What On Earth is ESG? | The Big Conversation | Refinitiv


ROGER HIRST: What on earth is ESG? Twitter is generally less than complimentary
with some of the following definitions of an ESG practitioner recently taken off Twitter. An asset gatherer as opposed to an Alpha producer. Someone who doesn’t know how to make a profit. The new feel good requirement to get new fund
flows. An online activist with a 401 K. skepticism
and cynicism about ESG is alive and kicking. But many people think that ESG is about climate
change. It’s not. It’s about corporate change, potentially sweeping
corporate change across many different disciplines. And that’s the big conversation. This year, there’s a real palpable shift from
a rhetoric to an urgent call for action. The shift is coming. If you’re ahead of that trend and you recognize
that trend, there are opportunities to make money and the companies that don’t measure
up are going to suffer financially, in my opinion. The companies that failed to make that leap,
you know, they’ll lose on every one of those dimensions. Finance is gonna be reshaped. So what is ESG and why should we care? ESG environment, social and governance is
not quite the same as socially responsible investing or SRI, which really focuses on
the social issues regardless of the financial impact to investors. ESG tries to identify measures which reduce
a company’s and therefore investors exposure to specific risks. For investors, it’s been easy to dismiss ESG
as yet another fad or marketing gimmick. Ignoring it has not been that hard to do because
its not really had many consequences. In fact, until recently, it was fairly difficult
to measure the costs and benefits for those who are trying to implement these strategies. At this year’s World Economic Forum in Davos,
ESG was by far and away the main topic of discussion. And this was not just a discussion about ESG
investing, but also about ESG corporate compliance. A vast number of corporate leaders are now
committing their company policy to an ESG future, and whether we as investors believe
in it or not almost becomes irrelevant. There’s going to be great numbers of opportunities
to profit from this trend and potentially lose out if ignored, regardless of whether
we emotionally embrace this policy direction or not. But what the hell is ESG? Well, as mentioned earlier, ESG stands for
environment, social and corporate governance. For most people, the focus has been resolutely
on the E of environment, climate change, global warming, and all those battle lines have been
drawn across various forms of social media. Of course, the environment is a key pillar,
but ESG is also about much, much more than just the E as Andre Chanavat of Refinitiv
explains. E is environmental. S is Social. G is governance. For example, how we categorise E: we’ve got
environmental innovation, we’ve got resource usage and we’ve got emissions. The for social, for example, you’d be looking
at human rights, your workforce has a health and safety issue. As well to think about, also what is your
corporate social responsibility strategy? And then of course, the G. The governance. So as a shareholder, what are your shareholder
rights? What is that? How is the board structured? So when we talk about ESG, we have over 450
individual measures. But, you know, you could go into easily into
the thousands. In 1993, there were only 50 companies who
published corporate social responsibility reports or CSRs. By 2015, there were over 7000. ESG data is now collected and collated into
an ESG score of which will have more in the next section. But this means that companies can now be compared
to each other, i.e. this is not just a flowery discussion about the ethics of ESG. It’s a discussion about the metrics. And from that we can make a relative evaluation
on individual companies. And the rise of measurable data allows investors,
corporate partners and investors like us to make an informed decision about capital allocation. With that comes an opportunity for investors
to profit from a corporate change which looks like it’s about to take off. Whether you agree with the underlying principles
or not, there will be plenty of opportunities for sceptics and evangelists alike. And that’s what we should care about as investors,
as outlined here by Audrey Choi, who focuses on sustainability for Morgan Stanley. We don’t even necessarily have to have the
conversation about whether you believe in climate change or not. Let’s have a conversation about what are you
concerned about in terms of risks and opportunities for your portfolio. I think traditionally you’re right, there’s
been this sort of tension of do I want to be a responsible investor or do I want to
make money? Think about it another way. If I said to you. Would you like me to invest your money in
a way that ignores a number of factors that could affect your business? I don’t know many investors who say please
ignore all those macro megatrend of facts. So what does that mean? We may choose not to invest based on personal
views of the environment or on ethics, but at the same time, we don’t want to invest
in stocks that might get penalized by large investors. Personally, I do want to invest in stocks
that are receiving beneficial flows as a result of maybe their ESG score. And markets have constantly presented us with
opportunities that we didn’t have to like, but we still try to embrace in order to make
a profit. For instance, although the tech boom of 1999
was at the time, clearly a bubble to many people, though not all, many sceptics still
rode that bubble for profit, even though they didn’t accept that soaring valuations were
going to be a new paradigm. Today, we dont have to believe in Tesla’s
accounts or its business model in order to participate in the opportunity to make or
lose money in the stock. Huge volumes there suggested traders and investors
are indeed embracing that bandwagon. Many argue that the current shift towards
passive investing itself has been a catalyst for the resurgence in ESG discussions by active
managers who are trying to stay relevant in the face of dramatic outflows. But despite that, there are still many investors
who continue to profit from that passive trend. Even if they believe that passive investing
is ultimately unsustainable, what’s key here is that the adoption of ESG is not just by
institutional investment managers, it’s by a broad cross-section of the corporate world. And 2020 looks like it will be the year when
the adoption of ESG policies will reach a critical mass amongst key corporate stakeholders. It’s a sort of tipping point onto which actual
investment trends will start to exert themselves. We may or may not be individually willing
on these changes, and these changes create the sort of uncertainty which we actually
prefer to avoid. But if the corporates are willing to act on
these policies, then we can either sit back and grumble or we can embrace and profit from
these changes. And I guess the important question is, will
these changes be fast or slow? And so far, these changes have been somewhat
glacial, but it’s clearly gathering momentum. Companies like Microsoft and BlackRock have
publicly embraced it. More will follow. Now, this might not affect our portfolios
this week or even this month, but ESG will increasingly be at the forefront of many investors
and particularly CEOs decision making. For investors, forewarned is forearmed. Even if ESG adoption is approaching a tipping
point, it won’t necessarily be the catalyst for an extreme market move. But it might help investors avoid the worst
vagaries of such an event. So, for instance, a discussion is building
about the pricing of a potential carbon correction. And what’s that, you might say? Well, according to Refinitiv data, last year,
around about 20 percent of global emissions were taxed at around about $28 per tonne and
that came to a total of about 220 billion. Now, if all emissions were taxed, the number
would be about 1.2 trillion dollars higher. So it’s a big absolute number. But when spread across all corporate revenues,
that’s only an additional cost of about one per cent. But if the IMF get their way and impose a
$75 per tonne tax, then the carbon gap would widen to 4 trillion. Once again, it may be that policymakers fail
to act or don’t want to act, but business leaders who are increasingly adopting the
ESG narrative will still need to factor in the possibility that policymakers might act. Therefore, monitoring ESG data could help
investors avoid the worst drawdowns. And this is why corporate change is key. Within Refinitiv categorization, emissions
only make up 12 percent of the total ESG score anyway. So it is that ESG is a lot more than just
the E. And the key thing to remember is that ESG is fast becoming a critical new factor
to help investors in their decision making process. This is not about embracing climate change. This is about embracing corporate change. Clearly, there’s an increasing amount of chatter
about ESG, but how is it gonna be measured and how can people make informed decisions,
particularly investment decisions? Companies are now signing up to the ESG protocols. And that means that they’re providing increasing
amounts of data. Now, this data can be compared and ranked
so that each company can be given its own ESG score, which then obviously begs the question,
what’s an ESG score? There’s a number of different methodologies
and nothing has been standardized as yet. But we’ll look at one that Refinitiv have
put together. As outlined in the previous section, environment,
social and governance issues are the three main pillars under which there are numerous
subcategories. Environment, for instance, is subdivided into
resource use, emissions and innovation. Social is subdivided into workforce, human
rights, community and product responsibility and governance is subdivided into management,
shareholders and corporate social responsibility. By way of example, within the governance pillar,
issues such as CEO compensation linked to total shareholder return are also taken into
account. For instance, if this has been rising to the
detriment of other stakeholders, it would be marked as a negative and I think most people
would probably agree with that sentiment. Those 10 ESG themes are then combined across
three main categories to provide the ESG score. Refinitiv also include an additional category,
the controversies score, which has collated from media sources and is combined across
all the 10 themes in order to discount the main ESG score for, as its name suggests,
public controversies. Together with the main ESG score, this forms
the combined ESG score. These scores can then be ranked, where a score
of zero to 0.08333 gets you a D minus, which is the lowest grade whilst a score between
0.9166 and one gets you top marks of A plus. Marks of C plus and B minus are a round about
middle of the class. In terms of the ten categories, the weights
are not divided equally. For example, emissions have only been allocated
12 percent of the total. The two largest weights go to management within
that governance pillar at 19 percent and workforce within the social pillar at 16 percent. And the three pillars environment, social
and government social takes a slightly higher weighting at thirty five point five percent. So ESG scores are therefore taking into account
a wide variety of factors. And it’s not just dominated by climate. Even though this drives the majority of the
narrative. And the ESG score then opens up the discussion
about comparing companies with peers within and across sectors. Some of the large cap energy stocks may be
expected to score badly, but that’s actually not necessarily the case. For instance, Royal Dutch Shell scored straight
A’s across the three pillars of environment, social and governance, scoring a maximum A
plus in that environment. Pillar, which, if you recall, has three subdivisions
of resource use, emissions and innovation where the company collects an A plus for each
of those three themes. Now, whilst the basic ESG score for Shell
is an A, the combined grade drops to a C plus, scoring about 44.6 points because of a poor
return within the controversies category, where it’s polled particularly badly on business
ethics and anti-competition. And many other energy companies have a similar
score. Exxon also achieves a combined score of C
plus with A’s across those three pillars of ESG, but another D-minus within the controversies
box, where it does score poorly on the environment section. And it may be a surprise that Tesla, the company,
scores much lower than Shell and Exxon with a combined score of just under 20 for a D
plus grade versus C plus for the energy majors. And Tesla only really scores highly in the
innovation category of environment pillar. So Tesla cars may be eco friendly, but the
company is struggling with its ESG score. And its rival in the luxury electric car category,
Porsche, ranks even worse with combined point score of 9.75 for a D grade, the second lowest
category. At the top of the league, with a combined
score close to 93 is a US resort stocks, a holiday stock, but also an Italian oil services
company, which may be a bit of a surprise. There’s only a few companies which score below
10. But yeah, in fact there are a number of chemical
companies around those levels. But hopefully it’s now clear that ESG scores
are not just about jumping on the environmental bandwagon. It’s about recording a vast array of data
inputs for corporate decision making. ESG scores made up from company filings will
increasingly help guide corporate leaders within this evolving framework. Some investors will use these scores, whilst
others will care very little about them, at least at first. But ESG and ESG scores are here to stay. For ESG investing rather than corporate compliance,
the ultimate proof will be in the performance. Refinitiv have identified a number of ESG
investment strategies such as ethical and negative screening, to avoid companies involved
in unethical activities and positive best in class screening for companies that demonstrate
a positive contribution to sustainable development. But are stocks with a high ESG score going
to outperform on a regular basis other stocks with lower scores. It’s too early to say, although there are
now an increasing number of ways in which we can track the performance of ESG factors. But we still have to be aware that stocks
with a high ESG score may be outperforming other stocks for non ESG reasons. Indeed, many of the factors followed by pure
quantitative strategies will only have a small percentage of a stock’s out or underperformance
that is attributable to one single factor. And within a suite of ESG products we are
going to see quite a lot of differentiation. Some investors may focus on social aspects,
others on governance. One such index is the Refinitiv Global Diversity
and Inclusion Index, which ranks over 7000 global companies and identifies the top 100
publicly traded companies with the most diverse and inclusive workplaces, measured by 24 separate
metrics. This global index has outperformed MSCI World
Index over the last 10 years, though, with names like Accenture, Diageo, BlackRock, Novartis,
Allianz in that top 10 by market cap, this may indicate that large international companies,
which will often be the beneficiaries of, for instance, passive inflows, are also the
ones that have been best placed to address the specific ESG topic. Both the MSCI World Index and the Diversity
and Inclusion Index have been lagging the S&P 500. In Australia, the Fossil Fuel Free index has
also outperformed the broader Australian market over the last five years. The top 10 holdings of that index, however,
lack any of the large cap Australian banks, which have significantly underperformed the
broader Australian market. But for those who want to embrace ESG concepts,
there are now many ways to track the data to follow some of the investing trends via
indices and create personal portfolios that follow the ESG protocols. Now, whether ESG investments begin to outperform
or not, it’s worth keeping an eye on these concepts and indexes to basically make sure
that we’re not being left behind by sea change in sentiment.

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