Responsible and Sustainable Investing

INTRODUCTION

Responsible and sustainable investing are trending topics in the investment industry. GraySwan has, since becoming a signory to the PRI (Principles of Responsible Investing) in 2013, written numerous articles and research pieces outlining developments within the area of responsible and sustainable investing. We have covered the definition of responsible and sustainable investing, described the various role-players and unpacked what it means for investors to embrace sustainability and commit to the principles that provide a best practice investment framework within which the global community can ensure sound stewardship of our people and our planet.

“Stewardship is an ethic that embodies the responsible planning and management of resources. The concepts of stewardship can be applied to the environment and nature, economics,health, property, information, theology, cultural resources etc….”

DEFINITIONS

ESG describes the three main areas of concern that have developed as the central factors in measuring the sustainability and ethical impact of an investment in a company or business.

Environmental: this includes the topics of sustainability, ecosystems, climate change and fossil fuels vs renewable energy.

Social: socio-economic impact, diversity, human rights, consumer protection, animal and human welfare can be categorised here.

Governance: management structures, employee relations and ethics are included in this category.

In this article, we strive to summarise the major components of responsible and sustainable investing, the roles of various regulatory and industry bodies, and the key action points and considerations for investors in the current global context.

WHAT DOES SUSTAINABLE AND SOCIALLY RESPONSIBLE INVESTING ACTUALLY MEAN?

Responsible investing is an intentional investment strategy which seeks to generate both financial and sustainable long-term value. It consists of a set of investment approaches that integrate environmental, social and governance (“ESG”) issues into financial analysis and investment decision making. The first modern definition of sustainability came from the United Nations World Commission on Environment and Development (the Brundtland Commission) in 1987. Its report, ‘Our Common Future’, tackling the uncontrolled use of natural resources – led at the time by extensive deforestation – is most notable for coining the term ‘sustainable development’. This was defined as a development process that aims:

“to meet the needs of the present without compromising the ability of future generations to meet their own needs”

Derived from this definition of sustainable development, sustainable investing is broadly defined as the practice of incorporating an analysis of environmental, social and governance (ESG) factors when making investment decisions. While definitions differ, one of the most widely accepted is that used by the United Nations-backed Principles for Responsible Investment (UNPRI),:

“Responsible investment is an approach to investing that aims to incorporate ESG factors into investment decisions, to better manage risk and generate sustainable, long-term returns.”

A study by Bridges Fund Management entitled ‘The Bridges Spectrum of Capital’ outlines the difference between responsible and sustainable investment as one of degree. Responsible investment sought to “mitigate risky ESG practices in order to protect value”, while sustainable investment aimed to “adopt progressive ESG practices that may enhance value.”

GraySwan follows the principle that incorporating ESG factors not only protects investors’ portfolios against downside risk, but also generates superior performance over the longer term. The principal aim is to ensure that our clients’ investment portfolios are more sustainable and therefore more viable over the longer term. Implementation of responsible and sustainable investment choices at GraySwan is framed by our Responsible Investment Policy and backed by our commitment to the principles outlined by the UNPRI.

HOW CAN SUSTAINABLE INVESTMENT BE IMPLEMENTED?

There are various investment approaches to incorporating responsible and sustainable investing within an investment portfolio. Each investment approach may be used as a stand-alone implementation or in conjunction with the other approaches for a holistic implementation.

Restriction screening / restricted lists

Avoiding investments in certain sectors or specific issuers, based on values or risk-based criteria. Specifically, restrictions could be ‘hard coded’ into an investment policy to exclude ‘sin stocks’ (gambling, alcohol, weapons), or to exclude companies that generate more than 30% of their revenue from fossil fuels, for example. This type of screening approach purposefully reduces the investment universe of investible companies from the outset.

ESG integration

Considering ESG criteria alongside financial analysis to identify risks and opportunities throughout the investment process, which may lead to decisions to avoid, include or size certain investments. ESG integration can be qualitative or quantitative.

Qualitative ESG analysis looks at the company through the lens of ESG factors to understand the risks and opportunities within each company. Specifically, for example, a qualitative ESG analysis may highlight governance or remuneration concerns, raise a ‘red flag’, and thus increase the risk rating of the investment. Poor social scores (human rights, business ethics etc.) may similarly warrant a higher risk rating, while strong environmental score (investment in renewable energy, improved natural resource management or cleaner technology) could present a significant cost reduction and efficiency opportunity as well as enhanced long term sustainability. In many cases ESG scores are calculated quantitatively either using a data provider, (such as MSCI ESG Score (link here), S&P or Sustainanalytics) or using proprietary scoring tools. Portfolio positions are then weighted according to ESG score. Investment managers may employ a dedicated ESG team of experts to analyse investments and integrate ESG factors into decision making, may run-scoring tools to analyse the portfolio or employ a combination of both.

Thematic investments

Investing focused on specific themes and sectors positioned to solve global sustainability-related challenges. Specific thematic investments are wide-ranging from clean energy, water and food security to climate change etc. and may be narrowly focused or may be generalist. Generalist ESG funds tend to overweight high ESG scoring investments and underweight, or avoid totally, those with poor ESG scores. There are several investible ESG and Responsible Investing Indices globally. These indices can be accessed via low-cost Exchange Traded Funds (ETFs) or tracker mandates.

Impact investing

Allocating to funds or enterprises structured to deliver a specific and measurable set of positive social and/or environmental impacts alongside market-rate financial returns. Impact investing is an effective tool with which to explicitly allocate investment capital to investments that make an impact, either socially or environmentally. For example, clean energy finance, developmental finance and community property investments would all fall under impact investing.

Company / issuer engagement

Aiming to drive improvement in ESG activities or outcomes through proxy voting or active dialogue with invested companies/issuers. This approach often to some degree conflicts with the approach of restricting or avoiding low scoring ESG companies – active engagement with companies to drive ESG improvements is only possible when one is a shareholder of that company. Having zero exposure to companies that have high carbon emissions for instance would remove the possibility of shareholder engagement with company management and therefore an inability to force positive change.

COP26- WHAT WAS AGREED?

Forests

137 countries took a landmark step forward by committing to halt and reverse forest loss and land degradation by 2030. The pledge is backed by $12bn in public and $7.2bn in private funding. In addition, CEOs from more than 30 financial institutions with over $8.7 trillion of global assets committed to eliminate investment in activities linked to deforestation.

Methane

103 countries, including 15 major emitters, signed up to the Global Methane Pledge, which aims to limit methane emissions by 30 per cent by 2030, compared to 2020 levels. Methane, one of the most potent greenhouse gases, is responsible for a third of current warming from human activities.

Cars

Over 30 countries, six major vehicle manufacturers and other actors, like cities, set out their determination for all new car and van sales to be zero-emission vehicles by 2040 globally and 2035 in leading markets, accelerating the decarbonisation of road transport, which currently accounts for about 10 per cent of global greenhouse gas emissions.

Coal

Leaders from South Africa, the United Kingdom, the United States, France, Germany, and the European Union announced a ground-breaking partnership to support South Africa – the world’s most carbon-intensive electricity producer— with $8.5 billion over the next 3-5 years to make a just transition away from coal to a low-carbon economy.

How an investment manager applies any or each of these investment approaches will be defined in their RI/ESG Policy (as well as related policies such as their Proxy Voting and Engagement Policy). As investors, it is essential to understand the policies of each appointed investment manager in order to be able to establish whether their approach aligns with yours as the investor. GraySwan conducts significant ongoing due diligence on each of the investment managers we approve or recommend, ensuring that their culture and approach towards sustainability align with ours and that of our clients and investors. On the whole, investment managers agree that environmental, social and governance (ESG) criteria affect shareholder value both in the short- and long-term because ESG criteria affect both company risk and return.

Doing a ‘good job’ understanding the ESG issues facing a company ensures that the riskiest issues (often governance, but social and environmental risks are very real as well) are flagged and mitigated or avoided while longer-term opportunities can be identified.

WHAT ARE THE RISKS?

Sustainability challenges have come to the forefront in recent years. Starting with the global financial crisis in 2008 and ongoing corporate governance failures, we have also had to face droughts, pandemics, challenges to public health, heightened awareness of racial inequality and human rights globally, and evidence of failing infrastructure and threats to food and water security have highlighted the need to take drastic action to protect our existence as human society. From a purely environmental perspective, COP26 (the latest meeting of the parties on climate change held in November 2021) highlighted the increased commitment of stakeholders to reducing carbon emissions to net zero by 2050. Interest groups have all heeded the urgent call to action and investment managers and asset owners have loudly acknowledged their support of the goals of sustainability.

Regulatory risk

Efforts by governments at the international, national and regional levels to regulate ESG issues will have direct financial and legal implications for industries and companies in breach of such regulations. Specific examples include carbon taxes, health and safety regulation, POPI, governance regulation (King IV), requirements for integrated reporting, fines and sanctions imposed. The JSE published in December 2021 enhanced ESG reporting requirements for listed companies which impose a significantly higher level of transparency from listed companies.

Physical risk

Some sectors and companies will face direct consequences from the physical impacts of climate change, including droughts, floods, storms, and rising sea levels. Sectors such as agriculture, fisheries, forestry, health care, insurance, real estate, tourism, and water may be particularly exposed because of their dependence on the physical environment.

Legal risk

Companies could face risk from legal action. Similar to the lawsuits faced by the tobacco and asbestos industries, there is a possibility that companies and sectors responsible for large amounts of carbon emissions could be liable for damages associated with the physical effects of climate change such as flooding, severe weather damage and crop failures. The legal risk could also stretch to consumer protection and data privacy breaches (both covered under the ‘social’ pillar of ESG.

Reputational risks

Companies that are viewed negatively concerning ESG issues may face backlash from consumers in markets where the public is concerned about these issues. Particularly consumer awareness is operating at heightened levels, supported by a very socially and environmentally aware millennial generation.

On the flip side, companies that are positioned well within the context of sustainability should see significant financial upside over the longer term. These companies, with a proactive approach to the opportunities that ESG presents could see increased efficiencies, reduced costs, and the development of new business initiatives that profit directly from the global more towards sustainability (investment in clean energy technology, recycling, improved social and employment models etc.). South Africa, as a country, for example has a rare opportunity to benefit significantly from pressure to reduce carbon emissions.

South Africa is one of the most fossil fuel-intensive countries in the world, with a failing electricity supply infrastructure and lack of funding to finance a move to a green economy. However, we have a limitless supply of sunshine, wind and waves and the capability to produce significantly more renewable energy than we need.

COP26 deal has agreed to finance the early retirement of ESKOM’s fossil fuel-intensive power plants and replace these with wind, solar and hydro clean energy. In addition, with excess energy and the world’s largest supply of platinum South Africa has the potential to become an exporter of green hydrogen to the rest of the world (see our article on this new green revolution here).

DOES IT WORK?

For asset owners, the case for incorporating sustainable investing into portfolio management is only getting stronger. As the wide-ranging implications of sustainability issues, such as public health, climate change and social justice, become more apparent, so too have they become essential to effectively assessing investment risks and opportunities. Helping to make the case is evidence showing that incorporating ESG factors in portfolios could aid investors in capturing above-market returns. While the coronavirus pandemic induced a global recession and market volatility in the first half of 2020, sustainable funds—across stocks and bonds—in general helped investors weather the period better than many of their traditional peers, according to a recent study by the Morgan Stanley Institute for Sustainable Investing.

During longer periods, according to Morgan Stanley (as well as Morningstar and S&P) sustainable funds exhibit 20% lower risk than traditional funds. In addition to financial performance, asset owners see an opportunity to target positive social and environmental impact, avoid reputational risk and comply with regulations. Real experience is showing very clearly that the long term performance of sustainable funds is better than non ESG funds over three, five and 10 year periods (Morningstar research¹).

The growth of financial products and services do not necessarily translate into robust economic activity. The health of pension funds and investor portfolios, over the long term, is closely linked to the health of the economy as a whole. This involves rethinking how investors (both small and large) measure their contribution to economic activity, and how social and environmental changes affect long-term performance. Winston Churchill expressed it best when he said,

“The price of greatness is responsibility.”

Responsible investing is a balancing act. Investors have to balance positive ambitions for a better world with the practical implications of implementing their long term investment strategy in search of superior returns. There is no question that everybody wants to make the world a better place, but in the same world investors still require competitive returns in order to meet their liabilities and performance objectives.

GraySwan has been a UNPRI signatory since 2013 (the second investment consultant in South Africa to become a signatory). We firmly believe that there is monetary value in responsible investment if you follow a step by step approach to incorporate such thinking into your investment process.

CAN IT BE DONE?

We’ve already done so successfully for our clients, and their top-performing track records are proof that responsible and sustainable investing is part of a winning strategy.

Individual investors, family offices, corporate and institutional investors can all benefit from being more sustainable in their approach to investments. While historically, it was believed that a responsible and sustainable investment approach meant giving up some shorter-term gains for longer-term and more holistic returns. However, the statistics are showing that a more robust ESG score can translate into superior investment performance (whether from avoidance of short term risk factors or gains from longer-term opportunities).

The more investors focus on and demand responsible and sustainable business practices, the more these factors will be rewarded in the market- creating a virtuous cycle to generate both financial and sustainable value.