Integrating Environmental, Social and Governance (ESG) issues: Russell s manager research and sustainable financial value

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1 By: Will Pearce, Senior Research Analyst, and Mike Clark, Director, FEBRUARY, 2011 Relationship Management and Chair, Sustainability Council Integrating Environmental, Social and Governance (ESG) issues: Russell s manager research and sustainable financial value Investors are showing an increasing interest in ESG issues. That interest varies by country and by type of investor, both in its intensity and in the way the interest is expressed. In response to this interest, Russell became a signatory of the United Nations Principles for Responsible Investment in September 2009, committing to incorporate ESG issues into investment analysis and decision-making processes. In this paper we address how Russell interprets ESG issues and how that influences our manager research. We also draw out the difference between a values-based approach (based on an investor s unique beliefs) and the concept of sustainable financial value (based on the integration of ESG issues within the standard financial framework), and discuss how this distinction can help inform an investor as they seek to specify their objectives. DEFINING ESG ISSUES When an investor first considers ESG issues, they often think of screening strategies such as those used by funds that exclude tobacco companies, or armament manufacturers, or the exclusion of companies with specific political links, e.g. with South Africa in the 70s. But the consideration of ESG issues now covers a much wider range of factors, and often involves a more integrated approach to the building of portfolios. Since the earliest days of asset management, investors have had an interest in the governance of the companies in their portfolio. The governance function provides a direct link in the ownership chain, and can influence financial outcomes. Recent examples to highlight this linkage include Enron, Worldcom and Lehman Brothers. ESG issues now cover a much wider range of factors, and often involve a more integrated approach to the building of portfolios Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value

2 However, environmental and social issues have been less obvious to investors as a component of financial returns, but this is changing. Incorporating environmental issues is commonly taken to mean assessing climate change risk. This can lead to assessing carbon-related factors in evaluating a company s performance and prospects. The nature of such factors will differ between industries: car manufacturers, utilities and airlines will each address the issue in their own way. Environmental issues also extend to include pollution, alternative energy production and resource depletion. The consideration of social issues broadens an investor s perspective to give greater weight to a company s relationships with its customers, employees, suppliers and the wider community. Specific issues will have differing potential impacts for different firms. Employee relationships, product-related customer health issues, supplier factory standards and the activities long viewed by some as socially harmful such as tobacco are examples of the issues that may be considered. It is clear that the range of ESG issues that can be considered is extensive. An investor needs to develop a framework, including a financial materiality condition, to manage these issues effectively. ESG AND FIDUCIARY DUTY With its origins in the fundamentals of trust law, a view has persisted that applying apparently non-financial criteria to investment decisions is in conflict with trustees fiduciary responsibility to act in the best long-term interests of beneficiaries. This is commonly cited as an impediment at least for pension fund fiduciaries to incorporating ESG considerations into an investment approach. The longer-term nature of many ESG issues also makes it more difficult to demonstrate the impact on financial outcomes, especially in markets where many participants are taking a very narrow or short-term perspective. It is now more readily accepted that ESG issues can have an impact on investment returns, making their incorporation both legitimate and important for investors More recently, case law and legal opinion have evolved 1, as have the regulatory and statutory requirements across various jurisdictions. That said, we do not conclude that legal complexities have been resolved and we accept that it may be some time before any new consensus can be reached. However, it is now more readily accepted that ESG issues can have an impact on investment returns, making their incorporation both legitimate and important for investors. Russell recognises that the UN Principles for Responsible Investment should be applied in a manner consistent with fiduciary duty. We see this as a central feature of Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes, allowing us to approach implementation from a financial impact perspective. The connection between ESG and fiduciary responsibility can be managed by considering financial materiality and applying the concept of sustainable financial value. This allows us to better distinguish between issues potentially relevant to investment performance (i.e. simply value based) and those more closely associated with values-based investors for whom a wider range of influences, based on their beliefs, are of significance 2. That said, we recognise that there is potential for the outcomes of these two approaches to overlap. In equity portfolios, for example, both approaches could minimise exposure to sub-standard employee welfare practices in a mining company, for which low productivity, litigation issues and brand damage threaten growth and profitability. However, we 1 We note in this regard reports such as Freshfields (Freshfields/UNEP FI AMWG, A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment [2005]) and the follow up Fiduciary II (UNEP FI AMWG, Legal & Practical aspects of Integrating Social, Environmental & Governance Issues into Institutional Investment [2009]), which seek to establish the relevance of ESG issues to fiduciary duty. 2 Here we recognise mission-related investors who might more readily describe their investment goals within the wider mission of their organisation. Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 2

3 must clearly distinguish the fiduciary path to reach an investment outcome from one driven by non-financial considerations. Whilst noting the challenges that this poses, the framework we set out here allows us to embed ESG issues within our investment process and overcome many of the impediments sometimes put forward by conventional wisdom. THE LINK BETWEEN ESG AND FINANCIAL PERFORMANCE Evaluating the impact of ESG issues in making investment decisions is not a new phenomenon. In particular, the focus on corporate governance as a driver of returns has been fundamental to many credible investment approaches for a long time. But social and environmental issues have not been identified as a separate discipline or field of study until more recently. What has changed? Concern about corporate governance tends to rise with the incidence of spectacular corporate failures. The recent near-failure of many large banks has led to a strong focus on governance and, in particular, the role of the board in risk management. There is growing recognition that strong governance structures, appropriate executive control and high levels of transparency are amongst the factors likely to differentiate corporate performance over the long term. With the rise in societal and corporate adaptation to global warming, and the regulatory response to the associated risks, the impact of environmental issues on security prices is on the rise. Also, the social impact of corporate activity has become more visible. The link between the recent bank bailouts, the resulting burden on taxpaying citizens and lower economic growth is widely perceived. Recent events have undermined the commonly-held assumption that the financial sector is neutral in its effect on the macro-economy. Simply put, all this highlights the importance of understanding emergent issues in social and environmental fields, and bringing greater effectiveness and consistency to the focus on governance. Whilst noting the challenges that this poses, the framework we set out here allows us to embed ESG issues within our investment process and overcome many of the impediments sometimes put forward by conventional wisdom Capital markets evidence In recent years, a growing body of academic work has sought to establish relationships between indicators of corporate ESG performance and equity returns. In some studies, the goal is to identify an ESG factor and to test whether that factor is associated with a return premium or discount. Other studies use the performance of investment products constructed on consistently applied ESG criteria and draw comparisons with unconstrained peers and benchmark indices. The sheer number of publications, variety in methodologies and competing results make the task of drawing firm conclusions a challenge. From an empirical perspective, there is no consensus as to whether ESG effects have a systematically positive or negative influence on returns. An earlier Russell publication 3 applied concepts from investment theory to counter competing arguments as to why ESG/sustainabilityaware investing should either strongly under or out-perform unconstrained approaches. We readily acknowledge that this is not the last word on the topic and expect the investment community to continue advancing the debate, particularly as underlying company data improves. What is often lacking in empirical assessments of ESG impacts is a sense of causality the drivers of financial materiality. Practitioner studies have begun to fill the void, as has the growing evidence from our research contact with managers. We highlight a few examples of ESG issues cited as impacting the analysis and pricing of securities: 3 Russell Research: Sustainable Investing Marrying sustainability concerns with the quest for financial return for superannuation trustees, Nick Taylor & Scott Donald (August 2007) Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 3

4 The cost of greenhouse gas emissions embedded in the evaluation of utilities companies within the EU Emissions Trading Scheme. The impact of environment-friendly regulation driving growth and profitability amongst companies in the real estate sector. The effect of societal problems such as obesity on positioning and strategy of Consumer Staples companies. The effect on long-term corporate strategy of supply chain constraints caused by water stress in the clothing retail sector. The role of corporate governance standards in the Financials sector in contributing to the credit crisis. In this framework, ESG issues can be viewed as operating within a stock-specific context. As ever, markets efficiently, but imperfectly, discount information about future value. We expect properly functioning markets to price-in the impact of ESG issues as information becomes financially tractable. There is an evolutionary quality to this process which culminates in materiality asserting itself. For those issues lacking information that can be translated into financial form, the underlying driver of corporate performance may be tenuous and we see little reason to expect a marketpricing regime to operate. However, a greater understanding of influences can be achieved by raising levels of transparency in the reporting of relevant corporate data. Only the more evolved breed of product can genuinely be said to integrate ESG issues in a truly financial sense MOVING FROM (SOCIALLY) RESPONSIBLE INVESTING TO SUSTAINABLE FINANCIAL VALUE Although the pioneers of investment products incorporating ESG factors were generally motivated by moral or ethical considerations (the values-based perspective), the discipline has evolved well beyond avoidance or negative screening typical of traditional Socially Responsible Investment (SRI) products. The broader term Responsible Investing (RI) is increasingly used to denote a spectrum of strategies encompassing both SRI products and a new breed of products seeking to offer sustainable financial value. This latter category includes mainstream investment strategies that actively recognise the financial implications of economic activity over a longer timeframe and across a broader spectrum of issues than is commonly taken into account in traditional investment approaches. An important distinction to note is that only the more evolved breed of product can genuinely be said to integrate ESG issues in a truly financial sense (such as in the examples above). It is likely that investors with an analytical advantage in anticipating the impact of ESG issues on companies or sectors will be able to more accurately assess corporate value, identify mis-pricing, and control risk. Integration methodologies are evolving and it would be premature for any manager to claim to offer the perfect process. Common approaches involve identifying ESG drivers specific to an investment strategy, i.e. those issues believed to be financially material. These insights are incorporated within thematic research, risk control and are beginning to be embedded in valuation or forecasting techniques. Recognising emerging materiality, adapting analytical methodologies and weighing up risk and return are all fundamental to current practice in the active management community. Indeed, many investment firms are already doing this as a matter of course in conducting thorough analysis of investment opportunities, regardless of whether it is deemed to be specialist ESG research or just seen as part of evaluating all material factors impacting security prices. Beyond the core investment process, sustainable financial value also requires consideration of active ownership. This investor activity once referred only to proxy voting. But it now extends to include engagement, a richer dialogue between a shareholder and the investee company. In line with its commitment to the UN PRI, Russell has extended its Proxy Guidelines in 2010 to increase its active ownership stance. Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 4

5 Active ownership throws up a broader perspective worth noting. Among asset owners there is increasing recognition of the universal investor concept. A universal investor, sometimes referred to as a universal owner, is an investor whose size and diversification principles make it necessary to invest in all sectors of the global economy. Such an investor is affected by the overall performance of the global economy which underlies the investment performance of his broad portfolio. So the investor has an incentive to make the management of externalities part of his objectives. For when companies externalise their costs, overall economic performance is sub-optimal. As elsewhere, to avoid being overwhelmed an investor needs to make a materiality determination in their evaluation of these issues. Barriers to ESG integration Short-termism in asset management is encouraged by short contracting and monitoring horizons. This means that the benefit of a focus on longer-horizon ESG issues may not be fully valued by clients. Sometimes as in very high turnover strategies responding to rapidly changing stimuli this is perfectly reasonable, but in others it can result in unintended risk-taking. Residual scepticism amongst managers as to the materiality of ESG issues is also an impediment. A lack of consistent, comparable data can make analysis challenging. The quality of information provided by third-party databases, although improving, is sometimes questioned. Commentators have observed that information on ESG issues contained in Corporate Social Responsibility (CSR) reports is generally descriptive in nature. Many issues are currently not easy to translate into financial form. Finally, a shortage of in-house skill and know-how is hindering the integration process, particularly as the ESG landscape is an evolving one. Nonetheless, we expect that the mainstreaming of ESG investment practices will continue as institutions overcome some of the barriers around implementation and the scale of the impact of these issues is increasingly recognised. We anticipate a point at which ESG is no longer regarded as extra-financial information. This will depend in part on the pace in adopting standards of disclosure either from regulation or voluntary codes. A good example of the latter is the Global Reporting Initiative (GRI) launched over a decade ago. We expect numerous investor and NGO-led initiatives to add further momentum. ESG IN RUSSELL S MANAGER RESEARCH AND MULTI-MANAGER PORTFOLIOS Since an advantageous understanding of ESG issues can give investors an edge in identifying mispriced securities and under-appreciated risks, we believe that analysis of managers capabilities in this area is both necessary and valuable. At the same time it is important to maintain perspective and acknowledge that it will be more relevant for some manager processes than others. This is leading us to strengthen our understanding of best practice among active investors to support our manager research decisions and evaluations. We are not yet in a position to put forward a complete model of best practice in ESG integration, although our understanding is developing well. At this stage we can make the following observations: Our research policy is to incorporate ESG analysis within our existing assessment framework, adding to and adapting the criteria underlying the ranking process. Russell has not set up a separate team of ESG analysts. This approach is in keeping with the concept of the integration model we expect from managers. We approach this on an asset class by asset class basis, seeking to understand the most critical areas in which ESG issues can impact risk and return. Since an advantageous understanding of ESG issues can give investors an edge in identifying mispriced securities and underappreciated risks, we believe that analysis of managers capabilities in this area is both necessary and valuable Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 5

6 One asset class where managers have made significant progress in integrating environmental issues into their investment processes is Real Estate. The two prime drivers are environmental regulation and tenant preferences for buildings with strong sustainability attributes. Sustainability initiatives have gained traction through short payback periods and transparency in terms of impact to cash flow. Equity asset managers with a long-term process more readily integrate ESG issues into their security analysis. Their longer-term perspective supports the recognition and evaluation of the potential financial impact of externalities. A process with a shorter-time horizon may largely ignore them. We also note that such managers may have a more developed active ownership process. We observe that ESG integration has been primarily focused on equities and real estate. However, a number of market participants are now starting to integrate ESG factors into fixed income strategies. Some specialist active credit managers embed ESG research and analytics into their bottom up credit research process. We have conducted due diligence on several third-party providers of company and industry level ESG research. Our aim is to blend ESG data with manager holdings data to generate high levels of transparency around ESG exposure and sensitivities. In multi-manager investing this information is likely to inform our manager selection beyond the simple impact it may have on our ranks. Russell portfolio managers may look to appropriately position fund mixes with respect to ESG risks or may seek to include certain strategies with strong ESG capabilities as an alpha source distinct from more traditional approaches. BEYOND MANAGER PORTFOLIOS - ASSET STRATEGY DECISIONS So far, this paper has focused on decisions taken by investment managers and the securities in the portfolios they manage. We also need to consider whether, and if so then how, we might apply the concept of sustainable financial value to decisions taken at the asset strategy level. Are there some ESG risks which might best be managed at this level? There was a time when governing fiduciaries, pension fund trustees, positioned at the top of the decision making process, tended to set static investment strategies which were infrequently changed. But there is now a greater willingness to consider dynamic risk management, often manifested as dynamic asset allocation. This change has been helped by greater recognition of the benefits that a well-resourced managing fiduciary role can bring. Perhaps this is where risks such as carbon risk can best be managed across the total asset portfolio. For this to become a reality, we need more transparent pricing of carbon together with financial instruments which reflect that pricing. One asset class where managers have made significant progress in integrating environmental issues into their investment processes is Real Estate LOOKING FORWARD In this paper we have explained how Russell approaches ESG issues and how we have begun to incorporate potentially material factors into investment manager research. We also draw a distinction between the values-based approach and one concerned solely with sustainable financial value. We recognise this is a multi-year task, in the context of evolving manager processes and investor behaviour. We look forward to expanding this work in partnership with our clients as they develop their own views on what ESG means for them. Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 6

7 For more information: Call Russell Investments Sydney Melbourne Or visit Important Information This document is issued by Russell Investment Management Pty Ltd ABN , AFS Licence (RIM). It provides general information for wholesale investors only and has not been prepared with regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Copyright 2011 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from RIM. Russell Investments // Integrating ESG issues: Russell s manager research and sustainable financial value / p 7