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Magazine Issues » November 2015

ESG INVESTING: The key to Volkswagen

VW engineThe VW emissions scandal took many environmental investors by surprise. Fiona Rintoul finds that ‘governance’ was the key part of the ESG formula that would have provided an early warning.

If a company’s story would make a good movie, then that company probably isn’t a good investment, Gerold Permoser, chief investment officer and head of responsible investments at Erste Asset Management, told Funds Europe in the wake of the VW emissions scandal.

Think Enron. Think Lehman Brothers. And think: where does Permoser keep his crystal ball? Because a few days later, Leonardo DiCaprio announced his production company is to make VW: the movie. 

Things look ropey for the manufacturer of the ‘people’s car’, brainchild of Hitler. But what lessons can investors draw from the VW emissions scandal? 

The scandal is a particular headache for compilers of environmental, social and governance (ESG) research and data. Many of their clients, says Olivier Lebleu, head of international business at Old Mutual Asset Management, are now “scrambling to explain why VW was ‘best in class’ according to ESG data providers”.

The VW case highlights a danger with ESG. Particularly if you buy it in from outside, it may become (or be perceived to have become) a box-ticking exercise. 

“An overlay is very arbitrary,” says Lewis Grant, senior portfolio manager at Hermes Investment Management. “Data providers are trying to follow hundreds of companies. We take data and combine it with our investment knowledge for a more rounded assessment.”

Many claim to walk the walk in this way. But are they really any different from other ESG data providers?

“The buy side is stepping up its commitment to ESG investing, and you will know it is really happening when a major institution is prepared to say openly, ‘We are holders of VW because we think at this price
all the ESG risk is in the price’,” says Lebleu. 

This touches a raw nerve. All the chat about ESG criteria becoming part of mainstream analysis emphasises the financial benefits of an ESG approach. To say that you care about the environment, or sweatshop workers, just because you do is professional suicide in the investment industry. 

But to eschew VW if the risk is priced in because there’s a bit of a smell about it isn’t very hard-nosed either. So, are ESG-oriented investors taking advantage of VW’s low share price to turn a profit? Hell, no.

“Never try to catch a falling knife,” says Grant. “When we see a company break, we want to see real, significant commitment to change before we go back in.”

But then Hermes, armed with proprietary data from Hermes Equity Ownership Services, was clever enough to get out of VW in August before the emissions scandal broke. What did it see that others didn’t? In a nutshell, plummeting corporate governance scores. “We aren’t just looking for companies to have good governance,” says Grant. “We favour companies that are getting better. At VW, we saw governance scores fall from the mid-70s to the mid-60s.”

Why the tumble? What was wrong with governance at VW? Plenty, according to Christian Strenger, a member of the Deutsche Asset and Wealth Management supervisory board. “The supervisory board is all insiders. There is too much Qatar, too much Lower Saxony, too much family, and then you have this whole group of people from the labour side.” 

Signs were there that something was amiss at VW. According to Chris Wehbé, global market strategist at Alquity, there always are when doom threatens. “When you see blow-ups of this kind, they are not totally out of the blue. BP’s safety record was always poor. At VW, people knew there were issues with Porsche and preference shares versus ordinary shares. VW has struggled to pass the smell test for some time.”

Why, then, did some companies miss – or ignore – the signs? Why, for example, did RobecoSAM, which compiles the Dow Jones Sustainability Index, choose VW as car industry group leader shortly before the emissions scandal broke in September?

It’s hard for research to uncover what Christopher Greenwald, head of sustainability investing research at RobecoSAM, calls “wilful deceit”. And while the VW ownership structure and board of directors are now being roundly criticised, there is as yet no trail of blood leading in that direction.

“Aspects of the advisory board were committed to sustainability and took it seriously,” says Greenwald. “There was an inconsistency between that and the pressure that some managers were under that came from the business goals.” 

But of course the business goals were set by the board. The most problematic was VW’s overweening (as it now seems) desire to be the world-leading auto manufacturer by 2018. 

“If this is your only goal, the tendency to have a blind side is bigger,” says Permoser.

Perhaps the board knew about the rogue software that allowed VW to cheat on emissions tests in a bid to fulfil that goal; perhaps it didn’t. Either way, it doesn’t say much for them. “Which is the lesser evil: massive fraud, or management didn’t know this was going on?” asks Howard Sherman, head of corporate governance business development at MSCI, which had alerted its clients to concerns about corporate governance at VW and removed it from its ESG indices in May.

This is really a story about people – and old-fashioned things like good and bad. 

“It’s a question of sufficient culture in the management,” says Strenger. “You can have the best models and subscribe to codes, which VW did, but if the culture is not properly lived by the key people, it is all in vain. You cannot prescribe by law or by code that you have to be a good person.”

Nor can you learn everything about people from data. Sometimes you need to look into the whites of the boss’s eyes – or at least make judgements around the data.

“It’s an assessment rather than a data-mining exercise,” says Nick Anderson, head of ESG at Henderson Global Investors. “That’s where fund managers can add value.”

But which data you prioritise and how much attention you pay to it are also important. Erste Asset Management was slightly overweight VW. Permoser says a couple of tell-tale incidents at the German company, such as the scandal of prostitutes at the VW workers’ council some years back, now nag at his conscience.

“We put too much weight on the good points, such as the social and environmental sectors where VW was very good,” he says. “We didn’t put enough weight on governance.” 

If there is one lesson from the VW emissions scandal it is this: governance matters. “MSCI emphasises corporate governance a great deal,” says Sherman. “Therefore, our assessment of VW was more realistic.” 

In the wake of the VW scandal, Erste Asset Management is reconsidering how it aggregates data. VW had a split ESG rating: good in E and S and poor in G. This begs the question: should investors look at total scores or should it be one strike and you’re out? “We need to take low scores and translate that into good questions,” says Permoser. “We need to do a lot of engagement. It’s interesting how companies react. Some bluntly tell you they don’t want to talk to you.”

This is back to basics. Perhaps ESG needs to redefine itself to shake off any remaining notion that it is peripheral – or even detrimental – to performance. 

“You’re talking about understanding management’s motivations and behaviours, which no fundamental analyst would disagree with,” says Wehbé. 

It’s almost a philosophical issue. What is correct behaviour? What is a good person? Are people who hire prostitutes for the workers’ council more likely to cheat emissions tests than people who don’t do that? 

These are questions for us all. Business leaders such as Ferdinand Piëch, former VW chairman – or, say, Fred Goodwin, the former RBS chief executive – don’t exist in a vacuum. They force us to ask ourselves if, as a society, we prize and encourage the right kind of business leaders. “In some ways, VW is an echo of the financial crisis,” says Anderson. “We need to focus on how companies manage businesses for the long term and not get caught up in the short term.”

The spotlight will now turn from VW on to the entire auto sector, just as it fell on the financial and energy sectors after blow-ups there. Here again, there are questions for us all. How committed are we really to improving environmental standards?

“Across the entire sector, there is a lack of a consistent and rigorous testing regime,” says Greenwald. “It needs to be strengthened within the EU and made more consistent between the EU and the USA.”

A potential good outcome from the whole unsavoury business, adds Greenwald, is that it could accelerate the move towards alternative vehicles, as the scandal puts diesel engines in general under pressure. 

Meanwhile, we are left to wonder how the wholesale deceit at VW could have gone so entirely unnoticed.

“It does seem hard to believe,” says Anderson. “Chief executives across Europe will be looking at their whistle-blowing policies.”

©2015 funds europe