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ESG Integration – Have we crossed the tipping point?

Well, it’s been awhile and I have been quite hesitant to continue on this journey to blogging yet, there just seems to be so much happening that I feel that it should be shared.  So, here I am back into my chair willing to share what’s happening in my life, but mostly with my passion regarding sustainable business and sustainable investing.

So, to take this first leap, I’d like to share with you below an article that I wrote and that was published in the Winter 2016 newsletter of the Pension Industry Association of Canada  (PIAC):

“ESG Integration – Have we crossed the tipping point?”

Canadian journalist and bestselling author, Malcolm Gladwell, describes a tipping point as “the moment of critical mass, the threshold or the boiling point”.  Have we crossed into the tipping point with regards to the integration of environmental, social and governance (ESG) factors into traditional investment management?

2015 has certainly been a year of headlines regarding these topics with well-known names like Mark Carney signaling that climate change is a risk that needs to be managed. Companies like Barrick, Yamana Gold and CIBC, receiving “no’s” on their Say on Pay advisory votes and shareholders voicing their dissatisfaction by withholding support for a number of directors.  The Canadian Coalition of Good Governance (CCGG) actively began to push for proxy access.  A new leader in Canada’s federal government.  Increased provincial collaboration on carbon pricing.  And finally, the year will end with the hosting of the UN Climate Change conference in Paris.

In June 2015, the CFA Institute published the results of its first ESG survey and it found that 73% of respondents take ESG into account in their investment analysis and decision-making process.  The main motivations being to help manage investment risks, growing investor demand, and that it’s one fiduciary duty.

On the corporate side, the Global Reporting Initiative (GRI) says that it has seen a 24% annual growth, over the past 6 years, in the number of voluntarily published corporate sustainability reports using their framework.

Over the last five years, we’ve seen close to 50 non-financial initiatives, frameworks, standards and rankings come to fruition, many intended for a variety of different audiences.  In fact, according to the Global Initiative for Sustainability Ratings (GISR), there are at least 80 firms that offer more than 350 rating products related to corporate sustainability.

Of these initiatives, some focus directly on investors.  In 2006, the UN Principles of Responsible Investing (UNPRI) was launch and last year alone, it saw a 15% growth in signatories, currently sitting at 1425 and now represents over $60 Trillion in assets under management.

The CDP, which requests standardized climate change, water and forest information from the world’s largest listed companies, has also seen a 15% annual growth in companies responding to its annual survey.  It now has over 5000 companies reporting and represents 822 investors with approximately $95 trillion in assets.

Since 2011, the Sustainable Accounting Standards Board (SASB) has been creating and disseminating accounting standards that reporting issuers can use to disclose material sustainability factors in their fillings with the Securities and Exchange Commission.  They have developed standards for more than 80 industries in 10 sectors and on average each have about 14 key material indicators.  They plan to release provisional standards for all remaining sectors and industries by 2016. We’ve also seen the development of the International Integrated Reporting Council (IIRC), which has put forth a framework for integrated reporting.

As we seek better transparency around these issues, the amount of information to digest grows.  Investors often feel dissatisfied with how risks and opportunities are being quantified in financial terms, and there tends to be little comparability, even with companies in the same sector.  It can be very challenging to sift through this information to find what’s most material to one’s potential investment universe.

So as investors, where can you get relevant ESG information?  The brokers, right?  In Canada we haven’t seen our mainstream brokerage community embrace the integration of ESG factors into their research products.  We are, however, seeing global players like Goldman Sachs, Bank of America Merrill Lynch and Citibank, to name a few, producing great thematic research.  Over the past 5 years we’ve also seen significant consolidation of the pure ESG research providers, with some of the most recognized names in North America being Sustainalytics and MSCI.

In addition to the traditional brokers, another service provider is leading the way.Bloomberg, which provides financial data to the investment community, now also collects ESG data from published corporate public information.  They’ve seen extraordinary growth in ESG data downloads with a 76% increase year over year, with more than 17,000 users globally.

Many of the initiatives to date have been voluntary.  But there’s a growing voice for mandatory reporting.  The Sustainable Stock Exchanges (SSE) launched their “Model Guidance on Reporting ESG Information to Investors” which is meant to assist stock exchanges to provide written guidance on reporting ESG information by their issuers, by the end of 2016.  This was followed by The World Federation of Stock Exchanges, which has launched its first round of recommendations of material ESG metrics for exchanges and provided similar guidance for issuers.

But what about shifting regulations directly related to pension funds? Nationally, the Ontario Pension Benefits Act comes into effect as of January 1, 2016.  Plan administrators must include information about whether ESG factors are incorporated into their Statement of Investment Policies and Procedures (SIPPs) and, if so, how they are addressed in the plan’s investment strategy.

The US market also shifted this year.  In October, we saw revised guidance from the US Department of Labor, which now means that fiduciaries cannot accept lower expected returns or greater risks, but that they may take ESG benefits into account as “tiebreakers” when investments are otherwise equal.  This meaningful change is expected to advance the rate of adoption of ESG in the USA.

The changes in North America are in addition to the regulatory frameworks that have been in existence since 1999 in the UK, where pension funds are required to disclose the extent, if at all, to which ESG considerations are taken into account in the selection, retention and realization of investments.

France also requires listed companies to incorporate information on ESG categories into the annual management report, be approved by the board and verified by a third party.  In addition, mutual funds have to mention in their annual reports how ESG objectives have been taken into account in their investment policies.  In 2015, France also passed the Energy Transition Law, which will require listed companies to disclose financial risks of climate change and measures that have been adopted to reduce those risks.  This has also been extended to banks and credit providers and institutional investors.

Both corporations and investors are also feeling growing societal pressures.  As investors look to assess all of the potential risks as they embrace ESG integration, non-governmental organizations (NGO’s) are often great sources of information and perspective. This type of relationship is new for most investors.

Yet, pension funds are also becoming the target of NGO campaigns, in particular around divestment of fossil fuels.  This year we’ve seen the UK Fossil Fuel campaign which released the fossil fuel holdings of local pension funds with a view to putting pressure on them to divest from coal and oil and gas holdings.  There’s also the Asset Owner Disclosure Project which has released it’s 3rd annual index of the top 500 global asset owners, and found that nearly half appear to be limited in their consideration of climate change in their portfolios.   Locally, we’ve also seen the launch of the “Decarbonizer” by Corporate Knights.  It is a tool that can allow the public to assess what returns might have been, if the funds had divested of its holding to fossil fuel companies or investing in “green” companies.  For many pension funds, the possible reputational damage could be significant should they be targeted by some of these organizations, or other social networks that use these tools.

All of these frameworks, initiatives and regulatory changes lead us to the point of greatest importance for most investors — materiality.  When looking at the integration of ESG factors into one’s investment process, what one is really looking for are the key, material issues that may impact their investment decisions.

In March of 2015, the Harvard Business School published the “First Evidence of Materiality”, which highlighted that firms with good performance on material issues and concurrently poor performance on immaterial issues, perform the best over time. The results of this work speak to the efficiency of a firms’ investment in ESG-related issues.  As investors, you want to be able to assess these material issues early and ensure that management teams are investing and managing these issues well.

In general it’s been a difficult process for companies to articulate the financial impact of the E and S-related issues.  It has been even more difficult to define the value-enhancing initiatives that are feeding into long-term corporate strategy of these organizations.  All of these strategic efforts also need to be balanced with some of the broader ESG issues like carbon emissions and climate change.

Let’s take one of the leaders in this space.  Four years ago, Unilever, launched its Sustainable Living Plan.   They are now able to communicate that many of these brands, are achieving high single and double-digit sales growth.  Their CEO notes “these brands accounted for half of the company’s growth in 2014 and grew at twice the rate of the rest of the business.”[i]  Most recently however, the CEO has also highlighted that Unilever estimates that the greenhouse gas impact from people using its products has actually increased by about 4 percent since 2010 and that their water use has gone down just 2 percent.  They are also being criticized for poor conditions in tea estates in Keyna, and in India, the company is being accused of failing to clean up a contaminated factory.

Another interesting example is Target.  It too has expanded its selection of sustainability products and launched the “Made to Matter” line.  One year into it’s program, “sales of these products grew twice as fast at Target as they did elsewhere in the marketplace – these brands seeing a 25% overall spike in sales since the launch of the program.  The “Made to Matter” products at Target are projected to bring in $1B in sales in 2015”[ii].  As much as this looks like a great opportunity, it needs to be weighed against risks as well.  Target was also subject to security breaches last year and their reaction, compared to Home Depot and JP Morgan, seem to suggest some elements of negligence.  Both Unilever and Target are great examples of how risks and opportunities need to be weighed in the investment analysis process.

What both of these examples show, is that the judgment of the investment manager is critical.  Given the proliferation of information, limited research product, resources, and talent, how can investment managers determine what is material and what can have financial impacts?  As pension funds, are those managing your funds proactively managing these risks and opportunities?

As we come to the close of 2015, we’ve seen some pretty high profile companies, like Volkswagen and BHP Billiton, face situations that continue to put ESG issues on the front page.  Ultimately, it appears that the ship has sailed on this market theme, and although we have no idea how rough the seas will be, it appears it’s time to set your own course.





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