Magazine Issues » May 2019

ESG inside view: What is ESG and why should investors care?

Shoe_factoryJulie Moret, who leads ESG at Franklin Templeton Investments, considers what fund managers mean when they say they integrate ESG into their investment processes.

The term ‘ESG’ can be confusing for investors. There are a number of ways to define what constitutes ESG investing and there are different ways to integrate it. This means investors today have an increasing number of products with varying approaches to choose from.

Investment groups have long captured material ESG considerations, often more as an implicit component of fundamental research which they don’t necessarily carve out and label as ESG. In recent years, the availability of alternative ESG information and tools has vastly increased, along with the development of central ESG teams. This has broadened and deepened the range of approaches to assess these issues.

ESG datasets and tools can be used in several ways. They can be used for flagging controversy, for client customisation, for portfolio monitoring, and as research inputs. We caution, though, that these must be closely wedded with insights from investment teams to be meaningful.

But what is ESG, and why should investors care? In our opinion it is different to ethical (i.e. values-based) investing, which is often confused with ESG, and doesn’t require a trade-off in terms of performance.

ESG is essentially a set of performance indicators that provide a measure of sustainability to assess the future preparedness of companies, managing what are often longer-term strategic risks, which can reshape competitive advantage and ultimately long-term value creation for shareholders.

At a holistic level, asset managers have a fiduciary duty to be responsible stewards of clients’ capital. At a firm-wide level, we believe the integration of ESG factors should be viewed alongside financial analysis as a form of risk-based investing combined with active management, grounded in economics that looks to assess both opportunities and risks. The combination of the two deepens fundamental research and provides an additional tool to differentiate between companies. Fund managers would then be able to implement this analysis in their portfolio in the context of their wider investment decisions for their respective funds.

Social issues: an overlooked area
Some investment professionals will treat ESG factors like any other type of financial factors and they recognise they can affect economic, industry and company analysis. In turn this can impact forecasted financials or adjustments to valuation models.

An example of how this works in practice can be illustrated by an often overlooked area, namely social issues. Labour standards have always been an important issue in the emerging market apparel and shoe supply chain. Researching cases involving slavery and semi-slavery labour conditions over the past eight years in a Latin American country found that financial penalties were negligible in relation to the companies’ revenues. The evidence of such irregularities in the supply chain can cause significant reputational damage, impacting sales negatively.

In our assessment of a shoemaker that outsources over 90% of the production of all its goods sold, we identified that this type of risk exists given the industry and market in which it operates and the large level of outsourced production. Although the company minimises its risk by performing frequent due diligence on its numerous suppliers, it cannot be ruled out.

As the financial impact of a potential fine based on historical analysis in the industry is negligible, to integrate the risk of reputational damage, we adjusted the cost of equity through beta, implying a higher, on average weighted-average cost of capital. Consequently, the impact of this adjustment reduced the upside potential on a base case scenario.

Higher knowledge
While ESG factors have long been integrated in investment decisions, investor interest in the topic has increased significantly over the past five years globally. The challenge for asset managers is providing the necessary transparency on how ESG practices are being applied across portfolios, and how rigorously they are embedded in investment decisions.

The growing number and sophistication of ESG questions we are seeing in requests for proposals, as well as in due diligence meetings, demonstrates the increasing understanding across both retail and institutional investors. Now moving beyond just an equities story, we are seeing growing interest in how ESG is applied in fixed income investing, as well as in alternative asset classes such as infrastructure and private equity.

Currently climate continues to be a key theme, particularly focusing on understanding the impact on investments from transition, policy and physical risk. Sustainable development goals and impact investing is a topic that often comes up with conversations we are having with investors in Europe, as well as the large public pension plans in the US with endowments, foundations and high-net-worth investors.

As the industry continues to harness its ESG capabilities, investors are still embarking on a journey to identify the managers able to meaningfully integrate ESG. Investors need to clearly articulate their investment beliefs and how that translates to expectations from the fund managers they choose to invest with. Within this, there are two crucial criteria for investors when assessing a manager’s commitment to integration efforts, which asset managers need to be able to articulate.

Firstly, explaining the firms’ approach to ESG and providing evidence of how that translates into the investment process, how it informs their stewardship activities and what the outcomes have been.

And secondly, if there are dedicated ESG specialists, how they work alongside and collaborate with investment teams to inform investment decisions.

Julie Moret is global head of ESG at Franklin Templeton Investments

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