The potential for strong, long-term returns was the chief ‘pull’ factor attracting investors who first understood the impacts of sustainability on stock performance. Now, ‘push’ factors are driving more fund managers to consider these dynamics. They include the desire of asset owners, governments and the public for evidence that the broader, enduring effects of investments are being assessed and how they contribute to decisions to buy and sell securities.
Combined, these forces are driving greater integration of environmental, social and governance (ESG) considerations throughout the investment industry. Even the influence of US President Donald Trump, who threatened within hours of taking office to abandon the Obama administration’s climate-change reduction and waterway preservation plans, has not diminished investors’ interest in capturing the commercial benefits of sustainability. As the White House aims to support further shale oil and gas extraction on federal land and revive the US coal industry, many investors question the long-term financial prospects of fossil-fuel businesses worldwide – asking when, rather than if, the assets of these companies are likely to become stranded.
One of the more recent pull factors is the set of Sustainable Development Goals (SDGs) established by the United Nations (see figure 1). The SDGs aim high, seeking to end poverty, safeguard the planet and ensure prosperity for all people by 2030. This would require co-ordinated efforts between governments, corporations and individuals. Whether this can be achieved is up for debate, but in an investment context the goals provide a way to align the interests of investors, companies and society on ESG matters.
The ESG spring has joined the main stream
It is clear that ESG awareness and implementation are becoming widespread across the investment industry. Funds managed by signatories to the UN Principles of Responsible Investment have passed $60tn, amounting to more than 50% of invested assets worldwide. The majority of high-net-worth individual investors now seek more ESG disclosures from their wealth managers, with those under the age of 40 the most demanding, according to the World Wealth Report 2015. National governments, notably China’s, are employing environmental finance, using instruments such as green bonds, as they aim to reduce the carbon intensity of their economies. Public policy and regulation, such as the French law requiring asset owners to disclose how they are assessing carbon risk, also focus investors’ attention on sustainability matters.
In turn, companies are being asked for better disclosure of their governance practices and how they consider the environmental and social impacts of their operations. The updated UK corporate governance code, issued in September last year by the Financial Reporting Council, stresses the need for company boards to consider strategy with a view that extends beyond a minimum of 12 months. Emphasising the disclosure of principal risks, the code aims to improve transparency under a comply-or-explain framework. In February the London Stock Exchange Group released “Revealing the full picture: Your guide to ESG reporting”, which provides guidance on addressing ESG considerations in investor reporting and communications.
Investors are also being provided with guides that encourage them to assess the ESG merits of companies. The Principles for Positive Impact Finance are designed to help investors understand and monitor the ESG impacts of their activities (see figure 2). Released in January by the UN Environment Programme – Finance Initiative, they constitute a direct response to the challenge of aligning investment practise with ESG pull factor of the SDGs.
Methods for integrating sustainability characteristics into investment decisions are also available to a broad range of investors, rather than being the domain of specialists. In early 2016, Standard & Poor’s launched an index consisting of companies with the potential to create long-term value based on financial quality and sustainability criteria. With asset owners in mind, global investment consultant Willis Towers Watson has created a framework for a long-term mandate, with a structure and incentives promoting a focus on time horizons expanding up to 10 years.
Such efforts are supported by consistent improvements in the quality of ESG data reported by companies. So far, the depth of information provided on corporate governance typically outweighs disclosures on environmental and social matters. Our research indicates that a persistent ‘governance premium’ amounting to 30bps each month can be captured by avoiding the worst-governed companies in the global equity universe1. We have identified some evidence of a link between good environmental and social risk management and returns, but there is not yet enough meaningful and timely data to provide a statistically significant result.
But as more companies continue to report on these matters, and a longer history of data is compiled, we expect to see environmental and social factors to be confirmed as influential drivers of return.
Seeing the SDGs in an investment context
The aim of ESG integration is to avoid businesses with unsustainable risks, which compromise their long-term revenues, and identify those that are embracing sustainability dynamics to enhance profitability. For companies to achieve long-term success, we believe it is essential for them to commit to responsible business practices and build trusting relationships with all stakeholders while skilfully executing superb corporate strategies.
In an investment context, the SDGs direct capital towards companies whose activities contribute to positive economic, social and environmental impacts. Since the themes captured in the SDGs – such as good health and well-being, affordable and clean energy and sustainable cities and communities – address fundamental challenges that society is grappling with, companies involved in providing solutions are likely to benefit from sustainable cash flows and be attractive long-term investment opportunities.
Many companies, regardless of sector, have some exposure to the SDGs. Even chemical companies are starting to report on revenue earned from environmentally beneficial products. Considering the SDGs, therefore, does not penalise investors by restricting the range of stocks available to them.
We aim to invest in companies that generate strong, sustainable returns and which are experiencing positive change. Analysing ESG considerations is a fundamental part of what we do – we see it as a way to manage risk and to improve returns, and the SDGs provide a complementary framework for targeting companies that fulfil these criteria.
MSCI ESG Research has created a data set for investing in alignment with the SDGs. The index provider assesses the percentage of revenue that companies earn from activities supporting relevant environmental and social themes (see figure 3). It shows that while the revenues of 934 companies have some alignment with the SDGs, this number almost halves to 487 if a 10% revenue threshold is introduced. And at a 20% threshold, 303 companies are tracked. But like most ESG data, MSCI’s is retrospective and refreshed annually, meaning that it only presents half of the picture.
To assess ESG risk, we look at a company’s shortcomings but also its potential to change. Our initial question – ‘What are the negative aspects about this company’s ESG exposure?’ – demonstrates our bias towards protecting capital. This is followed by an examination of what efforts it is making to nullify those risks and improve its ESG performance. Because most ESG data is backdated and updated at lengthy intervals, this forward-looking perspective helps us to identify investment opportunities.
Determining the positive impact of a company’s activities and projects is not easy, and the metrics for gauging impact that have been developed need to be improved. For instance, they cannot often be applied consistently across companies while being specific enough to accurately communicate impacts. Despite the guidelines available, most companies are not yet focused on tracking how their operations and products are aligned with societal and environmental needs, and even if they were, there is a cost for capturing data about these impacts and demonstrating how they are linked to revenues. Another important aspect for investors to assess is a company’s sustainability targets. Businesses are wary about revealing potentially commercially sensitive targets, but an awareness of them is useful in confirming whether they are an integral part of the company’s strategy.
Sometimes, only part of a company’s operations satisfy the SDGs. Instead of ruling it out as a potential investment, the stock can be analysed to find out if this part of its business will grow – thereby making it an opportunity. In our view, companies with increasingly positive ESG exposures are more likely to outperform. For example, when analysing environmental factors, we consider a company’s carbon footprint but also the wider impact of the products or services it delivers. This provides a more expansive view of the environmental risks and opportunities that it faces.
Factoring the SDGs into our analysis of companies is aligned with some of the core elements of our investment philosophy: responsibility and long holding periods. Our responsibilities as investors do not stop with a decision to buy or sell a stock: through constructive dialogue, exercising shareholder rights and engaging when necessary, we endeavour to act as a responsible steward of our investments. Such active ownership is key to encouraging companies to support the SDGs.
This is not only in the interests of ourselves, our clients and society, but also those of the companies we invest in. By embedding the SDGs in their corporate strategies, they can better meet consumer needs and generate growth – as evidenced by the following case studies on current portfolio holdings Cognex and Procter & Gamble.
Cognex: eye, robot
Cognex, a Massachusetts-based provider of machine-vision systems and industrial barcode readers, aims to help manufacturers improve their efficiency. Its products track items during manufacturing, with its more advanced systems suitable for 3D processes. For example, the company’s systems can locate, identify and measure parts, guide robots through assembly processes and verify that manufacturing has been completed. They can also be used to sort and distribute items in logistics processes.
The strength of Cognex’s innovation and growth is complemented by the solidity of its balance sheet. Its key markets are the US, Europe and China. With a client base consisting of large and small businesses, it benefits from a steady flow of correspondingly sized orders. Given its exposure to industrial companies, Cognex should benefit from the ongoing recovery of the sector. In addition to these attractive fundamentals, the company is also aligned with four SDGs – the first being its contribution to industry and innovation.
By reducing its impact on the environment – 80% of its financial year 2015 revenue targets were linked to reducing climate-change impacts through greater energy efficiency – Cognex contributes to the goals of creating sustainable cities and communities, responsible consumption and production, and climate action. This is supported by many industrial companies’ efforts to reduce carbon emissions, resulting in greater demand for energy-efficient products.
Cognex also focuses on developing its employees’ skills. Training, retraining and retaining talent is equally as important as attracting it, and companies that demonstrably value their staff are attractive to us as investors – from sustainability and profitability perspectives.
Procter & Gamble: sustainability and consumer staples
The Cincinnati-based multinational is one of the world’s largest consumer-goods companies. Its brands include Pampers, Tide, Bounty, Gillette and Oral B. As a maker of household-name nappies, laundry detergents, paper towels, razors and toothbrushes, it is a mature business that generates stable cash flows.
In 2014, the company announced a plan to sell non-core businesses in order to optimise the margins of what it perceived as its most important operations. This involved focusing on growth products in developing nations.
The company benefits from strong governance and has worked with Hermes EOS since 2012 to improve its board structure and composition. Hermes EOS would prefer the separation of the the chairman and CEO roles at the company, but recognises the importance of the lead independent director currently in place. We agree that an independent chairman would improve the leadership of the board and would like to see directors appointed with experience in the fast-moving consumer goods industry.
The majority of Procter & Gamble’s revenues are aligned with the SDG aiming to achieve widespread good health and wellbeing. From its financial-year 2015 revenue, 58% is linked to creating a social impact by meeting basic needs, with 2% derived from healthcare products and 56% from sanitation goods. We note, however, that SDG-aligned revenues do not always reflect a company’s intended impacts.
Aiming to make its operations more environmentally sustainable, Procter & Gamble has set climate, waste and water targets for its businesses to achieve by 2020. They include:
- Reduce absolute greenhouse-gas emissions by 30%
- Ensure that 30% of plants’ energy use is provided by renewable sources
- Trace palm oil and palm kernel oil used in products back to plantations, in order to ensure that there is no deforestation in the company’s supply chain
- Ensure that 90% of product packaging is recyclable, or part of a programme seeking to make it recyclable
- Reduce corporate manufacturing waste dumped in landfills to zero
- Reduce packaging by 20% for each use by a consumer
- Provide 1bn people with access to water-efficient products
These objectives are aligned with a number of SDGs: clean water and sanitation, clean water and energy, responsible production and consumption, climate action and life on land. These efforts provide further evidence of how a large, complex business can change to seek greater profitability while creating sustainable impacts. So far, the company has achieved the following 2020 goals:
- Reducing energy use at company facilities by 20% per unit of production
- Cut kilometres travelled in bulk transportation by 20% per unit of production
- Reduce water use in manufacturing facilities by 20% per unit of production
- Gain third-party certification for all of the virgin wood fibre used in tissue, towel and absorbent-hygiene products
We continue to monitor the stock to see the impacts of its new corporate strategy and to track its efforts to achieve its sustainability targets.
The SDGs: a pull factor for the long term
For investors focused on long-term return targets, ESG integration provides insights into which companies are comprehensively managing risks and can generate sustainable cash flows. The SDGs – which focus on enduring economic, social and environmental challenges faced by society – can be aligned with ESG analysis as they help investors identify companies with a material revenue exposure to products and services that assist in overcome these problems. Such businesses are likely to produce recurrent and healthy cash flows – providing a strong pull factor compelling investors to take ESG seriously.
1 For our analyses of how ESG investing improves returns, please see the following publications at www.hermes-investment.com:
‘ESG investing: does it make you money, or does it just make you feel good?’ published February 2014
‘ESG investing: it still makes you feel good, it still makes you money’ published February 2016