ESG - Don't just use the rear view mirror

Rear view mirror

While it is important to understand a company’s past, it’s even more important to know where it is going.

No 'Perfect' company

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. This is just as important in the realm of ESG as it is for any other earnings driver.

This is why a forward-looking approach to ESG analysis is incorporated in the MCA investment process when evaluating a company’s inclusion in our investment universe. This mindset has been integral for instance in our analysis of fossil fuel-exposed companies, and the impact of the financial services Royal Commission.

Past ≠ Future

We believe a reliance only on simple screening for evaluating ESG may put undue precedence on the past activities of a company, and penalise companies who are moving in the right direction.

Not only is current ESG disclosure imperfect, but current ratings systems are generally biased towards best-in class businesses, which tends to reward funds with explicit ESG objectives, while penalising those that take a more nuanced and engagement-oriented approach.

What’s more, they may not be sensitive to quality – for instance, that larger companies tend to report more voluminous ESG data simply because they have the resources to do so, and not necessarily because they are the most sustainable.

Looking at the road ahead

While it is important to understand a company’s past, it’s even more important to know where it is going.

As such, Martin Currie Australia’s investment process is focused on understanding the sum of its discounted future cash flows of a business (and how these are aligned with current valuations).

For us, ESG factors should be measured for in the same way, just like any other factor that could impact a company’s Quality and future earnings drivers.

ESG analysis also forms an integral part of our analyst’s mid-cycle normalised earnings forecasts used in our Valuations models.

For example, we care about the impact of a changing market structure or a new patent as much as the future implications for returns from a poor governance structure or a potential penalty for environmental non-compliance or employee safety.

Pace of change is integral

Regular direct engagement with company management and boards helps us to understand to what extent they have identified material ESG risks and how they are managing these so that they do not impact future earnings, and their plans for future improvements in this space.

If a company is not working to improve ESG outcomes, our Quality score would continue to fall reflecting a higher level of overall risk and this would be reflected in our portfolio construction process.

However, our approach means that we may invest in a company that optically may appear less impressive if you take an ESG snapshot versus peers, but that is nonetheless making speedy progress in the right direction.

Through our active ownership efforts, we seek to nudge companies along here, highlighting what we consider to be best practice and offering advice as to how they can get there. To this end we try to think more holistically when assessing a company and its long-term prospects.

Seeing the big picture

In this sense, by blindly excluding companies that have some ESG risks, based on simple quantitative measures such as percentage of current earnings, investors may ignore the strategic work by a company to address these risks.

For example, we are often asked why we don’t have a 100% exclusion of fossil fuels, and thus exclude companies such as AGL1 from our stock universe.

By contrast, we feel that we should be rewarding companies that are proactively moving in the right direction, and AGL is at the forefront of expanding renewable energy production in Australia.

Environment case study: Fossil fuel

Around 70% of AGL’s current electricity portfolio is currently coal generated.

However, around 20% of AGL’s portfolio is currently from renewable sources and the company has 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).

Our view is that the energy market is in transition from coal to gas and ultimately to renewables. While they are not there yet, AGL is making important steps towards a future where no coal is used for their power generation, and it is their future operations that are important to investment returns.

Lessons learned

Taking a pragmatic view, of course, is always important. For instance, the recent Financial Services Royal Commission has raised many questions from clients about the ethics and culture of Australian Banks and financial institutions.

Our approach at MCA is to actively engage with companies that have in this case negatively impacted their clients, the community or brand, and understand what lessons have been learned and actions been taken to restore their overall level of conduct.

It is clear to us after meetings with the banks that the issues published at the Royal Commission have, in many cases, occurred in the past. The banks have already been working with the regulators APRA and ASIC, to change behaviours, culture, governance and disclosures within their respective organisations.

What we can and do factor into our Valuation and Quality measures in situations like this are any future implications to earnings, for example, the cost of increased regulation, customer remediation, reputational damage or litigation.

Governance case study: The Royal Commission

It is apparent that the Royal Commission has uncovered numerous past examples of inadequate systems and in some cases poor corporate culture causing harm to the banks’ customers.

Already we have seen new management of CBA and AMP1 (and new Chair/ board members) dealing with the Royal Commission disclosures and we expect improved behaviours and governance to positively impact Australia’s financial companies going forward.

The importance of a forward-looking mindset

Investment analysis requires active and ongoing engagement with companies to understand how seriously ESG issues are been taken by board and management.

At Martin Currie, we integrate our forward-looking ESG analysis into our investment process and Valuations. We believe this is critical to our investment performance, as companies with strong ESG momentum and Quality scores will perform well against the broader market over the long term.

1 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.

Important information

Past performance is not a guide to future returns.
The information contained in this presentation has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. 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.
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.

Martin Currie has procured any research or analysis contained in this presentation for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given.