ESG: The missing dimension in risk management
Embedding ESG into the investment process will be in the long-term financial best interest of beneficiaries
ESG is on everybody’s lips these days but there are still no generally accepted standards as to what it really entails – or even what it means. Moreover, today’s investment management norms in a benchmark-focused world still materially constrain ESG actions.
There is a debate on exclusion versus engagement, and that is good. But the discussion, in my view, is still far too narrow. It is fair enough to acknowledge that exclusion means no longer having a voice at the table but, on the other hand, engagement without the potential to vote with one’s feet may have limited impact.
And the conversation is all about the UN Sustainable Development Goals, carbon footprint, ethics, or some other desired social outcome. A proper discussion on the risk management implications of ESG is missing.
Our view of portfolio risk is far too narrow. Volatility is seen as the key measure, and volatility is, by its nature, historical and backward-looking. Our thinking is dominated by market benchmarks, with the result that we worry as much about what we don’t own as about what we do own, a rather perverse result.
Asset owners spend most of their time thinking about the risk of their portfolio of managers to their strategic market benchmark (those risks are small), and only intermittently, typically every few years, do they consider the risks from their strategic benchmark to the liabilities that they seek to meet (those risks are large).
If, instead, we make our prime benchmark the return we need to meet our liabilities – a real return goal for a foundation or a funding ratio for a pension fund – we open up a wholly different dimension. I am not arguing for the abandonment of market benchmarks; I am suggesting that they should take second place to a real world outcome benchmark. We should always look at market benchmarks to answer the question as to how well we exploited the opportunity set in a given period, but that is secondary to whether we are meeting our return goals.
Risk takes on a different dimension in a real-return world. First, we spend our time concentrating on what we do own, rather than what we don’t, and second, we can think of risk in a very different, forward-looking way. Tobacco is a good example.
- There is too much focus on market risk and benchmarks, at the expense of real world outcomes
- Risk should be viewed more holistically
- Embedding ESG considerations in investment processes will be in the long-term interests of beneficiaries
Before investing in a company or sector, it is reasonable to ask whether the enterprise has a legitimate long-term franchise. Many would say that tobacco fails this test. The health consequences for its customers, issues over labour standards, and the overall costs to society all bring into question the legitimacy of tobacco companies. In fact, at over $1trn (€900bn) per year, some argue that smoking is the number one cost to society.
It is entirely plausible to argue that, ultimately, tobacco companies will have to meet the cost of the negative externalities they create, and that they will be taxed and regulated out of business.
What we don’t know is how quickly this might happen. But if we are the long-term investors we are encouraged to be, not investing in tobacco can be seen as a risk-management decision and not, as in the past, an ethical one. To date, over 100 organisations representing over $9trn in assets have signed a tobacco-free pledge.
Maastricht University School of Business and Economics explored this idea in an interesting piece of research. It examines several plausible scenarios for the tobacco industry.
The results of the study are unambiguous. The researchers find “a continuous decline in the market capitalisation of tobacco firms in the long run” is probable. Arguably, this is already borne out with the tobacco sector dropping 41% last year. The research was prepared for Tobacco Free Portfolios, a non-governmental organisation encouraging tobacco-free investment.
This kind of argument adds the distinct dimension of risk management to the ESG discussion. It is sometimes argued that trustees cannot exclude tobacco companies (or any other group) because their primary duty is to invest pension scheme assets in the best financial interests of members and beneficiaries, where financial interests are deemed to be risk-adjusted returns.
“Just as it would be foolhardy in the extreme to try driving a car by looking in the rear-view mirror, so investors need to look forward and try to anticipate change”
This argument is fundamentally flawed for two reasons. First, in the UK, non-financial interests can be taken into account where the financial impact is not significant, and where most members would be likely to share trustees’ view on ESG. Ex-ante, it is not possible to say whether a tobacco-free benchmark would produce higher or lower returns than the broad market over a particular period.
What can be said is that the impact either way will be trivial compared with the impact of other decisions trustees take in terms of broad asset-allocation choices and the hedging of interest rate and inflation risk. It is also reasonable to assume that most scheme members, once familiarised with the impact of tobacco, would favour a tobacco-free approach on moral or ethical grounds.
However, I do argue that we should go further and embed plausible ESG outcomes into long-term expectations. I have used tobacco as an example but one could perhaps form similar views of the prospects for coal companies in a carbon-free world.
Asset owners are, or should be, well aware that they need to view risk in a much more comprehensive, integrated fashion. Casual inspection of broad market indices shows that their make up changes significantly over time as the leadership of industries and companies changes. In 1980, seven of the top 10 companies in the S&P 500 were oil or oil-related companies. Today’s top three S&P 500 constituents, Microsoft, Apple and Amazon, weren’t even in the index in 1980, and there is just one oil company – Exxon Mobil.
The world does not stand still. It changes and at an increasingly rapid pace. Just as it would be foolhardy in the extreme to try driving a car by looking in the rear-view mirror, so investors need to look forward and try to anticipate change. Critical to doing this is to be prepared to think long-term. Knowing that one will not be judged as an asset manager or asset owner by the results of the next three months, or even the next several years relative to a historic market benchmark, liberates the investment process and makes this possible.
It is encouraging to see both passive and active managers producing credible investment strategies and products that truly integrate ESG factors into the investment process. There is, however, still a long way to go before we see most assets invested managed in this way. As is usually the case, I suspect it will be the early movers who will benefit most. And the key reason will be that embedding ESG thinking into the investment process will not just be the right thing to do now and for future generations, but will also be seen to be in the long-term financial interests of asset owners and their beneficiaries.
Alan Brown is chairman of the board of trustees of CDP and a governor of the Wellcome Trust