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Bringing clarity to ESG investing

Environmental, social and governance (ESG) investing has entered the mainstream as governments, regulators and clients demand that both companies and their owners consider the wider implications of their business activities. But this shift in attitude has also been accompanied by a surge in ESG-related terminology. Today, we cut through the noise and provide some much-needed clarity on the various forms of ESG investing.

Key Points

  • Our history of ESG investing means that we are well placed to cut through the noise and provide some much-needed clarity on the various forms of ESG investing
  • Prevalent responsible investment approaches can be categorised into four different activities: negative exclusion, positive screening, impact investing and mainstream ESG investing
  • Our Global Equities team adopt a mainstream ESG integration approach – that is, incorporating ESG considerations alongside insights from engagement, valuation, growth prospects and market sentiment, among others

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
  • 1800-1899

    • Quakers &
      Methodists

      Socially responsible investing (SRI) originates in religious groups. Quakers and Methodists, establish investing guidelines for their followers. Other religious orders soon adopt a similar faith-based approach to investing.

    • x1

      The Quakers Friends Fiduciary opens and adopts a no weapons, alcohol or tobacco investment policy.

  • 1900-1969

    • Hand glass

      An ecclesiastical group in Boston, United States launch the pioneer fund. It is the first public offering of a screened investment fund, where exclusionary screens are centred on social issues, such as alcohol and gambling.

    • hermes-1

      Following the Great Depression and a number of corporate scandals, investors begin to focus their attention on governance issues. As a result, they drop the ‘S’ from ‘SRI’ – and responsible investing is born.

    • Hand root
      hermes2

      The rise of civil rights and anti-war movements prompt investors to consider shareholder advocacy when influencing corporate behaviour. Vietnam War protestors urge that university endowment funds exclude defence contractors in their investment policies.

  • 1970-1989

    • PAX

      Pax World launches the first socially responsible investing mutual fund in the US.

    • Hammer

      The US Congress passes the Community Reinvestment Act to address discrimination in loans made to individuals from low- and moderate-income neighbourhoods.

    • Hermes wings

      Ralph Quartano, former Hermes CEO, urges companies to do the right thing: "I expect M&S to be on the side of the angels."

    • The Chernobyl accident on April 26, and other incidents during the same decade such as Bhopal gas leak and Exxon Valdez oil spill, raise concerns about corporate responsibility, the threat of climate change and ozone depletion.

  • 1990-1999

    • The UN’s Rio Earth Summit takes place in Rio de Janeiro, marking the largest environmental conference ever held, with 172 governments in attendance. The Summit’s message – that nothing less than a transformation of our attitudes and behaviour would bring about the necessary changes to preserve the planet – is transmitted around the world.

      UN’s Rio Earth Summit

      172 governments
      attended

    • $625bn South Africa flag

      screened to exclude investment in South Africa

      Investors exert pressure on fund managers to avoid investing in South African companies due to apartheid. In the US, more than $625bn is screened to exclude investment in South Africa.

    • Alastair Ross-Goobey, former Hermes CEO, seeks shorter contracts for CEOs of all FTSE 100 companies.

    • Boycott clothing companies

      Controversy in the international supply chain of leading clothing companies dominates news headlines. The apparel industry comes under scrutiny for child labour and other human rights abuses in its supply chain, prompting many customers and investors to boycott companies.

    • Hermes establishes a team focusing on the corporate governance of companies.

    • The Pensions Act 1995 comes into effect on April 6, requiring trustees to disclose their policies on social, hammer 2 environment, and ethical matters in the investment process.

    • The Kyoto Protocol, an international agreement linked to the United Nations Framework Convention on Climate Change, is finalised in Kyoto, Japan. Glob It marks the first agreement between nations to mandate country-by-country reductions in greenhouse-gas emissions.

    • Hermes wings

      Hermes Real Estate establishes an energy-conservation strategy.

    • The UK Combined Code on Corporate Governance is published. It sets out principles of good corporate governance aimed at companies listed on the London Stock Exchange. The latest version is the UK Corporate Governance Code (2014), which is overseen by the Financial Reporting Council.

  • 2000-2009

    • Windmill

      As investors' focus shifts to environmental, social and governance (ESG) issues, ESG investing becomes the latest iteration of sustainable investing.

      ESG

      Environmental • Social • Governance

    • Norway flag
      100%

      integration of sustainability

      Norway’s Government Pension and the US’s largest pension fund, CalPERS, commit to 100% integration of sustainability over 15 years.

    • An amendment is made to the UK Pensions Act, hammer 2 requiring the consideration of ESG issues during the investment process.

    • Talks Hermes wings

      Following the success of its UK activist fund, Hermes developed a European version. But the strong connotations attached to activism meant that we needed a new name to capture the long-term, collaborative nature of our work, and which resonated with continental European companies. We decided on engagement, whose relevance and cross-border appeal ensured that it has become the investment industry’s definitive way of describing how responsible investors perform stewardship services.

    • Check list

      social
      responsibility

      After admitting widespread problems in its international supply chain, including unsafe machinery and child labour violations, The Gap publishes its first social responsibility report. Other companies follow.

    • Hermes wings

      Hermes EOS, our specialist stewardship services team, is founded.

    • The Principles for Responsible Investment (UNPRI) – a set of six investment principles encouraging ESG matters to be incorporated into investment practice – are launched by the UN. The principles were developed by investors – including Hermes, which became a founding signatory – for investors. They are voluntary but have attracted more than 1,750 signatories from over 50 countries, representing approximately $70tn.

      • 1700
        signatories
      • 50
        countries
      • $70tn
        represented
    • The Rockefller Foundation

      The Rockefeller Foundation launches the Impact Investing initiative and coins the term impact investing at a Global Urban Summit.

    • The US Congress
      passes Sudan
      Accountability and
      Divestment Act
      of 2007,
      allowing state and local governments to cut investment ties with companies doing business in Sudan. The Act is aimed at pressuring Sudan to end the violence in the Darfur region.

    • Global Impact Investing Network

      The Global Impact Investing Network (GIIN), a not-for-profit organisation devoted to increasing the effectiveness of impact investing, is launched.

  • 2010-present

    • Hermes wings

      Hermes signs the UK Stewardship Code.

      The Hermes Responsible Ownership Principles are published.

    • Hermes wings The 300 club

      Saker Nusseibeh, Hermes CEO, founds the 300 Club.

      Hermes GPE implements its proprietary ESG Framework into all of its investment decision making processes.

    • $3.74tn

      of professionally managed assets
      in the US consider ESG factors

      The US SIF (The Forum for Sustainable and Responsible Investment) Trends Report finds investors consider ESG factors across $3.74tn of professionally managed assets in the US.

    • Check sign

      Responsible
      Investment Guide

      The NAPF (now PLSA), the industry body for UK pension schemes, launches its Responsible Investment Guide.

    • $45tn

      The UNPRI assets under management by signatories hits $45tn.

    • #10

      The London Stock Exchange becomes the 10th exchange to join the UN Sustainable Stock Exchange initiative, committing to promote debate about ESG issues among companies and investors.

    • Eiffel Tower

      195

      countries adopt the
      global climate deal

      The UN Climate Change Conference COP21 takes place in Paris. The Paris Agreement sees 195 countries adopt the first-ever universal, legally binding global climate deal.

    • UN Sustainable Development Goals The UN Sustainable Development Goals (SDGs) are established. They serve as a blueprint for significantly changing the world – by ending global poverty, safeguarding the planet and ensuring prosperity for all – by 2030.

    • $23tn

      Value of socially
      responsible assets

      Socially responsible assets under management grows to $23tn in 2016, according to the Global Sustainable Investment Alliance.

    • Under a new EU Pensions Directive, member states have an obligation to "allow Institutions for Occupational Retirement Provisions (IORPs) Asset 21EU Pensions to take into account the potential long-term impact of investment decisions on ESG factors".

    • A number of banks funding the Dakota Access Pipeline pull out of the project, amid environmental and human rights concerns voiced by indigenous people, the public and investors.

    • US President Donald Trump walks away from Paris Agreement, saying it would "hurt the American economy and society alike".

      Donald Trump
    • 51.84

      MSCI EM ESG
      Leaders Index

      MSCI Emerging Markets ESG Leaders Index hits a record high of 51.84. The index has been outstripping the MSCI Emerging Markets benchmark consistently since the 2008-09 global financial crisis.

    • car

      The UK and France announce climate change plans to end the sale of petrol and diesel cars by 2040.

    • Hermes wings

      Hermes joins the United Nations Global Compact, the world’s largest corporate sustainability initiative. It urges companies everywhere to align their operations and strategies with 10 universally accepted principles in the areas of human rights, labour, the environment and anti-corruption, and to take action in support of UN goals and issues embodied in the Sustainable Development Goals.

    • Apple investors call for action over iPhone addiction among children. In an open letter to Apple, two of its largest investors said: "Apple can play a defining role in signalling to the industry that paying special attention to phone the health and development of the next generation is both good business and the right thing to do." They also want Apple to study the effects of heavy usage on mental health and create new parental controls.

    • New York City files a lawsuit against five oil majors - BP, Chevron, ConocoPhillips, Exxon Mobil and Royal Dutch Shell – accusing them of contributing to climate change.

    • Source: Thomson Reuters, Financial Times, The Guardian, United Nations, and Hermes as at January 2018

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.

ESG is now mainstream

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.

Getting the language right: the Hermes ESG lexicon

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:

  • Negative exclusion: applying exclusions – or negative screening – to the investment universe at sector or thematic level, typically based on moral, ethical or religious beliefs. For example, avoiding investments in the tobacco industry or those based on climate change;
  • Positive screening: actively investing more in – or overweighting – companies and assets that demonstrate relatively better environmental, social and governance credentials;
  • Impact investing: investing in (or engaging with) companies which have (or could have) a central purpose of solving societal problems, such as those set out by the UN SDGs; and
  • Mainstream ESG integration: integrating material ESG and other sustainability factors as well as insights from engagement, alongside fundamental business-performance factors, in mainstream investment decisions.

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:

  • Asset engagement: actively engaging with companies to align their behaviours with the long-term interest of clients and their beneficiaries by improving the strategic, financial and ESG performance of companies and assets; and
  • Advocacy: engaging with public policy makers, regulators, governments and industry bodies on enhancing governance, environmental, social and stewardship standards globally as well as regionally, at a thematic-level (such as climate change or diversity) or by industry sector.

Figure 3. The Hermes responsible investing and ownership roadmap

Source: Hermes as at January 2019.

Integrating ESG

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:

  • The Alpha Model is our “automated analyst” which assesses the attractiveness of every investable company in our universe on a daily basis. The metrics used to select stocks are justified by both economic reasoning and statistical effectiveness, and have a long-term focus that leads to low portfolio turnover. They are grouped into six categories: valuation, corporate behaviour (including governance), growth, profitability, capital structure and sentiment. The model identifies which stocks have the most attractive combinations of these characteristics and the output is subsequently used to create an optimised portfolio that aims to maximise risk-adjusted returns. The Alpha Model also uses proprietary data from Hermes EOS to incorporate an assessment of corporate governance in every valuation (see The Alpha Model: laying the path to consistent returns).
  • MultiFRAME is our proprietary risk model which assess top-down market risk. It has the flexibility to stress-test the portfolio, interpret how it would respond to different market environments and measure its exposure to any quantifiable risk.
  • The ESG Dashboard forms an important part of our qualitative analysis, enabling analysts and portfolio managers to easily incorporate ESG analysis into their stock-picking processes and, importantly, to flag stock-specific sustainability risks. The Dashboard provides a concise digest of the ever-increasing amount of data on ESG risks. As well as incorporating a wide range of research from leading data providers, the report includes proprietary information from Hermes EOS on voting and engagement. Indeed, Hermes EOS has helped define the key performance indicators or risk factors on which each company is measured. These are either generic, such as board structure, or sector specific, focusing on the major risks by industry – such as CO2 emissions and fleet consumption for the automobiles industry, paper sourcing for media and energy efficiency for airlines (See ESG Dashboard 3.0).
  • The ESG Portfolio Monitor shows aggregate ESG risks within a portfolio, in absolute and relative terms. By knowing the source and magnitude of these risks, portfolio managers can better manage them. It contains data from Hermes EOS, as well as leading data providers and our proprietary QESG Scores.

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.

A decade of ESG-focused engagement

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:

  • Board composition: In 2009, we urged the company to consider the board composition, particularly longstanding members and the need for refreshment.
  • Pay: In 2010, we raised concerns about remuneration structures and the need to establish a policy that effectively aligns employees and the long-term shareholder interests.
  • Corporate culture: In 2011, we pressed for greater alignment between risk-taking practices and the interests of long-term shareholders.
  • Climate change: In 2016, we pressed for the company to increase its 2020 funding target for clean energy and other environmental activities. Last year, we asked the company to report against the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
  • Board independence: In 2017, we raised that we would like to see a good-quality candidate for its lead independent director. Separately, in 2018, we requested that the holding company discloses the names of the main bank subsidiary board’s members and how they convene.

Driving progress on long-term ESG issues

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.

A healthier, cleaner and safer world

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.

Scalable solutions to real-world problems

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.

Bridging the gap for better informed ESG investing

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.

Risk profile
  • Past performance is not a reliable guide to future performance
  • The value of your investment is not guaranteed and may go up or down
  • The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments
  • Any investments overseas may be affected by currency exchange rates
  1. 1Annual Impact Investor Survey 2018,” published by the Global Impact Investing Network in June 2018
  2. 2Annual Impact Investor Survey 2018,” published by the Global Impact Investing Network in June 2018.
  3. 3BoA’s loan growth drives better-than-expected profit,” published by Reuters on 16 January 2019.
  4. 4http://corporate.thermofisher.com/content/dam/tf/responsibility/Documents/2017%20CSR%20Report%20FLR.pdf,” published by Thermo Fisher Scientific in 2017.

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