Improved environmental, social and governance (ESG) data, new regulations, investor demand — and recent elections — are accelerating the growth of ESG investing. Even so, institutional investors have questions about performance, relevance and implementation. In this round table discussion, Vicki Bakhshi, head of governance and sustainable investment at BMO Global Asset Management; John Streur, president and chief executive officer of Calvert Research and Management; and Alex Bernhardt, principal and head of responsible investment for the U.S. at Mercer Investments, lay out the rationale for ESG investing, how ESG is moving beyond a distinct category of investing and how asset owners can measure their ESG-related investments.
Not Your Parents' ESG
As responsible investing gains steam among asset owners, the concept is evolving from a distinct approach to a set of factors that influence a broader range of investments and investors
John Streur: It is no longer more talk than action. The biggest driver to change is the fact that corporations around the world are really adopting sustainability business practices and making these practices work from a financial point of view.
One piece of evidence is the amount of sustainability reporting we're beginning to see. Five years ago, less than 25% of the 500 largest companies were producing sustainability reports. Today that number is up over 80%. A lot of action is in analyzing how major corporations around the world are deploying capital to get returns through sustainability practices.
Vicki Bakhshi: There is a shift from talk to action. And that's been driven by two things. One is the change in mindset: acknowledging that ESG offers extra information. As asset managers, we're all looking for extra information that can give us the edge. Secondly, the competitive landscape around ESG is stronger.
Our clients are asking far more discerning questions differentiating those who are talking the talk and those who are walking the walk. That's really driving up the level of quality of ESG asset managers.
Alex Bernhardt: I would take it even further. The attitudinal shift which Vicki mentioned is really holistic and across the investment value chain.
The Principles of Responsible Investment (PRI) signatory base is now over $62 trillion in AUM, which is over half the global institutional investor capital base. And retail investors indicate in survey after survey a keen interest in sustainable investing. Such trends are putting more pressure on corporations for sustainability reporting and investment managers for ESG integration.
Streur: Short term, this has energized ESG stakeholders, and there has been an uptick in interest, demand and commitment to ESG.
However, government regulations and spending in the U.S. are very important to sustainable development and social justice. Everything that we've seen from the Trump administration has been a rollback of policies that support these initiatives.
Longer term, if these policies are actually implemented as advertised, it will harm U.S. businesses in their efforts to globally compete on sustainability.
Bakhshi: Sitting here in London, the big shock of last year was the Brexit vote. And similarly to what's been said, there are short-term effects but deeper consequences as well.
In the short term, it's going to cause increasing uncertainty, which investors never like.
What's most interesting from a responsible investment point of view is if you look at the deeper causes of why that vote took place. It was about whether capitalism is genuinely working for everyone.
That's where there's a very interesting link to responsible investing. We can demonstrate the benefits of a more sustainable form of capitalism where investors aren't part of the problem, they're part of the solution.
Bernhardt: Some of the recent political changes in the U.S., the UK and elsewhere may galvanize the private sector to work harder to solve the social and environmental problems that we're facing as a global community.
Prior to these political events there may have been a Panglossian attitude in the private sector toward governmental solutions to issues like climate change but this attitude I think has been replaced by an understanding that solutions to such large social issues may need to emanate from the private sector.
In the end, we could see much more activity in sustainable investing.
Bakhshi: There are regulatory developments that are global that are driving much of this activity. A recent Department of Labor bulletin referred explicitly to the potential for financial benefits from shareholder engagement, which is hugely important. Stewardship codes are now proliferating in Canada and throughout Asia.
Why do we do this? It's the right thing to do. But it's also the smart thing to do for all the reasons that have been said. We were part of the PRI right at the beginning, and the UK stewardship code too.
It's in our self-interest and the interests of our clients. But we also have that wider responsibility to create a more sustainable form of capitalism.
Streur: The mission is to better connect the capital markets to these vast and long-lasting social and environmental outcomes that companies have on the planet, people and on the future. For Calvert, for myself, we'll pursue this mission regardless of the political environment, regardless of the regulatory environment.
Our objective is, first and foremost, to produce competitive returns for clients, and in conjunction with that, to be part of the drive for improvement. It informs the culture of the organization. We are part of the pioneering generation doing this.
Bernhardt: Mercer was involved at the origination of the PRI as an adviser to the U.N. We were also a founding signatory. We've since embedded similar beliefs that reflect the principles of responsible investing corporate-wide.
Bakhshi: The question starts with, what is an ESG investment? For us, there are two different types. One is products that specifically have ESG as a formal part of their construction. And second is the way we view ESG across the board as part of our company and risk analysis process.
For BMO ESG strategies, which we call our responsible strategies, we have an in-depth, in-house research process which looks at, among other things, the broader sustainability credentials of the company. For instance, do they have decent policies on key issues like climate change? More widely, ESG enters into many of our investment strategies purely from a financial risk management perspective. If we have serious concerns, we may not invest.
Streur: Calvert is dedicated to responsible investing across its assets. We use a process that has four main elements — what we refer to at Calvert as the Four Pillars.
The first is return considerations. We're dedicated to pursuing competitive financial results for our clients.
The second piece is having a full understanding of the ESG risks and opportunities that each security holds. In that regard, we have a 20-person team that builds proprietary models and produce proprietary scores.
The third main piece is shareholder engagement in proxy voting. This year, we have about 25 resolutions that will be filed in the 2017 season around ESG issues.
The fourth main pillar is impact. We want to set clear goals and create metrics to measure the impact of all this activity.
Bernhardt: At Mercer, we advise on manager selection rather than security selection. Our manager review process for many years now has had an ESG rating framework. We look at qualitative factors — do ESG factors influence idea generation or portfolio construction? Is there a firm-wide commitment or is ESG just a side issue that one portfolio manager is interested in? How progressive is the organization at pushing the agenda? These ESG ratings inform client investment decisions to varying degrees.
Bakhshi: At BMO, we use a range of sources, including MSCI ESG data. But the key is not what sources you use but how you use them. And we're often less interested in the level of the score, because that's often just a product of the methodology, but in how that score is changing over time, whether the company is getting better or worse.
We're always digging deeper to understand what's behind that changing score. We have an extensive program of investor engagement where we're going out and having a dialogue with companies where there is a weakness in ESG scores.
That's particularly important in emerging markets where disclosure is poor. When you actually go out and speak to them, you may find out they're doing more than you think. Or maybe not. But you don't know until you have that conversation.
Streur: At Calvert we build proprietary models. The metrics for the key performance indicators that we use within those models come from three primary source categories.
One is a set of sources that the subject company provides. We also bring in information from regulators, exchanges and trade associations. And then third, we use a variety of sources to scan global media to understand what third parties are saying about companies and their behaviors.
We have about 1,600 key performance indicators on our proprietary research system. And then our analysts select the ones that are most relevant and most material to a particular sub-industry.
Streur: S is a very broad category and an extremely important one. It includes everything from product safety, community engagement, supply chain behaviors to workplace safety. As we know, United Airlines had a tremendous problem recently. That was in the S category.
For us at Calvert, with our history of human rights initiatives, S is not a neglected category. It's just as strong as the rest.
Bakhshi: S absolutely is important. It has had less of a high profile than governance and environmental issues. S has some of the most important links to performance because S is fundamentally about people.
There are good S metrics. Are they consistent across a very large universe of companies? Not yet.
Take gender diversity as an example. We have great statistics on gender diversity at a board level. If you look at the employee level, the data is weaker. It's not reported as consistently.
So we've been thinking with other investors about how we can come up with a short, consistent set of questions for mainstream analysts around the subject of human capital so that we can get improvements in the consistency of disclosure.
Bernhardt: I agree that S is something of a neglected factor vs. E and G. However, there is overlap between factors traditionally considered to be environmental, like climate change, for instance, and social factors. Climate change has a very strong social dimension given that vulnerable communities, especially in low-income countries, are more likely to be susceptible to the physical impacts of climate change.
Also in the social category, we launched, through our talent group, a series of reports over the last few years called 'When Women Thrive,' which really look at gender inequality in the corporate environment. We're now working to further develop this idea of how human capital management is really important to corporate value. We're really excited about that.
Streur: There's not a trade-off. But five years ago there probably was a trade-off. The difference today is that we have a much better inventory of securities to deal with and a much deeper ability to do the research.
Today we can look at the 1,000 largest companies in the U.S. and find 65% of them to work with. That allows us to engineer effective solutions for clients, whether those are passive or active.
Bakhshi: With SRI investing, there tend to be particular sectors where you're likely to be underweight, such as mining. If you get a run in the sector, you could get some short-term deviations from benchmarks.
But in our view, the overall impact of choosing companies with good ESG is positive, as it means companies are better placed for the long term and potentially have lower overall volatility.
Streur: Impact investing is very different from the ESG investing we've been talking about. These are investments, often through private equity, that directly target a community or geographical region, and have high social or environmental impact.
We also believe that impact of investments should be material and measurable. In addition to traditional performance metrics, investors should be able to see how their investments are doing in comparison to others in ESG areas.
Impact investors expect competitive returns and really significant impact that one can measure. This is an area that Calvert has a long history in.
Bakhshi: The interesting question right now is can we credibly take the principles of impact investing that have been established in the private equity space and scale it up to large-scale public equity investments? There are some real challenges, but that's what investors are starting to expect.
Here in Europe, one framework that's gathering momentum is the U.N. Sustainable Development Goals, which have specific targets around areas like health, water and climate. There's a significant investor effort to use those metrics as a means of reporting on larger-scale investments.
Bernhardt: We suggest investors start with a beliefs exercise of what they believe the impact of ESG factors or SRI exclusions might be on portfolio risk and return, as well as on the institution's broader reputation. There's an opportunity to conduct cost-benefit assessments. Having some cohesion around the institutional views on these subjects is important.
We're starting to see an increasing number of investors integrate ESG holistically across their portfolio. In these instances, ESG doesn't influence asset allocation in the sense that you're making specific ESG investments, it's really more of a holistic, policy level approach.
However, there are more segmented approaches that are valid and that exist in the market. We see a lot of foundations allocating, say, 10% of their portfolio to a mission-related investing pool. We're seeing a number of large public pension funds make passive allocations to low-carbon index funds.
Streur: What Alex just articulated is perfect. Really, it should be a thoughtful approach that starts with policy statement and then carries a strategy across the board.
I would add that the fixed-income segment offers some special consideration — green bonds, environmental bonds are a special case where special expertise is required.
Bakhshi: In Europe, we sometimes get investors who want to put 5% or 10% into impact-type strategies, but it's far more common for investors to take a portfolio-wide approach.
The range of asset classes that can be covered by an ESG approach are expanding beyond active equity to fixed income, real estate and infrastructure and so on. Asset owners are now thinking, 'How can I use ESG to help me achieve my ultimate objectives in terms of risk and return?' Sustainability funds can be a way of generating alpha.
Bakhshi: We have private equity solutions. In some ways private equity is one of the best-placed asset classes to implement these strategies.
In terms of investor engagement and actually improving the underlying company's performance on sustainability and governance, it's a struggle in public equities. It takes a lot of work to get large companies to shift.
But if you're a long-term holder in private equity, you can make transformational changes in sustainability to the companies that you are investing in. It's one of the most exciting asset classes if you're really trying to make an impact with your investments.
So we don't see a problem with track record, per se. It comes back to asset allocation. Is there a private equity allocation to start with? And if so, what can ESG-focused options offer?
Streur: There is a set of managers in this space on their second or third fund, and you can look at their track records. But they are not really large pools of capital. It's tough for large institutions to come in at scale, though we definitely see some institutional involvement.
Bernhardt: I would call it more of a challenge than a problem just because I'm inherently an optimist. There are a lot of impact-oriented strategies entering the market, with limited track records or relatively small size, which can be difficult for a lot of institutional investors to stomach.
That said, there are ways to allocate to some of these 'green' strategies, pun intended. They could be allocated to a foundation's or large pension's mission-related or emerging manager programs, respectively, or even slotted into innovation/opportunistic buckets.
Streur: Across the board. There is growing momentum in understanding how to make much more efficient use of energy, water and natural resources, and how to lighten the environmental footprint. Investment opportunities are opening up for us.
In the emerging markets and small-cap segment, as Vicki observed earlier, there's not a lot of information from ESG vendors. And these companies don't do a lot of formal reporting. In both of those sectors, we find significant opportunities that the traditional ESG data vendors don't pick up.
Bakhshi: Echoing on emerging markets, that's absolutely right. So now we have a responsible emerging markets strategy. You have to dig to find who the genuine sustainability leaders are, but they are there.
In our responsible global strategy, BMO is looking at sectors that would play well if we see inflation and interest-rate rises.
Bernhardt: There are new opportunities entering the market pretty much every day. Innovation in fixed income certainly has lagged public equity, but we're starting to see a lot of movement in that space. There's no shortage of opportunities. The challenge is keeping up with the innovation.
Bernhardt: Yes. However, there will always be significant differentiation in the way investors are treating ESG factors.
Streur: No. We're going to continue to have a large cohort of investment products that are completely passive and are not willing to engage with company management and embark upon ESG-oriented proxy voting policies. I think that's a significant problem that we face structurally.
Bakhshi: Yes and no. Yes, we'll realize more and more that ESG issues are just part of good investment analysis. The big money is shifting this way now.
The no is you'll still need specific ESG strategies. Pension funds are getting increasingly sophisticated in this area, wanting to have their own responsible investment approach and strategies. We must make sure there's a good range of ESG products for the next generation to meet their needs.