Putting theory into practice
Accessing the True Value of ESG
7 September 2018
ESG analysis must be embedded into the day-to-day work of the people who actually make the investment decisions
PUTTING THEORY INTO PRACTICE
Analysis of ESG cannot be done by half measures. To gain a full understanding of how sustainability factors can impact
a company’s future returns, they must be embedded throughout the entire investment process – from idea generation and stock research, to financial modelling and portfolio construction.
In our view, there are three core strands:
Recognising the ESG factors most material to a company’s business model.
Incorporating these factors into financial modelling, for a more complete image of the business’ stability.
3) Active Ownership
Developing strong relationships with companies to gain greater insight, and build conviction in
the sustainability of their business models, as well as engaging to improve ESG practices.
At the heart of each stage is Engagement. Led by our portfolio managers and analysts with day-to-day responsibility for
investment decisions, we engage through a range of interactions: one-to-one with individual firms; in collaboration with
other investors (through initiatives such as those run by the Principles for Responsible Investment [PRI]); with outside
bodies, including government departments or non-governmental organisations (NGOs); and with other relevant
Engagement underpins our approach to ESG analysis and allows us to turn the theory (discussed in our first paper)
into practice. Throughout this document, we refer to three companies which are prime examples of how active
engagement has helped us better understand whether performance is sustainable in the long term.
A UK-based specialty chemicals company, where sustainability and ESG are central to its
A leading Australian energy company, which generates electricity from both coal and renewable
A Peruvian financial services company, with a long history of sustainable growth, which has
addressed many ESG factors traditionally associated with emerging markets.
WHAT WE AIM TO UNDERSTAND – GOVERNANCE IS THE KEY
We consider the integration of ESG analysis into our
investment process as a fundamental part of our fiduciary
duty – protecting and advancing the economic interests of
our clients. Understanding the governance of the companies
we invest in is the starting point for this analysis. It provides
us with the context for how a company creates value and
helps us identify the ‘non-financial’, or more accurately, the
‘not-yet-financial’ factors that could impact its ability to
generate long-term sustainable returns. This focus on
governance finds validation in the International Corporate
Governance Network’s statement on how corporate
sustainability is best achieved:
‘Sustainability implies that the company must manage
effectively the governance, social and environmental aspects
of its activities as well as its financial operations. In doing so,
companies should aspire to meet the cost of capital invested
and generate a return over and above such capital. This is
achievable sustainably only if the focus on economic returns
and strategic planning includes the effective management of
company relationships with stakeholders such as employees,
suppliers, customers, local communities and the environment
as a whole.’
Our particular emphasis on governance therefore stems
from the belief that it is a fundamental determinant of longterm
performance. Problems here are more often than not
reflected in a company’s environmental and social track
record, making it a reliable proxy for wider sustainability. As
such, governance provides us with both an overview and a
framework for integrating ESG analysis into our investment
Back to summary
Targeting what matters most
The materiality of ESG factors is essential in our analysis. As we established in our first paper, research has shown
companies focusing on ESG factors most material to their business models tend to fare better than those adopting a
less targeted approach. A Harvard Business School research paper discovered that, over a 10-year period, investments
involving ‘high performance’ on material factors and ‘low performance’ on immaterial, produced greater alpha than all
other investments, including those scoring highly on both material and immaterial issues.1
1Khan, Mozaffar N., George Serafeim, and Aaron Yoon. ‘Corporate Sustainability: First Evidence on Materiality.’ Harvard Business School Working Paper, No. 15-073, March 2015.
When analysing materiality through the governance lens, we look to understand the mechanisms in place, how a
company allocates capital and creates value, and get a sense of the culture of the organisation. We want to gauge the
extent to which the board/management understands the potential material risks and opportunities presented by ESG
factors to a company's ability to generate long-term sustainable returns.
We recognise, however, that these ESG factors vary greatly by industry. As such, we have created bespoke research
frameworks, which help shape our conversations with company management and allow us to understand how they are
dealing with the environmental and social issues most material to their business. For each individual firm assessed, we
build into our research template the potential impact of material ESG risks and opportunities, assess how the company
is managing these, and identify areas for future engagement. This work is then added to by wider external research. In
the following case studies, we highlight how we have identified material ESG factors: Exhibits 1 and 2 demonstrate the
importance of balancing the risks and opportunities, while in Exhibit 3, we show how materiality is rarely static and
evolves over time.
EXHIBIT 1. CREDICORP – BANKS AND THE ‘SOCIAL LICENSE TO OPERATE’
A small percentage of Peru’s population controls much of the wealth,
while a large proportion are under-served (or non-served), in terms of
banking penetration. This presents an opportunity for Credicorp to
grow its customer base (over the last five years, more than 500,000
people have been bancarised by the company, receiving their first
ever loan through its subsidiary Mibanco.2)
2Credicorp annual report 2017.
There is an accompanying risk, in countries like Peru, of poorly
educated portions of the population being exploited by mis-selling
and inappropriate lending. As can be seen in the UK's scandal over
mis-sold payment protection insurance, society is no longer as likely
to tolerate unscrupulous behaviour from banks. Institutions need to
ensure they can retain their social license to operate – as well as avoid
This has been a particular area of engagement for us with Credicorp.
It has a programme to increase financial literacy among younger
people as they come into the formal workforce, as well as a talent
programme to train and develop the next wave of its banking staff and
leadership. The firm’s social agenda is not based purely on altruistic
intentions, but on the belief that it will enable sustainable and
profitable growth, creating more value for shareholders.
EXHIBIT 2. CRODA – IDENTIFYING THE OPPORTUNITIES (NOT JUST THE RISKS)
The UK-based company’s products often form critical components
to brands where sustainability is the key selling point. For instance,
companies including sustainability ‘superstars’ Unilever and L’Oreal
(both A rated by CDP, formerly the Carbon Disclosure Project) rely on Croda’s know-how to make their
end-product a success.
In our engagement, it has been evident that customers' desire for
sustainable produce is driving innovation. The most recent example
of this in the commissioning of Atlas Point, a US$170 million bioethanol
plant in the US. Its output will allow Croda’s customers to
stamp their products as ‘USDA Certified Bio-based’. This clears an
important obstacle to calling their products 100% renewable,
enabling them to achieve the so-called ‘green premium’, justifying
higher prices for eco-friendly products.
In addition, a significant issue for many personal-care companies
(about one-third of Croda’s business) is palm oil, because of the
environmental and social impacts it has on the ecosystems of the
countries where it is produced, such as Indonesia. Croda uses very
little palm oil, but is a significant buyer of palm-oil derivatives, such
as fatty acids and glycerine. The company is aware of its
responsibilities in this area – 12 of its 13 manufacturing sites already
have certification from the Roundtable on Sustainable Palm Oil
(RSPO), and while it has not yet achieved 100% RSPO accreditation,
it says addressing the issue is a priority.
EXHIBIT 3. AGL – ESG FACTORS AREN'T STATIC
This integrated power generator with exposure to coal, gas and
renewables has been held in some of our Australian investment
strategies for several years and its quality rating has remained fairly
constant. However, there has been considerable fluctuation over
that time in the relevance and materiality of various ESG factors.
There are clear environmental risks to consider, resulting from the
company’s coal exposure. In Australia (and globally), there has been
a shift in demand towards power production that is less harmful to
the environment. Around 70% of AGL’s portfolio is currently coal
generated, which includes two New South Wales Government coal
power stations, Bayswater and Liddell, acquired in 2014.
However, around 20% of AGL’s portfolio is from renewable sources
and the company has also announced its intention to move away
from coal – with a long-term plan to shut its coal-fired power
stations (in 2022, 2030 and 2048).
What has been clear in our engagement though is that, while the
facts over climate change have not changed, its materiality to AGL’s
business case has shifted in recent years. Dramatic rises in energy
prices (such as the sharp rise in the cost of electricity – see chart)
have led to public opinion veering away from greener energy in
favour of cutting the costs of powering people’s homes. Moreover, a
change of government has led to an increased threat of regulation
to keep prices low.
Australian electricity prices are on the rise
Source: Australia Bureau of Statistics.
Back to summary
Assessing the impact of ESG
With the material ESG factors identified, these are then integrated into fundamental stock analysis and the decisionmaking
process. The relevant factors are incorporated into extensive financial modelling, as we assess a range of probable
impacts on variables – such as the cost of capital, cash flow, revenue projections and capital expenditure.
Assessing the risks and opportunities from ESG factors helps us build a fuller picture of the company and how we
expect it to perform in the future. Exhibit 4, for example, shows how, given the likelihood of large rises in the carbon
price in the future, Croda’s commitment to sustainability could see a tangible benefit, while Exhibit 5 demonstrates the
less-obvious impacts of AGL’s policy to pull out of coal power. Ultimately, we are looking for signs a firm can continue
on a path of sustainable growth and that its business model is not at risk from exogenous shocks arising from
governance structures or mismanagement of stakeholder risks. Exhibit 6 shows some of the evidence we seek from
companies, to show they are taking ESG factors into account.
EXHIBIT 4. CRODA – CALCULATING THE ESG PREMIUM
Croda views its sustainability programmes as helping
customers manage their risk in terms of achieving their own
sustainability objectives – an insurance policy with a hard-toquantify
That said, although classed as a specialty chemicals firm, its
predominant use of lanolin (wool grease), rather than
‘cracking’ hydrocarbons, in manufacturing, gives it an
advantage over other businesses in the same sector.
A greater proportion of Croda’s raw materials come from
renewable sources – around 60%, compared with less than
16% among its main competitors, which have their roots in
the carbon economy of the 19th and 20th centuries.
This renewables mix will be a major source of differentiation
for the company, especially with the carbon price predicted
to rise swiftly in the future. Indeed, the EU carbon price has
risen to more than four times that amount – from a very low
€4.39 (around US$5) per tonne – between May 2017 and
August 20183. Looking ahead, the High-Level Commission on
Carbon Prices has said the explicit global price level needs
to be at least US$40–80 per tonne by 2020, and US$50–100
per tonne by 2030, in order to achieve current
3Source: EU Allowance carbon price. Sandbag Climate Campaign CIC, under a Creative Commons Attribution Licence (CC BY 2.0 UK).
4Source: Carbon Pricing Leadership Coalition, May 2017.
EXHIBIT 5. AGL – ACCOUNTING FOR UNINTENDED CONSEQUENCES
AGL flagging its intentions to exit coal by 2050 is beneficial
to the environment, but could have other knock-on effects
for the company. Announcing the closure of its coal assets
so far in advance has allowed competitors to speculatively
build renewable energy capacity and solar plants, raising
the question of whether AGL has yielded some competitive
advantage to its peers by encouraging others to build
renewable energy. We have engaged with the company's
management on this area, who recognise that, in hindsight,
this strategic shift could have been managed differently.
As the market moves towards more renewable energy we have also adjusted how we model the future, as an overbuild of renewable energy plants would see marginal power prices fall to zero if there is an over-supply of power. In addition, the risk to reliability of supply (for example from periods of low wind speeds) is encouraging investment in batteries or gas as a backup. These are areas of future engagement.
EXHIBIT 6. CREDICORP – KEEPING A CLOSE EYE ON LENDING DECISIONS
Around 55–60% of Credicorp’s balance sheet still comes from corporate lending. Peru’s resource-intensive economy is dominated by minerals and mining and, in such an environment, there is a great deal of scrutiny on banks’ corporate lending decisions. Financial institutions globally are increasingly being held to a greater level of responsibility for these decisions. As a result, we expect to see evidence that banks are cognisant of the implicit and explicit risks associated with their roles in financing large projects or direct capital investment in businesses which impact local communities and the environment. These include the effects of mining operations on water resources, a project’s impact on the local habitat and biodiversity, or the social consequences of health & safety considerations for employees.
As a result of our engagement over the years, we have seen increased disclosure in these areas, and evidence that the company is not just aware of these issues, but making some headway in addressing them. Measures include: reporting annually on greenhouse-gas emissions, designing and implementing systems to monitor direct & indirect environmental risks generated by its operations, and measuring its carbon footprint through independent consultants.
Financial institutions globally are
increasingly being held to a greater
level of responsibility for [lending]
Back to summary
Seeing the bigger picture
1) Developing strong relationships
As we referenced earlier, a fundamental tenet of unlocking the value of ESG analysis is that it must be embedded into the day-to-day work of the people who actually make the investment decisions, rather than delegated to a separate team, one step removed from the process. Our analysts incorporate ESG factors into their research & scrutiny of companies to delve deeper and build conviction in each investment case.
Active ownership is vital to this process. By developing strong relationships with companies, we are able to encourage greater transparency, ask more insightful questions and ultimately, gain greater insight into the company's governance – and by extension the sustainability of the business model. Credicorp is a good example here. A lengthy holding period in our Emerging Markets strategy has enabled a consistency of dialogue and allowed us to work with officials who have graduated to more senior positions in the group (for example, the former Head of Retail, who is now the Deputy Chief Executive). As a result, we can be confident that, while ours will not be the sole voice on engagement issues, it will be among those which resonates most.
Crucially, active ownership allows us to be more forward-looking and make qualitative assessments of vital governance factors – such as culture or quality of management. Our conviction will also be significantly influenced by non-quantifiable issues – for example, our impression of the people at the helm, whether we feel they exhibit integrity, transparency, and a genuine understanding of many factors that will determine the sustainability of their business.
By contrast, a purely quantitative approach, relying too heavily on ESG metrics and disclosures, is inherently backward looking. Strategies that do this may be unable to take into account ESG risks which take time to rise to the surface. We believe active ownership is vital for highlighting potential problems (and opportunities) at a much earlier stage.
2) GETTING IT RIGHT – NOT JUST 'RIGHT NOW’
We recognise there is no 'perfect company'. From an investment perspective, the pace of positive change is often more important than a company’s precise starting point. As discussed in our previous paper, there is an academic grounding for this, as higher rates of improvement in ESG characteristics (‘momentum’) have been found to be an important indicator of improved financial performance – leading to increasing valuations.5 Management teams that are committed to improvement, transparent about where ESG issues fit into a broad vision and demonstrate a move towards best practice, typically indicate a sound long-term investment.
5“Can ESG Add Alpha? An Analysis of ESG Tilt and Momentum Strategies”, Zoltan Nagy, Altaf Kassam and Linda-Eling Lee, Journal of Investing, Vol. 25, No. 2, Copyright © Institutional Investor Journals.
Context matters, and this means being sensitive to local regulations and levels of corporate maturity when gauging a company’s relative performance on ESG metrics. Our framework for corporate governance reflects this, looking at broad-based principles, rather than a single set of global standards. An overly rigid approach might well result in avoiding companies which are actually the best governed among regional peers. By contrast, as we demonstrate in Exhibit 7, engagement allows us to take a more nuanced view.
Context matters, and this means being sensitive to local regulations and levels of corporate maturity when gauging a company’s relative performance on ESG metrics.
Proxy voting is a core element of our approach to active ownership. Our analysis and engagement informs how we vote, but our focus is always on our clients' best interests, and promoting the long-term sustainability of the business concerned. This requires integrity and objectivity, at times differing from the consensus view, going against management (and indeed supporting them) if we believe this is needed to ensure future sustainable growth of a company. Proxy voting is a powerful tool for active investors, as is demonstrated by the action taken regarding AGL in Exhibit 8. By steering companies in the right direction, we aim to ultimately improve corporate practice.
EXHIBIT 7. CREDICORP – EVERY CASE IS
The Romero family has been involved with the bank
for a century and still has a significant stake, with
members of the family having served in various
management roles. Until recently Dionisio Romero,
was joint chairman and chief executive, which would
generally be considered a corporate governance flag.
On the face of it, governance arrangements such as
these, which are not optimal, might not pass an ESG
screen. However, our focus has been on whether the
structure has resulted in any inappropriate behaviour,
or whether there are any obvious family conflicts of
interest which could pose a risk to minority
shareholders. With Credicorp, on investigation we
found no indication of activity historically where
minority investors were being exploited, or our clients'
interests mispresented by the firm's governance
In fact, the roles have now been separated, with
Walter Bayly (formerly Chief Executive of a Credicorp
subsidiary) the new chief executive, while Romero
remains as chairman. This highlights both a maturing
approach to governance and sustainability, and the
benefit to us as investors of allowing things to evolve.
EXHIBIT 5. AGL – MAKING OUR VOICE
The ‘two-strikes’ law on remuneration in Australia is
designed to hold directors accountable for executive
salaries and bonuses. It means an entire company
board can face re-election if shareholders disagree
over how much executives are to be paid.
AGL was hit by its first ‘strike’ at its AGM in 2016, over
the chief executive Andy Veysey’s A$6.9 million salary.
We were among the shareholders who voted against
the company’s remuneration report as we were
unhappy with both the level and some of the
underlying metrics it was based on. What has been
significant for us is how the company has approached
the issue in our engagement since then. Management
has made it clear it is conscious of the issue and that
remuneration of any new chief executive is likely to be
3) EFFECTING POSITIVE CHANGE
Finally, active ownership is also a key means of influencing positive change. Through engagement and voting we can work to improve governance behaviours among investee companies, enhance disclosure on how firms are approaching material ESG issues, and share best practice we see at other companies. We engage with companies on a regular basis, and look to understand how the business is evolving, how it is impacted by changes in the external environment and, where we identify potential shortcomings, try to nudge them in the right direction.
This is only possible because ESG analysis is embedded fully in the lifecyle of the investment case. Importantly, we are, in many cases, able to take on the role of ‘trusted advisor’, rather than simply a shareholder, offering ESG-related guidance. Increasingly we are noticing this is not a one-way street; given our strong interest and experience in this area, and we are often approached by the companies who we engage with. Most recently, our engagement with Credicorp has benefited from our wider collaborative engagement, as part of a PRI initiative on cybersecurity. The wider engagement has helped in two ways: in terms of us assessing the financial institution's cybersecurity measures (an issue of increasing importance in modern society); and in helping the business improve its disclosure on the subject and develop a greater understanding of investors expectations.
There is growing evidence that companies taking material sustainability factors seriously, perform better than those that don’t. However, taking a best-in-class approach is not necessarily the wisest path for investors. We place the emphasis on positive ESG change, and believe that active ownership is a key tool with which we can help drive this. Critically, we believe ownership of the ESG analysis and engagement should sit with the analysts and portfolio managers themselves, rather than being managed by a separate team. This ensures that material sustainability factors are integral parts of the conviction-building process and inform our engagement, both before and after a decision to invest has been made. When we talk about full integration, this is what we mean.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
Past performance is not a guide to future returns.
Market and currency movements may cause the capital
value of shares, and the income from them, to fall as well
as rise and you may get back less than you invested.