Governance and sustainability 2017 outlook

Last year saw a number of very significant global developments on the sustainability front, including the speedy ratification of the Paris Agreement on climate change and beefed-up environmental policies in China. Our governance and sustainability (G&S) activities have kept a strong momentum too, with a busy engagement schedule and continued refinement of our integration – efforts that are being acknowledged externally. There is no shortage of issues to analyse and engage companies on going into 2017, whether it be climate change, diversity, cyber security or executive pay. As always, materiality will be the yardstick when deciding where to spend our time and energy.

13 January 2017

Why is governance and sustainability relevant?

We believe environmental, social and governance (ESG) factors are fundamentally intertwined with long-term business performance and, by extension, risk-adjusted returns to investors. Indeed, the academic research is pretty unambiguous about this link, particularly when gauged through the lens of materiality and over a sufficiently long time horizon. In the past there has been a significant emphasis on the riskmanagement aspect of ESG – with good reason, given the number of high-profile cases where poor performance on this front has hurt shareholders. However, we believe an equal weighting should be placed on the opportunity side of the equation. Companies that fully embrace sustainability – aligning their businesses with best practice – are, among other things, likely to enjoy better customer loyalty and pricing power, which ultimately translates into a healthier bottom line and cash flows. In other words, it is a source of competitive strength and, in our view, therefore has to feature in the assessment of a company’s prospects.

What makes our offering distinctive?

Governance and sustainability is embedded across our business, with strong support from the board, CEO and CIO. Contrary to many of our competitors, we believe this process should be fully owned by the analysts and portfolio managers – that is, the people who know the companies best. This includes both the initial analysis and the ongoing stewardship that follows a decision to invest. Where we have identified material issues we will feed these into our modelling work, with effects on variables such as turnover, costs and the cost of capital. As Head of Governance and Sustainability, my role is not to dictate research agendas but to provide oversight and assistance, ensuring that the investment teams have access to the best information and focus on the most material issues.

Active ownership, or stewardship, is a critical aspect of our investment philosophy at Martin Currie. Targeted engagement on ESG issues forms part of our stewardship activities and underpins our ongoing dialogue with companies. Actively making voting decisions is another central strand of this. The engagement agenda is prioritised based on our assessment of the significance of the issues facing a company: the risks to our clients; the size of our holding; the potential to effect change; and opportunities to collaborate. Our preference is to engage privately, but we will join up with other investors when we see opportunity for change, aligned interests and a clear purpose. Importantly, engagement is not a one-way process and it has been encouraging to see companies approach us for feedback – particularly with regards to governance – on how to improve their performance.

What were the key developments in 2016?

There were a couple of very consequential developments worth highlighting, one being the ratification of the Paris Agreement on climate change on 4 October – much faster than many observers had anticipated. Although the jury may still be out on the ultimate aggressiveness of emission cuts, this clearly signalled momentum behind the critical long-term decarbonisation of the global economy. This was of course followed by the US election, the outcome of which defied expectations and potentially puts important issues in play including inequality, tax reform, healthcare affordability and the move towards clean energy. While it is too early to tell, the long-term course and timing of ESG-relevant policies could thus be materially altered under Donald Trump, both domestically and internationally.

Looking eastward, China released its draft 13th five-year plan covering the period 2016–20. Without a doubt, the highlight is the plan’s treatment of the environment, which is the subject of 16 of the 33 targets set. All 16 are mandatory, putting pressure on central and local officials to reduce energy usage, protect land, improve waterway sand reduce air pollution. China also is taking steps to develop carbon and pollution markets, with regional pilot projects under way and a national emissions trading system planned for 2017. Continued government-led efforts will have widespread implications for industries throughout China and this is something we will continue to watch closely.

For Martin Currie specifically, there were a couple of ESG-related developments worth noting too. As signatories to the Principles for Responsible Investment (PRI), we have committed to report on our activities in relation to responsible investing each year and in 2016 we were awarded an ‘A+’ (the highest performance band) for our Governance and Sustainability strategy. Notably, less than 20% of the 1,061 PRI signatories achieved ‘A+’ in the strategy and governance module – an extremely encouraging result from which we can continue to build on our capabilities and expertise. Meanwhile, in the UK the Financial Reporting Council (FRC) began a tiering exercise with regards to signatories to its Stewardship Code. Following this assessment Martin Currie was placed in the highest category, Tier 1, joining approximately 120 of the 300 signatories in this group – another acknowledgement of our stewardship efforts.

Can you outline a few sustainability themes that you are focused on?

We have made significant strides with regards to ESG over the years, but even so, integration is a dynamic process that requires continuous refinement. The overarching goal is to ensure that our sustainability analysis adds as much value as possible to our fundamental research. The quality of company disclosure is naturally key, and here we observe ongoing improvements across markets both due to regulation and shareholder pressure. For instance, listed companies in Hong Kong and Singapore face enhanced ESG reporting requirements under a ’comply or explain’ framework, with Singapore recently becoming the latest member of the United Nations Sustainable Stock Exchanges Initiative. The following are a number of important areas where our G&S work is ongoing:

Diversity has become an increasing focus for investors over the last couple of years with a recognition that a breadth of experience and perspective can bring real benefits to the corporate board and more widely within organisations.

Climate change

Climate change As alluded to, climate change continues to loom large and although there is lingering uncertainty as to what the incoming US president will do here, the long-term trajectory of the global energy mix is clearly not one where fossil fuels can maintain their historic prominence. As seen with the strong support for climaterelated proposals at annual general meetings in recent years, we expect to see continued pressure on businesses – particularly in the energy sector – to prove that they can handle a scenario of more stringent regulation and/or sped-up demand destruction, due to the rapidly improving economics of renewable energy, battery storage and electric vehicles (EV). Indeed, we see companies continuing to shift their focus from the operational ramifications of climate change legislation to thinking very seriously about the strategic consequences for their businesses. When it comes to EV penetration it is difficult to make exact forecasts but it is evident that lithium battery costs have dropped to such a degree that we may be getting close to an inflection point, with long-term implications for oil demand.

Water scarcity

Water scarcityWater scarcity is an area connected to climate change, with the supply/demand imbalance set to get worse over the coming decades. Key long-term drivers such as population growth, urbanisation, rising living standards, infrastructure deficits, changing weather patterns and regulation will continue to gather momentum in the years ahead. At the same time, water quality and safety remains under constant threat of pollution from many sources. Indeed, the previously mentioned Chinese five-year plan underscores the country’s commitment to tackle the issue of severe water pollution. The Indian government has also implemented an ambitious infrastructure development and water treatment plan. Companies increasingly recognise the seriousness of the issue, and for us it is manifesting itself in continued engagement efforts, including a PRI collaborative effort on water usage in the agricultural supply chain.

Cyber security

Cyber securityCyber security is another key subject our investment teams are exploring. Big data and increasing digital interconnectivity is having a dramatic impact on socioeconomic structures but also exposing many aspects of business to increased risks. Cyber security has been hitting the headlines over the last couple of years and is an increasingly important consideration for company boards. Recognising this growing risk we have joined the steering committee of the PRI collaborative engagement on cyber security. This committee aims to set the terms of engagement, as well as the particular areas of focus and identify target companies. Our internal work has involved narrowing down a number of key questions to ask our investee companies, focusing on board awareness and accountability, prevention and mitigation of attacks.

Diversity

Diversity Diversity has become an increasing focus for investors over the last couple of years with a recognition that a breadth of experience and perspective can bring real benefits to the corporate board and more widely within organisations. We believe that this ties into our focus on governance and culture and plays a key role in how a company is managed. Diversity is most readily articulated through gender diversity but is increasingly demonstrated through a broader skills matrix at board level. Shareholders are placing a greater emphasis on the need for a balanced mix of expertise, experience and skill-sets, as evidenced by an increasing number of diversityrelated proposals put forward to shareholder meetings. Regulators have also been indicating a desire to see improved disclosure in this area, particularly when it comes to board composition. For example, US Securities and Exchange Commission (SEC) chair Mary Jo White, stated in June 2016 that low levels of board diversity in the US is unacceptable and that the SEC is considering introducing requirements for greater disclosure on this issue.

Executive pay

Executive pay Finally, executive pay has remained high on the agenda over the last year, and as we go into 2017 there is no letup in the debate around this issue. In 2016, two FTSE 100 companies had their remuneration reports voted down, one of Australia’s largest banks withdrew the incentive grant to the CEO after a shareholder revolt and other companies across the world received very significant negative votes over a range of pay issues. In summer 2016, the UK Executive Remuneration Working Group (an independent panel set up to address the concern that executive remuneration has become too complex and is not fit for purpose) produced its recommendations for improvement. These included a call for boards to explain the reasons behind their company’s maximum pay level and greater transparency around target setting for bonuses. Pay has been a key area for our company engagement and we are pleased to report success in a number of cases – it is certain to remain on the agenda for us in 2017 too.

What is coming onto the G&S radar for 2017?

As mentioned, we will watch developments in the US closely as these will be of both domestic and international consequence. While the contours of Trump’s policy agenda are slowly emerging, there is still significant uncertainty as to his ultimate approach in many areas – climate change and energy being particularly hard to call given his many contradictory remarks here. Beyond this, we are likely to spend more research effort around major issues such as food safety and corporate governance reform. The importance of the former cannot be overstated, with the World Health Organisation having warned that antibiotic resistance is one of the biggest threats to global health today. Worryingly, an expanding list of infections, including pneumonia, tuberculosis and blood poisoning are becoming increasingly difficult and sometimes impossible to treat.

While the contours of Trump’s policy agenda are slowly emerging, there is still significant uncertainty as to his ultimate approach in many areas – climate change and energy being particularly hard to call given his many contradictory remarks here.

The overuse of antibiotics in agriculture is widely recognised as a contributing factor to this crisis. As investors we need to understand the attendant systemic risk affecting the food, farming and pharmaceutical industries. As for corporate governance, we expect to see greater government-led efforts – particularly in the UK where proposals are currently out for consultation – spanning topics such executive pay, directors’ duties and board composition. The outcomes of some of these initiatives are likely to inform some of our company engagement in 2017.

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