It’s a noisy world for investors. Whether its climate change mitigation, electric vehicle penetration, the transition from a linear to a circular economy, or achieving the UN Sustainable Development Goals (SDGs), the debate on ESG investing has been pushed to the forefront of the investment industry.
But what seems to be missing from the discussion is how the rapid ascent of ESG into mainstream has been accompanied by a sharp rise in the volume of terms used to describe ESG.
Today, the investment landscape is saturated by a plethora of ESG-related terminology. To demonstrate this, we scoured five ESG-terminology guides produced by our industry peers. We collated all of their definitions to highlight the vast range of words used to describe ESG within the asset management industry (see Figure 1). And as investors wade through vague definitions, from ESG to sustainability, it is not surprising that many are confused.
Figure 1. The investment landscape is cluttered with a slew of ESG-related terminology
Source: Hermes as at January 2019. Note: the bigger the word, the more frequent it appeared in our research study.
Of course, ESG investing has long been with us. At Hermes, our history of ESG investing spans more than three decades (see Figure 2). We adopt a responsible approach to investing across all of our strategies: for example, our Global Equities ESG strategy has integrated ESG factors into its idea generation since its inception in 2013. In addition, Hermes EOS has been a pioneer of stewardship since 2004. That’s why we are well-placed to cut through the noise and provide some much-needed clarity on the various forms of ESG investing.
Figure 2. ESG investing: a 200-year history
Source: Thomson Reuters, Financial Times, The Guardian, United Nations and Hermes as at January 2018.
In this issue of Equitorial, we present the Hermes view on the abundance of confusing ESG terminology in the investment universe and explain how we integrate it into our team’s strategies.
In the past 20 years, the number of asset managers offering ESG strategies has grown by more than 400%1. That’s according to the Global Impact Investing Network (GIIN). The surge of ESG investing during this period can be attributed to the seminal report Who Cares Wins published by the UN Global Compact in 2005. It found that integrating ESG into capital markets resulted in more sustainable markets as well as better outcomes for societies. At the same time, the UNEP Finance Initiative released a report that showed ESG issues are relevant for financial valuation. Together, these two reports laid the foundations for the launch of the Principles of Responsible Investment (PRI)in 2006 – of which Hermes became a founding signatory.
That was 13 years ago. Today, the PRI is an established body, boasting more than 1,600 members and represents over $70tn assets under management. Governments and regulators are demanding that companies and their owners consider the wider ESG implications of their business activities by introducing or strengthening stewardship codes. For example, the UN SDGs were established in 2015, serving as a blueprint for significantly changing the world by 2030, while in the same year, 195 countries adopted the first-ever universal, legally binding global climate deal – the Paris Agreement.
What’s more, there is a growing body of research supporting the integration of ESG. In our recent research paper ESG investing: a social uprising, we found that companies with good or improving social characteristics have tended to outperform their lower-ranked peers on average by 15bps per month, while companies with good or improving corporate governance have tended to outperform companies with poor or worsening governance by 24bps per month.
ESG is therefore no longer on the periphery of the investment management industry, it has become standard practice industry-wide: in fact, GIIN found that 225 investors invested $35.5bn in 11,136 impact investing deals in 20172.
Even though ESG investing has become standard practice among asset managers, a standard set of ESG definitions has not yet been established industry-wide.
For this reason, we have decided to wade through the noise and present our view on ESG investing.
At Hermes, we believe there are two mutually reinforcing strands of responsible investment management: responsible investment and responsible ownership. Together, these aim to generate sustainable wealth creation for the end beneficiary investor encompassing both investment returns and their social and environmental impact.
Prevalent responsible investment approaches can be categorised into four different – but not mutually exclusive – activities:
Another integral element to responsible investment management is responsible ownership – that is, being a good steward and owner of companies and assets through asset engagement and advocacy:
Figure 3. The Hermes responsible investing and ownership roadmap
Source: Hermes as at January 2019.
Armed with a better understanding, investors should be able to identify the four distinct approaches to ESG investing.
Importantly, our definitions highlight that our Global Equities team adopt a mainstream ESG integration approach. Indeed, we have followed this approach since the team’s inception in 2007 – long before ESG investing had entered the mainstream.
By combining quantitative tools with a qualitative assessment and active ownership of positions through our responsible investment and engagement specialists, Hermes EOS, we aim to achieve capital appreciation by investing in global equity securities with favourable ESG credentials. We use four main tools:
These tools allow us to follow a mainstream ESG integration approach – that is, incorporating ESG considerations alongside insights from engagement, valuation, growth prospects and market sentiment, among others. Our model favours companies with an attractive blend of these characteristics.
Our case studies below – Bank of America and Thermo Fisher – demonstrate the practical application of a mainstream ESG investing approach, where we have seen the significant impact that the consideration of ESG characteristics can have on our valuations.
Bank of America is one of the world’s biggest financial institutions, serving individual consumers, small and middle-market businesses and large corporations with a full range of banking, investing, asset management and other financial and risk management products and services.
We have long held a position in Bank of America, and our proprietary Alpha Model views the company as positive according to its profitability, growth and capital-structure characteristics. We see Bank of America as a strong brand, one which can use its size and diversity of offering to deliver growth, even in a difficult environment.
Most recently, the company posted solid Q4 2018 revenue growth – ahead of analysts’ expectations – driven by its consumer bank. Under the helm of chief executive Brian Moynihan, Bank of America has adopted a conservative approach, cutting costs and tightening risk controls: in fact, over the last decade, the company has cut $30bn in annualised costs3. Its peer JPMorgan Chase missed profit estimates in Q4 2018, citing a decline in its fixed-income trading revenue, while Citigroup also posted a fall in bond trading.
We began engaging with Bank of America in April 2009 on a number of long-term ESG-related issues, ranging from risk management, governance and culture to remuneration. Initially, our ESG Dashboard flagged the company for its exposure to high-profile lawsuits, which related to the global financial crisis.
So far, our engagements with Bank of America, which span the last decade, have focused on:
Over the last decade, Bank of America has acknowledged our concerns and, in many cases, it has made great strides in tackling ESG-related risks.
The bank has made a number of changes to its board. During our engagements, we have discussed these changes as well as the appointment of directors with relevant expertise, such as risk management, financial and regulatory experience. In addition, Bank of America has transformed its culture, adopting a zero-tolerance approach to unethical conduct issues and questionable lending practices. In fact, its 2015 Corporate Social Responsibility Report highlighted how the company’s purpose statement is driving its decision-making and strategy throughout the bank.
What’s more, we were pleased that the company embraced our discussion on the living wage for its own staff. It has acknowledged our concerns about board independence and climate change. The bank has been a strong advocate of the TCFD, forming an internal working group comprising of regional leads and internal risk and ESG committee team members. We expect to see a response to the TCFD recommendations this year.
Our dialogue continues today – and we await further improvements on long-term sustainability issues that we have raised in recent years.
Thermo Fisher Scientific produces instruments, equipment, software, services and medical consumables that help scientists accelerate life sciences research, improve patient diagnostics, deliver medicines to market and increase laboratory productivity. From lab plastic ware to mass spectrometry, the company’s products are used across pharmaceutical, biotechnology, academic, government, environmental and industrial research, as well as the clinical laboratory.
We have a position in Thermo Fisher. The diversified nature of the company’s product portfolio is attractive, given no single product or end-market materially impact its performance. In addition, the company targets an organic revenue growth rate of 4-6% and an earnings per share of about 12-15% per annum, reflecting its cost-cutting culture and process improvements.
Our proprietary Alpha Model also views Thermo Fisher as very attractive. That’s because it boasts strong and stable growth as well as good and improving margins. What’s more, it is attractively valued. Indeed, it ranks ahead of its peers in the six factors – valuation, corporate behaviour, growth, profitability, capital structure and sentiment – used to generate our Alpha Score. It is broadly neutral on corporate behaviour. Understandably, sentiment towards Thermo Fisher is strong.
Encouragingly, the company also generates a significant portion of its revenue through activities that have a positive impact on society, such as access to healthcare or sustainable solutions that help customers reduce its environmental footprint. It offers 45 ‘greener’ products, which strive to provide customers with alternatives that are less hazardous, more energy efficient and reduce waste.
Thermo Fisher is also contributing to the UN SDGs. Its diagnostic tools are helping achieve the SDGs by diagnosing some of the world’s most infectious diseases. In addition, the company produces environmental tools and IT systems, such as soil analysers that help produce healthier and safer crops, water analysers that help deliver safe drinking water, and air quality measurement tools that help track pollutants and assist industrial manufacturing monitor compliance.
In 2017, Thermo Fisher formed a partnership with Mars Inc. to tackle aflatoxins – naturally occurring poisons that contaminate an estimated 25% of food crops and 4.5bn people worldwide4.
Aflatoxins originate in certain species of fungi that grow on feed and food, such as groundnuts, peanuts, spices and corn. They are near-impossible to destroy. They are considered a Class 1 carcinogen by the International Agency for Research on Cancer.
The project aims to identify a protein to reduce the impact of the aflatoxin in food. Importantly, this have a positive impact in developing countries, where the amount of aflatoxins in food products is not well regulated.
Engaging on ESG risks
Interestingly, Thermo Fisher is not highlighted as a clear leader by ESG data providers. That’s because many data providers apply the same level of scrutiny to healthcare providers as they do to pharmaceutical companies – a highly regulated industry. However, the diverse nature of the business means it is exposed to lower levels of risk. That said, it does have some weaknesses – or at least areas of risk that could be better addressed – particularly around disclosure.
We are engaging with the company. We are encouraged by the strength of its governance – notably, the appointment of an independent chair, which serves to highlight its positive corporate mind-set. In addition, Thermo Fisher has developed policies and systems to address some environmental and social issues. Nevertheless, we are encouraging the company to extend its programmes and policies to better demonstrate key risks, such as business ethics.
ESG investing has entered the mainstream, but education is still needed.
Many people – including asset managers, trustees and consultants – use ESG-related terminology interchangeably. For investors, we therefore need to bridge the gap for better informed ESG investing while also ensuring that we focus on meeting evolving clients’ needs.
As an asset manager, we can contribute to this effort, not just by integrating ESG into the investment process, but shaping the ESG agenda by educating investors about it too.
The environment that businesses – and we, as investors – operate in continues to change: there is an increased focus on a wider range of issues. Our approach to investment management – responsible investment and responsible ownership – ensures that we are not only meeting these increasingly demanding requirements but we are also at the forefront of driving improvements within society.