under management now total about US$14 trillion in Europe and US$12 trillion in the United States, according to Deloitte.2 While the US has historically trailed Europe in ESG implementation, the consultancy believes a turning point is around the corner. It estimates ESG-mandated AUM could grow almost three times as fast as non-ESG AUM in the US, accounting for half of all professionally managed investments by 2025.

Despite the rapid progress, there have also been some notable barriers. For many, the focus so far has been on rankings that are often static and uniformly applied for all sectors, based on data that may not be relevant. An ESG score, however comprehensive, is far from a complete picture – within assets, sectors and countries – from which to base investment decisions. Engagement has also traditionally taken a siloed approach, mainly focused on equities, while sidestepping investments elsewhere in the capital structure. And while attempts have been made to consider forward-looking information into the investment process, they have often been applied on an idiosyncratic basis rather than in an integrated way.

In this article, we explore the growing importance of ESG to investors; charting its course from its ‘dark green’ screening days through to today and the impact of stewardship, engagement and its influence on the drivers of returns. We also consider the progress needed to address some of the shortcomings when translating ESG factors into asset allocation decisions. Investors, too, must advance their understanding of how the ‘E’, the ‘S’ and the ‘G’ relate to each other and to financial metrics in a dynamic process that is both suitable to the particular investment as well as being harmonious within the broader portfolio.

Beyond risk mitigation

Of all the asset classes, ESG has been embedded into equities the longest. Indeed, company engagement started several decades ago, through voting and the rights and responsibilities that come with being a shareholder.

However, investors traditionally saw ESG analysis as part of their risk management process. It still plays that role, but its value is much broader. “In my view, it is more a way of identifying the most meaningful scenarios of how ESG is likely to help meet a corporate strategy. The real lens through which to assess ESG is ‘is this company’s business model sustainable?’,” says Jaime Ramos-Martin, global equity portfolio manager at Aviva Investors.

An increasing amount of data shows that companies adopting sustainable business practices are rewarded by financial markets. In the recent sell-off caused by COVID-19 fears, many strategies with higher ESG ratings exhibited less volatility to outperform their respective benchmarks, except for active US large-cap equity funds, according to Reuters (see Figure 1). Separate research from Bank of America Merrill Lynch covering the US market between February 19 and March 25 estimates the top 20 per cent of ESG-ranked stocks outperformed by over five percentage points. This trend persisted on a sector-adjusted basis.

Companies with higher ESG scores are more likely to be found in technology, healthcare or consumer staples, which have fared better than other sectors such as airlines in recent months. “There is an element – by design of ESG funds and the nature of this crisis – that favours certain sectors,” says Ramos-Martin. “Then there is true ESG resilience.”

Corporate leaders in ESG often focus on longer-term resilience and the sustainability of their business models. These attributes may offer downside protection, he adds. Take supply chain management, which forms a significant part of a company’s ESG resilience. Companies with more sustainable supply chains were better able to manage through the early months of the COVID-19 crisis relative to others with efficient, ‘just-in-time’ systems.

Given the unprecedented fiscal and monetary support to tackle the economic fallout from the pandemic, there will be a renewed focus on corporate governance. Practices like excessive tax optimisation, poor labour and community relations, and poor environmental compliance will be harder to defend. In contrast, companies with stronger ESG credentials are more likely to meet the conditions to receive government support through stimulus packages, Ramos-Martin argues.

Diversification benefits are possible too. According to ESG Performance and Disclosure: A Cross-Country Analysis published in 2019 by the European Corporate Governance Institute, ESG also has “a small, but statistically significant, impact on reducing volatility, which may mean there are portfolio diversification benefits from high-quality ESG investment in certain situations”.

A more complete picture

Translating non-financial information into metrics that offer insight into financial performance can be a real challenge – requiring a step change from traditional company analysis which has, historically, been a separate skillset.

“I’m expecting to see those skillsets converge,” says Paul LaCoursiere, global head of ESG research at Aviva Investors. “Think about ESG from a financial or asset valuation perspective. If it’s relevant there, it means that all analysts should be thinking about it and including it in their analysis, whether that’s done to identify risk or opportunities. ESG should be joined up with the more traditional financial modelling that analysts have been doing for decades.”

Furthermore, although ESG integration has largely focused on equities, LaCoursiere sees this as outdated. “Our view of ESG risk is that it’s agnostic to the part of the capital structure you’re investing in. In other words, you’re analysing the company, and the risk is relevant whether you’re investing in senior unsecured debt, subordinated debt or the equity,” he says. “There could also be a different level of sensitivity or a different magnitude in terms of the ESG effect on pricing in credit relative to equities, but you’d expect the relationship to be correlated across equities and credit.”

Investors’ engagement approach should be equally uncompromising regardless of whether you’re a bondholder or shareholder, adds Rachel Harris, senior investment director at Aviva Investors. She believes bondholders have as much power to affect changes by working with company management as equity investors, particularly for large-cap, investment-grade companies. “They are every bit as reliant on the debt capital market as they are on the equity capital market,” she says.

ESG: A tactical and strategic input

Outside equities and credit, ESG metrics have typically not been applied to strategic and tactical asset allocation decisions. That is changing, however. At the multi-asset level, ESG factors such as climate change might inform certain portfolio tilts due to concerns over stranded assets. For example, they may be incorporated into decisions on the portfolio exposure of one sector relative to another, or one country versus another.

Climate change also informs strategic asset allocation decisions. Modelling longer-term environmental scenarios may help gauge the potential physical exposures arising from climate risk in various countries – and therefore the impact to ratios such as productivity in different parts of the world, says Peter Fitzgerald, chief investment officer, multi-asset and macro at Aviva Investors.

In India, for example, air pollution from intense crop residue burning led officials in New Delhi and other cities to take extreme measures such as shutting down schools, public buildings and construction work to protect public health. During a public health emergency in 2019, New Delhi’s Air Quality Index touched 480 out of 500, which falls into the severe category. The consequences to its economy are significant. Estimates from the International Food Policy Research Institute suggest exposure to the pollution from crop burning causes economic losses of about US$30 billion annually for the states of Punjab, Haryana and Delhi.3

The solution lies in more sustainable farming management practices, requiring government intervention. This may improve the underlying economy as well as air quality, says Fitzgerald. Having a view on the impact of new legislation to ban intense crop residue on pollution is therefore insightful.

“These kinds of inputs help us complete the investment picture,” he says. “We don’t just see ESG as a risk, we also see ESG as one more factor that helps us find opportunities, and this is integrated through every step of the investment process.”

Quantifying value and optimising portfolios

Linking non-financial, ESG information to forward-looking financial implications is critical for a more rigorous risk allocation and portfolio construction process. LaCoursiere is leading a collaboration with Aviva Quantum data scientists called ESG Elements, which aims to implement a more dynamic approach to ESG ratings, tailored by sector and linked to financial market performance.

Josh Lohmeier, head of North American investment grade credit at Aviva Investors, sees this playing “an important role in improving allocations to idiosyncratic ideas, as well as assessing risk at the broader portfolio level”.

The first step is to better understand ESG drivers under various scenarios from a factor perspective. Water usage, for example, may be more relevant to a utilities company relative to a healthcare company, which may have higher reputational risk. In the future, artificial intelligence, machine learning and alternative uses of data may uncover material ESG information that traditional methods cannot. Raw media processing of news and social media posts, for example, could help investors gauge ESG momentum by tracking the increasing frequency of references classified as either negative or positive sentiment.

Additionally, modelling ESG indicators in a consistent and coherent manner to compare across companies and sectors, and then to conduct more accurate ESG stress tests, can improve ESG risk management and potentially generate alpha at the enterprise and portfolio levels, says Lohmeier.

“Are certain companies and sectors inherently causing climate change problems globally? And are they going to be more volatile?” adds LaCoursiere. “Then you need to consider how will the subtotal of your ESG risk impact performance at the portfolio level?”

Sam Savage, author of The Flaw of Averages: Why We Underestimate Risk in the Face of Uncertainty and executive director of ProbabilityManagement.org, a non-profit organisation focused on modelling uncertainty, uses rising sea levels to make a similar point, suggesting it can be analysed to help gauge climate change risk.

To apply to different economic situations, Savage argues probability distribution modelling techniques – developed in financial engineering – may be best suited for ESG stress tests. This technique represents uncertainty as an array of auditable simulated outcomes and metadata called a stochastic information packet (SIP). A global SIP of sea level rise could be accessed by individual regions, which in turn would calculate their own SIPs of economic impact based on local knowledge of factors such as the hydrology, tide basin and storm surges.

“The resulting SIPs would be coherent in that they reflected the same sea level conditions on each trial and could be added together to estimate the global economic impact. The data and the technology are there. It’s a matter of getting everyone on board,” says Savage, whose work for Shell in 2005 pioneered the field of probability management.

In asset management, a multi-dimensional approach to risk modelling is perhaps most famously applied in the efficient frontier for portfolio construction. “We need the efficient frontier because you cannot represent utterly orthogonal dimensions as one number that will be meaningful to everyone,” adds Savage. “You need a process of optimising the trade-off between the risk and return, which can then be applied to individual circumstances. Risk is in the eye of the beholder.”

A qualitative view

When considering ESG metrics, or any metrics for that matter, it is important not to place too much emphasis on quantitative factors alone. An ESG score is a snapshot in time. If it is not overlaid by qualitative information and judgement, the model will simply be a mirror of the past – a function of the information you have fed into it.

Additional qualitative inputs, such as shifts in the regulatory environment, physical and transition risks, and other material considerations, may indicate whether ESG momentum is improving, stabilising or deteriorating, and help investors evaluate whether “this company will improve in a year or two”, says Harris.

“It’s not only about the quantitative score, and it’s not only about qualitative piece,” she adds. “It’s also how to engage with companies. After all, the best way of looking to the future of ESG is to try and influence that future. It’s all of those elements – quantitative, qualitative and engagement – working together.”

As Harris says, trying to influence the future is one way to gain more control of future outcomes. For example, investor engagement is designed to encourage companies to behave in more environmentally and socially responsible ways.

In the case of climate change, positive signs are emerging but much more needs to be done. “There has been a massive shift in the last three or four years, and companies have begun to acknowledge the need for them to take action,” says Rick Stathers, senior ESG analyst and climate change specialist at Aviva Investors.

“But there are only 850 companies committed to align their emissions pathways with what is required under the Paris Agreement,” he adds. “There just aren’t enough companies fully analysing the potential ramifications – and what I mean by that is analysing the impact through the value chain, on cost of goods sold, on the supply chain, and ultimately, the impact to customers and their disposable income.”

Understanding macro drivers

ESG factors can also uncover insight at the macro level. Complementing country-level ESG scores with “a timely judgement on ESG momentum” helps investors identify material risks that may be mispriced in the market, says Tom Dillon, macro ESG analyst at Aviva Investors. A crackdown on press freedoms, for example, may indicate a shift in the future business environment.

This has been especially relevant in the spread of the coronavirus. In China, where COVID-19 originated, authorities revoked journalist credentials and silenced or arrested citizens who posted messages they deemed to be contradictory to official statements, according to the Committee to Protect Journalists and Reporters Without Borders.4 Information suppression has been widespread, not only in China, but throughout the world. Because this is a global health crisis, a lack of transparency affects how other governments respond, how medical centres prepare for the sick and, ultimately, how investors gauge the risk.

The importance of understanding the impact of ESG drivers on macroeconomic dynamics at the portfolio level has never been stronger. “If investors don’t understand or don’t account for these macro ESG factors, they are frankly missing a major risk factor,” adds Dillon.

On the flipside, conventional economic indicators such as unemployment may provide a more nuanced understanding of how ESG trends can impact investments. In the US, more than 42 million workers had filed for unemployment benefits by the end of March because of the pandemic.5 The unemployment rate neared 15 per cent at the end of April and, although it fell slightly in May to 13.3 per cent, it remains higher than at any time since the Great Depression (see Figure 2). Furthermore, income inequality has been rising, as shown in Figure 3.6

In their new book Trade Wars Are Class Wars, Matthew Klein and Michael Pettis argue rising inequality directly causes trade conflicts, including the ongoing tensions between the US and China, as government policies have benefitted the elite much more than the average worker. During the past two decades, the labour income share relative to China’s national income has hovered around 40 per cent, far below the range of between 60 and 70 per cent for the US and Europe. The country’s workers and retirees are earning a disproportionately low share of national income, which diminishes their purchasing power, Klein says.

As China’s national income rises but the share going to pay its workers doesn’t, deep imbalances are created in the local economy that then get exported to other countries, mainly the US, he adds. In response, the US and other countries face an unpleasant trade-off between rising debt, lower wages and lower employment, hurting workers there too. Trade imbalances are necessarily equal to domestic imbalances. Until such inequality is substantially reversed, global trade tensions are inevitable.

“The fetish for ‘competitiveness’ among businesses and, to a lesser extent, among governments, is ultimately self-defeating insofar as it mostly means cutting labour costs,” says Klein. “What may make sense for an individual company doesn’t work when every company behaves in the same way. All that happens at the end of the day is lower disposable income for consumers, which either means lower sales or constant sales financed with higher debt. And while individual countries can try to preserve their manufacturing sectors and boost employment by reducing wages and non-wage costs, the net effect on the global economy if everyone tries to do this is to reduce overall incomes and, eventually, spending.”

The result is too much global savings chasing too few investment opportunities. Klein and Pettis, among other economists, argue the result is a perpetually low global interest rate environment with significant implications on asset allocation decisions. Since the pandemic, more central banks are heading towards the zero bound, most notably the US Federal Reserve but also in some developing nations.

“Policy tools that were previously concentrated in developed markets – including ultra-low interest rates and quantitative easing – are increasingly being deployed in emerging markets,” says Liam Spillane, head of emerging market debt at Aviva Investors. If you understand ESG factors in their entirety, you start to appreciate exactly why this is.


Macro ESG metrics have clear relevance for emerging market debt investors. “We find ourselves in a really unprecedented situation because the COVID-19 crisis is not just an economic crisis. This is also a health crisis and arguably a social crisis in many countries,” says Spillane. “As governments will need to issue more debt to support their economies, the scale and efficacy of doing so will come under increasing scrutiny.” At the same time, domestic fundamentals may be deteriorating, potentially increasing sovereign bond yields and the costs of servicing that debt.

Set that against the social concerns, and the risk of default for certain emerging market sovereign debt could rise. Divergence between countries is also likely to increase. “The social element within ESG might become louder, more disruptive,” Spillane adds. “We haven’t seen much of this yet, but the intersection between economic fundamentals and social requirements could become quite disruptive.”

The pandemic occurred at the same time as a dramatic drop in commodity prices, particularly oil, which is relevant to many emerging markets. In addition, tourism has been disrupted. “If we consider our investment outlook through the three different lenses, we end up with a situation in which the implications for each country look quite different in terms of its ability to weather this crisis,” says Spillane.

Colombia, for example, is hurt by falling oil prices, as are Mexico and Brazil. However, the latter two will likely experience a more severe outbreak and a bigger impact from reduced tourism revenues. Thailand, on the other hand, has reported relatively fewer deaths and is not dependent on oil exports. Yet it will still be harmed by the disruptions in tourism, which directly and indirectly accounts for about 22 per cent of the country’s gross domestic product (GDP).7

In assessing the severity of the pandemic on emerging market sovereign issuers, ESG indicators linked to social unrest may provide information advantages. Take Peru, which is relatively attractive from a governance perspective due to its legislative and fiscal framework. Compared to Brazil or Mexico, it is not as dependent on revenues from oil and tourism for GDP growth.

However, a sharp uptick in social unrest in April and May could indicate trouble ahead as the country grapples with the COVID-19 outbreak, says Dillon. About 70 per cent of the labour force is in the informal economy and therefore may lack workplace protections such as unemployment benefits, healthcare and other social rights. A longstanding underinvestment in healthcare may exacerbate the spread of the virus. Even before the pandemic, socio-political dynamics had become more uncertain.

Many of the incidents of unrest stemmed from these long-term social and political factors, which coronavirus has laid bare. Newly unemployed informal workers, unable to afford city living, battled with police to breach lockdown rules while returning to their hometowns. Meanwhile, healthcare workers demonstrated against inadequate resources, local leadership and late payment of their salaries.

“The fundamentals in Peru are strong, but understanding the risks around social unrest and political fragmentation is going to be critical,” Spillane says. “While the framework for how we think about ESG in our investment decisions hasn’t changed, the emphasis we place on each of the ‘E’, ‘S’ and ‘G’ factors around how we view value creation will change, but on a case-by-case basis. There is no broad-brush solution.”

Engaging the real world

When it comes to the ability to advance the ESG agenda, perhaps the asset class in the best position to do so is real assets. Compared to listed equities, for example, owning a direct stake in a private infrastructure or real estate asset can give investors more sway, says Mark Versey, chief investment officer of Aviva Investors Real Assets.

“As owners, we have the ability to directly influence corporate activities that improve ESG resilience,” he says. “In infrastructure equity, for example, we might own 100 per cent of the company and have people on the management team, or we might be on the board. This means we can directly influence strategy, by being part of the decision process rather than challenging from afar.”

Therefore, ESG risk assessment is fundamentally different from other asset classes. In equities, if engagement does not work, investors can easily sell out of their position. “However, in real assets, once you’re in, you’re in,” says Ed Dixon, head of ESG for real assets at Aviva Investors.

Typically, the investment is for ten years or longer, while the assets may be designed to last decades more. This increases the need to be aware of the impact of ESG factors.

“The risk of trends manifesting over a longer period is substantially higher,” says Dixon. “That forms the way we approach ESG in real assets – in terms of transactions, origination and investment strategy being a lot more front loaded.”

Take a pharmaceutical and medical supplier. Although healthcare brings relatively less environmental risk, reputational problems may arise if the tenant is embroiled in a public controversy relating to drug pricing, injuries and fatalities linked to their products. Other social risks may involve business practices such as how it conducts research. In addition, governance considerations may include remuneration, board diversity and M&A strategies. Even if the deal is completed, ESG risk – as with all key investment risks – still needs to be monitored as appropriate to the growth of the business.

For example, employees from one pharmaceutical occupant in Cambridge had to work on premises throughout the COVID-19 crisis because the company is involved with testing kits being rolled out to hospitals globally.

“We worked with them to solve a lot of safety problems to protect employees,” says Versey. “This has also helped us to progress on the journey on how to make buildings safer. When economic activities pick up, we can apply what we’ve learned to help other tenants.”

Investment performance doesn’t depend on ESG risk alone, but ESG risk can be a lens to find value. It can also help gauge the value at risk from disruptions including climate change, social unrest and, more recently, pandemics. Of all the asset classes, you could say that real assets have an unfair ESG advantage: Their tangible nature has always held appeal with investors.

As Versey puts it: “By being a direct owner, we have control. That’s a really important point. This direct ownership gives us this long-term mentality, and a long-term mentality is critical in ESG”.

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