Sustainability is set to become the gold standard of investing
Sustainability is reshaping the ecosystem of capital markets and the behaviours of their participants. But that journey will be evolutionary. It requires mindset shifts as much as physical changes from the way investing has been done historically. Early progress, however, augers well for the future in spite of formidable obstacles.
These are among the key findings from the latest survey by KPMG and CREATE-Research, ‘Sustainable investing: fast forwarding its evolution’. It focuses on early adopters of sustainability, covering 30 institutional investors, pension consultants and long-only managers with combined AUM of $4.6trn (€4.2trn).
Their journey started with the exclusion of ‘sin’ stocks: shares in companies associated with activities deemed unethical, such as weapons, tobacco, fossil fuels, abuse of human rights and poor labour standards. Over time, it was recognised that exclusion reduced the scope for diversification. In any case, dumping ‘sin’ stocks yielded handsome profits to those who bought them, without hurting the ‘sinners’.
As a result, early adopters have augmented their approaches by integrating key sustainability features into their investment processes in what appears to be an evolutionary investment journey of ABC: avoid harm and mitigate ESG risks; benefit all stakeholders; and contribute solutions to societal problems. Sustainable investing thus covers approaches that variously come under the generic headings of ESG, responsible investing and impact investing.
In all cases, progress is driven by large institutional investors which are moving well beyond a green ‘do- gooder’ image, duly taking account of the multi-decade nature of their future liabilities.
They are seeking to future-proof their portfolios against hard-to-model risks that are inherent in secular forces – like global warming, governance lapses, raging inequalities – that can pose existential threats to investee companies.
As a result, such investors are increasingly embedding sustainability into the DNA of their own organisation and enjoining their asset managers to do the same in the emerging model of sustainability that focuses on several critical areas and their interlinkages (figure 1).
The implied model sees capital markets as a bridgehead to a more purposeful capitalism that delivers businesses of enduring value for their four key stakeholder groups – shareholders, employees, customers and wider society.
At this early stage, the scenario also envisages sustainability as an evolutionary journey of experiential learning where ideas beget ideas. It enjoins business leaders at asset management firms to set the ‘tone from the top’ by:
• Creating a culture and belief that sustainability is not just another fad, but a sea-change in the way investing is to be done;
• Harnessing the collective memory of the business through joined-up thinking between the investment team and the stewardship team;
• Ensuring that their portfolio managers and research analysts develop the requisite expertise into the dynamics of sustainability factors;
• Encouraging regular engagement with investee companies, setting realistic expectations and monitoring progress regularly.
These requirements affect on all vital activities in the investment value chain. So the process is necessarily evolutionary. But that is not all.
More haste, less speed
Capital markets are slow to price in sustainability risks. Our survey uncovers two inherent forces that are slowing down progress. Each is expected to weaken over time, as ever more investors switch from the old ways of investing that solely targeted financial returns.
Case study: an owner, not a trader
Engagement is not a ‘once and done’ exercise but a long haul. It seeks to wean investors off a deeply ingrained addiction to quarterly numbers.
Our research shows that, on a five-year view, companies with poor sustainability scores have higher idiosyncratic risks and higher beta. We have such companies in our portfolio.
That leaves us with two choices. One is to dump them. The other is to encourage them to up their game. We have done both.
Principally, we require them to use the reporting framework of the Task Force on Climate-related Financial Disclosures (TCFD), with a strong focus on carbon footprint and actions taken to reduce it.
We also demand regular reporting on governance aspects such as board independence, executive compensation, risk dashboard, employment practices, gender diversity and community-related activities.
We vote at AGMs and back that up with year-round conversations with top executives to deepen our relationships in the targeted companies. In 2019, we engaged with over 800 major companies, via face-to-face meetings, conference calls and emails.
We enhance our leverage by subscribing to the UK Stewardship Code, the Japanese Stewardship Code, the US Forum for Sustainable and Responsible Investment, the Carbon Disclosure Project, the Sustainability Accounting Standards Board, and Climate Action 100+.
The UK Stewardship Code, hailed as one of the best globally, is being refined this year. The previous one asked for policies, procedures and basic disclosures from institutional investors.
In contrast, the new one requires evidence-based disclosures from us as to how these policies are implemented on the ground.
More notably, it also enjoins our board and c-suite executives to receive and approve the stewardship reports and put their money where their mouth is. The new code has thus shifted the burden of proof to us by mandating us as the agents of change.
1. Steep learning curve of data.
Currently, investors are enjoined to climb a steep learning curve because of a lack of the requisite data on three foundational concepts in sustainable investing – materiality, intentionality and additionality.
Respectively, they seek to assess:
• How material various sustainability factors are to a company’s financial performance?
• Does the company intend to act on them and ‘do good’ via its products, services and interactions with wider society?
• Does it generate societal benefits in addition to financial benefits?
For asset managers, while their sustainability policies are evolving rapidly, the requisite infrastructure of data, skills and technology has yet to catch up. Hopes have run ahead of expectations.
The problem is exacerbated by the fact that there are no generally agreed guidelines on what constitutes a ‘good’ or ‘bad’ company. The result is two-fold: greenwashing, as asset managers repurpose their old funds with a sustainability label; or whitewashing, as investee companies overstate their green credentials. Both are widespread. Both are seen as the birth pangs of a new form of investing.
2. Quarterly capitalism. The second force slowing down progress is the rise of short-termism – especially over the past two decades – under the guise of ‘quarterly capitalism’. Under it, listed companies are incentivised on short-term profits at the expense of long-term growth.
Equity markets have, as a result, morphed from a source of raising investment capital for growing companies to a vehicle for cash distribution and balance sheet management; as shown by massive share buybacks on both sides of the Atlantic.
Markets are no longer effective conduits between savers planning for a decent retirement and borrowers deploying savings to create wealth, jobs, skills and innovation. For retail investors, the desire to chase the next rainbow remains ever strong.
Small steps to a giant leap
The challenges outlined above have intensified efforts to develop best practices that can put sustainability at the heart of investing (figure 1). Progress is evident in three areas.
1. Data: let a thousand flowers bloom. Different constituencies are being encouraged through concerted action to tackle what is now sustainability’s Achilles heel – the lack of a robust template with consistent definitions and reliable data on how companies score on various sustainability factors.
For investors, climate change is an inexact science. The task of establishing a direct line of sight between it and investment outcomes is fraught.
Both institutional investors and asset managers are collaborating with over 150 data vendors to up their game. They are also collaborating with non-for-profit institutions globally to develop methodologies on how to measure, report, benchmark and improve sustainability performance.
For their part, data vendors are experiencing rapid consolidation and innovation, as competition has intensified. Asset managers, too, are developing their own proprietary methodologies in order to gain an information edge on the mispricing of assets. Learning-by-doing remains a powerful tool of progress.
2. Engagement: the new alpha behind alpha. Best practice in sustainability involves enriching the current infrastructure of data, skills and technology with shareholder activism that targets real-world outcomes at scale. Its principal tool is direct engagement between asset managers and their investee companies under the more muscular model of ‘Activism 2.0’.
It rests on the belief that sustainability only works if company boards are not only called to account but also held accountable. It directs asset managers to:
• Create an agenda for change and acceptable standards that are consistent with its delivery;
• Engage in proxy voting to ensure that investors’ voices are heard on board-level deliberations;
• Foster year-round dialogue with investee companies beyond shareholder meetings.
The days of engagement as a box-ticking exercise are over. Asset managers are increasingly expected to act as agents of change by seeking progress in three related areas – communication, learning and internal politics (figure 2).
These approaches seek to promote new learning in the belief that ideas breed ideas and only improved collaboration could deliver the goals of all stakeholders. Indeed, some investors believe that engagement enables them to develop structural capital that offers an informational edge; the ever-deepening knowledge about how sustainability is being implemented via a positive feedback loop.
Indeed, as they have moved up the learning curve, asset managers have realised the power of engagement – often in collaboration with other investors within global advocacy groups like Climate Action 100+ which has lately scored notable successes with some energy giants on their carbon emissions.
A more pragmatic approach to engagement is coming into view. Under it, if engagement does not work, asset managers now resort to the nuclear option: divestment.
Early adopters see sustainable investing as serving their own long-term enlightened self-interest as much as those of wider society.
Sustainability is set to morph into the new gold standard, as our societies seek to overcome the side effects of the turbo-charged capitalism of the past 40 years.
Progress so far confirms that sustainability is a series of small steps will add up to a giant leap by the end of this decade.
Amin Rajan is CEO of CREATE-Research and Anthony Cowell is partner and head of asset management for KPMG in the Cayman Islands
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