The case for ESG - LGIM

1 2018 The case for ESG For investment professionals The case for ESG. How integrating environmental, social and governance considerations into investment processes can mitigate risks and enhance performance. From the diesel emissions scandal lower overall portfolio volatility to the perceived exploitation of zero- and meet clients' growing appetite hour contracts, there have been for investments that better reflect many examples in recent years of their values. how failures in the way companies are run can have a harmful impact In this guide, we explain the rationale are less likely to face political or on the environment, society and behind this view and outline how regulatory pressure. investor returns. ESG considerations can be hard- wired into index-tracking portfolios. Such companies are also better We believe that integrating positioned to withstand and environmental, social and BEYOND THE BALANCE SHEET even benefit from shifts in the governance (ESG) factors into At the simplest level, ESG is about market environment.

2 Examples of investment processes can help good management. Companies the challenges that ESG can help mitigate the risk of such episodes with strong governance oversight to address include the impact of afflicting the companies held within are less likely to provide investors climate change on energy markets;. a diversified, long-term investment with unpleasant surprises; equally, the interplay between the growing portfolio. Such an approach, in our companies that are aware of their digital economy and security; and view, can also enhance performance, impact on wider stakeholders the rise of the conscious consumer.'. In order to assess the true strength Figure 1: ESG risks of a company's governance, we believe it is important to ask Inaccurate value of assets Cost of energy/carbon Cost of transactions New technologies questions about stakeholders Excessive risk taking Regulations/tax/subsidies Bankruptcy and timeframes that conventional Motivation/Retention of directors Cost of water/regulations Alignment with strategy Climate Penalty/tax due to pollution analysis and traditional investment Successful recruitment Auditor/ Change/ Land permits/new technologies Advisors Energy solutions might overlook.

3 When our Water Cost of disposal/recycling Share price dilution Remuneration Cost of virgin material clients expect us to look after their Reduction in shareholder rights Env Waste Sourcing efficiency Loss/gain share prices nc e ir pensions for decades into the future, Shareholder on a Mergers and acquisitions Govern Loss of access/Land use rights these are precisely the questions we mental Biodiversity Tax/penalty Financials Reputational damage Inadequate control Board General cannot afford to avoid. of Loss of competitiveness Directors Pollution Tax/penalty/liabilities Takeover targets S o cial Community support Lack of direction/strategy Worker turnover Human Rights Corruption Bribery Some risks faced by companies Penalties, loss of contract Supply Loss of work days Employee/. Community Chain Loss of business/fines will not be obvious, given the vast Reputation relations Reputation Staff turnover Cost of bribery amount of information that lies outside of the balance sheet, as Loss of efficiency/workers Operational cost Sabotage High turnover Reliability/efficiency Quality standard detailed in figure 1.

4 Reputation 2018 The case for ESG. In order to make a formal Figure 2: Share-price performance one year after an assessment of these risks and ESG risk event opportunities investors can compare and contrast different ESG Risk Event Date 1Y (%). companies' performance on key Energy accounting scandal 8/14/01 ESG metrics. Telecommunications accounting scandal 3/11/02 As we discuss later on, this need Upper Big Branch Mine explosion 4/5/10 not ultimately involve the blanket Deepwater Horizon oil spill 4/20/10 exclusion of certain sectors and Automobile airbag recall 1/21/14 stocks; for example, tobacco or Pharmaceutical accounting scandal 8/5/15 defence companies. Such action Automobile emissions scandal 9/20/15 forms a subset of responsible investing known as ethical' Average loss to shareholders after 1 year strategies, which we will not Source: Morgan Stanley address in this guide. PREVENTABLE SURPRISES ENHANCING RETURNS best governance practices at investee We believe incorporating The majority of academic and companies.

5 ESG factors into investment industry studies suggest that processes can play an important incorporating ESG factors into While most of the studies published role in mitigating risks, whose an investment process does not have focused on equities, there has crystallisation, as demonstrated detract from performance; that is, been promising research on other in figure 2, can take a toll on stock there is no virtue' discount applied asset classes. Of those published performance. to taking such an approach. Indeed, before 2014, high ESG scores were research indicates that a process linked to the performance of bonds Even though some events can which incorporates ESG factors in 63% of studies, and with the be labelled black swans,' many can, in fact, help to boost returns. performance of real estate in 71% of surprises will be preventable: a 2016 studies. Unlike for equities, the review study by Bank of America Merrill Of the 2,250 peer-reviewed studies found no studies showing a negative Lynch suggested that exposure to published on this topic between 1970 correlation for these two asset classes.

6 15 out of 17 US bankruptcies since and 2014, the overwhelming majority 2008 could have been avoided identified a positive link between DAMPENING VOLATILITY. through the integration of ESG high ESG scores and corporate ESG integration also helps to reduce within conventional analysis. performance, according to a review the volatility of an investment, conducted by Deutsche Bank and according to research from Harvard A 2016 report from Barclays, Hamburg This result Business School,3 Morgan Stanley,4. meanwhile, showed that bonds with held true for 47% of the individual MSCI,5 JP Morgan6 and State high ESG ratings had lower spreads studies and 62% of the meta-studies Street,7 among others. and higher credit quality than examined. By contrast, a negative other securities in the Bloomberg correlation was found in fewer than Indeed, Bank of America Merrill Lynch Barclays US Corporate investment- 9% of studies. notes, ESG appears to isolate non- grade index. Furthermore, it found fundamental attributes that have real that introducing ESG factors into the This highlights the opportunity for earnings impact: these attributes have investment process of a corporate engagement and active ownership, been a better signal of future earnings bond portfolio generated a small whereby asset owners and managers volatility than any other measure we but steady performance benefit.

7 '1 aim to incentivise the adoption of have found.. 1. 2. 3. 4. 5. 6. 7. SSGA, ESG Institutional Investor Survey, 2017. 2. 2018 The case for ESG. Lower volatility is in the interest the consideration of ESG issues companies can certainly be of long-term investors. This might that, it states, can help improve excluded with very little likely seem counterintuitive after the financial and non-financial impact on a mainstream portfolio, all, with volatility comes the performance of companies. such as pure-play' coal miners. potential for gains, not just losses. Others can be excluded in the However, this ignores second- ESG FOR INDEX INVESTORS event that proactive engagement order effects, particularly the Broadly speaking, there are three does not result in positive change. phenomenon of volatility drag' ways in which long-term investors (also known as variance drain,' a can implement ESG criteria within The increased scrutiny of ESG. form of sequence risk). a global index portfolio: data as part of these steps can also incentivise companies to For example, a loss of 10% in one Tilts: This means constructing manage and report their impacts year is not cancelled out by a gain an index of a broad universe of better, focusing on sustainability of 10% in the following year: if companies (such as the FTSE and reliable returns.)

8 The market you start with 1000, you end up All World) that overweights can exhibit reflexivity,11 whereby with 990. If the gains and losses and underweights companies there is a self-sustaining cycle that fluctuate by 50%, you end up according to their performance penalises the worst offenders and with 750. on specific criteria. The main rewards the best performers. advantage of this strategy is that These beneficial effects potentially it retains very similar return and LGIM'S APPROACH. enhanced returns and lower offers diversification, but can At LGIM, we seek to combine the volatility are in line with the also reduce exposure to certain benefits of the ESG tools at the fiduciary duty of pension scheme ESG risks and capture ESG disposal of index investors to trustees. opportunities. provide portfolios with risk/return profiles that are very similar to the Indeed, in 2014, the Law Engagement: By engaging with broader indices, while aiming to Commission stated that, Where companies, investors are able make a significant market impact.

9 You think environmental, social to communicate their interests and governance (ESG) factors are and expectations, in order to find The use of a tilt allows a diversified financially significant, you should grounds for mutual benefit. This portfolio to implement a consistent take these into account. 8 More entails meeting with company approach to incentivising and recently, in December 2017, the boards and other stakeholders, disincentivising companies in their government noted that meeting and voting at shareholder ESG behaviours. Even though we schemes' central purpose of meetings. According to a study have a large in-house engagement maximising retirement savings and from the London School of team, it is impossible to apply investing for positive social change Economics, a firm's returns were the same methodologies of ESG. should go hand-in-hand. 9 about 2% higher following an standards across thousands of initial ESG engagement and 7% securities. Our model thus allows Moreover, under the EU's higher following a successful us to create a level playing field Shareholders' Rights Directive, ESG with the right incentive structures.

10 Institutional investors and asset managers are required to be Exclusion: While blanket It is essential that companies transparent about how they invest divestment from companies understand how they are and engage with the investee and sectors can be a risky being incentivised or penalised. companies. Through increased strategy, since it results in a more Accordingly, we seek to disclose the transparency requirements, the concentrated portfolio, limited methodology that tilts exposures, directive encourages the adoption exclusion and the threat of allowing for open communication of a more long-term focus and it is still a potent tool. Some with investee companies. 8. 9. 10. Li et al, Active Ownership, Review of Financial Studies (RFS), Volume 28, Issue 12, pp. 3225-3268, 2015 (behind paywall). A presentation of the summary results is available here 11. George Soros - Fallibility, Reflexivity, and the Human Uncertainty Principle, Journal of Economic Methodology, January 13, 2014.