ESG factors will soon be a necessity in investment decisions

  • Business
  • Saturday, 27 Apr 2019

Jessica Ground (pic), global head of stewardship, Schroders is responsible for the sustainability strategy and global corporate governance at Schroders.

She oversees the integration of environmental, social and governance (ESG) factors into the investment processes across geographies and asset classes and leads a team of 12 dedicated ESG specialists.

Ground is also chair of Schroders’ Corporate Governance Committee. She joined Schroders in 1997 and is based in London.

Ground was a fund manager at Schroders from 2006 to 2017, which involved managing institutional portfolios for a range of clients with the Prime UK Equity team. She was an analyst at Schroders from 1997 to 2006, gaining extensive analytical experience covering financials and utilities sectors on a pan-European and global basis. Ground has a BA in History from Bristol University.

She caught up with StarBizweek to talk about the increasing importance of ESG factors in making investment decisions.

How important do you feel ESG factors are in assessing the quality of a company and thus also become a vital part of your investment process?Understanding how companies engage with, and adapt to, the stakeholders they rely on is vital to understanding the health and sustainability of their business. Changing social and environmental pressures mean companies’ abilities to adapt and thrive will be vital to their long term success, for instance by attracting talent, engaging customers or building robust supply chains.

For long-term investors, how companies make money is as important as the amount of money they make today. As a result, we believe successful investment is intrinsically linked to identifying, understanding and incorporating the effects of ESG trends. Companies which are well governed and operate transparently, responsibly and sustainably, will have the culture and transparency to support the long-term health of the organisation and increase shareholder value.

Do you feel that ESG factors should be a component of investment decisions, and thus moving forward, you would take into account the valuation, sustainability and fundamental risks inherent in every portfolio position?We believe analysing ESG factors help make better investment decisions so should apply to every company we invest in. We also use ESG in asset allocation decisions for example, in the long term impact on economic growth.

However, we have shown in our research that if it is not possible to manage an asset class well with regards to ESG, removing it completely can have a detrimental effect on the overall portfolio diversification and hence risk of a multi-asset portfolio.

The asset owner will need to assess the trade-off between maintaining a 100% ESG portfolio and the risk in the portfolio. Finally, looking at the total portfolio impact on measures such as carbon intensity is important to make the sure the whole of the portfolio is greater than the sum of its parts.

Businesses do not operate in a vacuum. In a global economy dependent on cross border trade and complex supply chains, companies are increasingly confronted with environmental issues such as climate change, water scarcity and pollution. Are you of the opinion that ESG factors may materially impact investment risk and reward?It’s not always easy to quantify the potential impact of ESG factors, but we believe they can have a material impact on a company’s performance in both the short- and long-term, as well as the inherent risk of investing in a company.

We’ve seen significant falls in the market value of companies immediately following ESG controversies, but the impacts on companies’ long term growth and profitability are equally important.

Having said that, it’s not as simple as saying that ESG factors are important. How investors analyse those factors and use their conclusions are vital; ESG information is no more useful than financial data – it can be hugely important, but only if one examines the right information in the right way.

Are you of the opinion that as ESG awareness increases, ESG externalities may become a very important criteria in the valuation of a stock? Soon, valuation of stocks may price in ESG externalities. Do you see this becoming a norm?Yes. Up until fairly recently, companies have largely been able to focus on maximising profits without too much concern for the negative externalities their actions created. We have started to see that strategy unravel and believe it will become more untenable going forward.

Social pressure and government intervention are forcing companies to take responsibility for the costs their actions create, through measures such as minimum wage legislation, sugar taxes, a clampdown on tax avoidance and carbon prices.

We have developed SustainEx, a framework which measures the benefits companies provide to society as well as the costs they would face if their negative externalities were priced. It is designed to help our analysts and fund managers identify risks and help ensure they are reflected in valuations and investment decisions.

In your ESG analysis, what are the main things you look at? (Employees/environment/consumers/suppliers/regulators/governance)There is no single answer and no short-cut to examining the stakeholders, issues and measures that matter most for each sector and company. As a result, we examine a range of ESG factors and the importance of different factors and different stakeholders vary significantly across sectors. We look at how companies interact with key stakeholders: governments/regulators, employees, customers, the community, supplies and the environment.

What is the reason for focusing on these factors? Is it to maintain competitive advantage

over the long term?It’s no longer enough for companies to just show the value they create for shareholders, increasingly they need to demonstrate the value they provide to society as a whole. Companies need to maintain a strong licence to operate with all of the stakeholders on which they rely to be successful in the long run. We believe those companies that try to maximise current shareholder profits by squeezing stakeholders or avoiding responsibility for costs they impose on the rest of society are likely to face the biggest problems.

Without a doubt, companies with weak ESG practises run a higher risk of future scandals. What is less clear though is whether ESG makes sense financially. Could we have your thoughts on this?We believe incorporating ESG analysis alongside traditional financial analysis enhances our understanding of a company’s fair value and its ability to deliver sustainable long-term returns. There is plenty of academic evidence showing that companies with better ESG practices tend to have better financial performance as well.

But, as with all aspects of ESG, how analysis is done and portfolios are built is key. It’s impossible to say ESG does or does not work as a blanket statement – it can add value if approached thoughtfully but simple exclusionary screens or using off-the-shelf analysis is unlikely to help financial returns.

What is the biggest hurdle now for ESG investing? Is it the cost? How do you see this problem being overcome?A lack of information and understanding was highlighted as a key barrier in our Global Investor Study. There are a range of approaches under the broader ESG umbrella and investors need to understand the approaches different funds take, what fund managers are trying to achieve and how they intend to achieve it.

Fund managers need to provide greater clarity and transparency to help investors select strategies that meet both their financial and sustainability objectives.

Governance is the ESG factor most investors are incorporating into their process. What about environmental and social factors? I understand it is starting from a low base, but how do you see its acceptance and growth moving forward?Governance tends to be well understood by investors and therefore it’s not surprising that it’s the factor most incorporated into investment processes. There is increasing awareness of environmental and social factors, and the importance of considering how they might impact investments, but it’s sometimes challenging to quantify what that impact might be.

It’s also unhelpful that “environmental” and “social” are fairly broad, abstract terms. When we talk about the importance of talent management, supply chains, regulatory risks or community disruption, it becomes fairly self-evident that these issues matter to companies.

At Schroders, our ESG specialists work with our analysts and fund managers to understand key sustainability trends. We develop proprietary models and analysis to help them understand the investment implications of those trends which can then inform their decision-making.

A lot of fund managers rely on off-the-shelf answers to complex sustainability questions and we think they need to evolve their approach by developing their own understanding and analysis of the issues.

Climate change is a great example – there are plenty of measures of carbon exposure available but far too little effort has gone into understanding the investment risk posed by a trend that will have a huge impact on markets and remains poorly understood. We have invested our time, knowledge and energy into developing frameworks and tools to measure the risks and opportunities climate change will create.

Although portfolio managers and analysts are more frequently incorporating ESG into the investment process, they rarely adjust their models based on ESG data. What are the factors or things that need to happen before ESG data is incorporated into their models?We’re not sure ESG factors should be incorporated into analysts’ models for next year’s earnings, but that doesn’t make the information redundant. It means we need to think differently about how we examine companies and form decisions.

Over three-quarters of the value of the typical company lies in the earnings they generate beyond the three years on which analysts focus. Understanding how companies will perform in the long term has a huge impact on their value today.

How is client demand for ESG investments? What is their level of understanding for ESG issues?Client interest and demand for ESG investments continues to grow as our Global Investor Study results show. About 79% of retail investors in Asia said sustainable investing has become more important to them over the past five years, which is higher than the global average. 69% said they’ve increased their sustainable investments over the last five years. On ESG knowledge levels, clients are becoming more sophisticated but there is also a keenness to learn more.

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