ESG: What lies beneath?

10 Sep 2018

Finding an investment that you believe could help build a better world is one thing; assessing if it is achieving its targets is a tougher prospect. Mark Dunne looks at how investors are deciding if managers at ESG-stocks are walking the walk or just talking the talk

There are times when if you want to get more out of something, you have to put more of yourself into it. This is especially true for those putting environmental, social and governance (ESG) factors at the heart of their investment decisions.

This is not a strategy for investors who want an easier life. Unlike those who just want to make an adequate return for the risks taken, measuring the success of an ESG-led investment is not as straightforward, the motivations of which stretch beyond the balance sheet.

It could be that you want to abolish child labour, improve diversity in boardrooms, conserve water or reduce harmful gas emissions. One route to achieving these goals is to invest in the offending companies and then use the influence shareholders have to push for change.

It is a popular strategy for those wanting to improve the world while growing their wealth, but a lack of credible data makes it hard to know if this approach is working. It is rarely as straightforward as talking to senior management to decide if what is written in the annual report is a fair reflection of the financial health of a company.

Investors and those managing ESG or sustainable portfolios may have to do the legwork themselves if they want to know whether children are still working on production lines or if a company’s carbon footprint has shrank by as much as management say it has.

This could be time consuming and expensive, making it difficult to know if capital is making the impact that was intended. This lack of credible data could be a problem in an industry where results have to be measured and benchmarked to attract more investment.

“This is an important topic,” says Rob Stewart, head of responsible investment at Newton Investment Management. And it is likely to grow in importance, adds John Streur, chief executive and president of responsible investor Calvert Research and Management. “Reporting on the impact that any investment portfolio has on the environment, individuals and society is the next major step in the ongoing evolution of environmental, social and governance investing,” he said.

Water management, climate change and health and safety do not usually feature in the financial analysis of a company yet they carry material risks. Part of the sales pitch of those managing ESG or sustainable funds is that such strategies could protect investors from litigation, changing weather patterns and a scarcity of natural resources.

This message could be helping to fuel the growing appetite for this market. There was $22.9trn (£17.6trn) under management in responsible investment funds in 2016, which was 25% more than there was in 2014, Global Sustainable Investment Alliance says.

A look at these figures shows that ESG is no longer a niche industry. Whether it is called ESG, sustainable, ethical or responsible investing, it is maturing and the need for credible, easy to obtain data is a must to attract more institutional capital. “As investors see the ESG risks and impacts of their portfolios quantified, they will see material differences between high-quality ESG portfolios and those managed without ESG or with weak ESG inputs,” Streur says.


Companies are trying to help investors in this area by publishing sustainability reports. However, Mette Charles of Aon’s manager research team for responsible investment treads carefully here. She points out that these reports are not always audited.

Newton is equally cautious. It prefers to check the accuracy of the non-financial metrics reported by company boards, as it does not like surprises. “We do not invest in a company until we have done some research on its ESG factors,” Stewart says. “So companies where we see significant, un-resolvable ESG risks do not make it to our portfolios.”

Independently-audited data is not available for every topic in the ESG arena, so Newton sometimes turns to other organisations to help build an accurate picture of what is going on. “We don’t like asking companies to reinvent the wheel, or having to search for relevant data ourselves,” Stewart adds. Bodies certifying the sustainability of palm oil are just one example of the help available. “That would be the starting point for this concept of an independent audit,” Stewart says.

Newton is currently using an external auditor to help assess the issue of child labour
in a clothing manufacturer that has operations in the developing world.

But asking for help is not the same as handing all of the work over to someone else. You still have to check that the auditor’s investigation has been thorough. Did they warn the company under investigation that they were coming or did they turn up unannounced? If all the bad stuff has been temporarily removed before the visit, what use is the audit?

So, however you approach your research there is a lot of work ahead. “For this level of detail it is something that has to be done on an individual basis,” Stewart says. “It is time consuming.” He adds that there is no way of doing this in an automated quant-type fashion. “This requires being on the ground, talking to the company face-to-face and understanding the business.”


Dutch asset manager Robeco is more selfreliant having developed a structured approach to measuring non-financial metrics. This has involved spending 20 years collecting ESG-themed data to help the firm understand the companies it is assessing. Today it has up to 3,000 businesses in its database.The information it compiles focuses on carbon footprints, water consumption, energy usage and waste generation.

Robeco likes to scratch the surface when assessing a company to get the most accurate data that it possibly can. Roland Hengerer, a director in sustainability investing research at RobecoSAM, highlights the electric vehicle industry as an example of the firm’s approach to researching a company. “We don’t just look at car companies, we go down the supply chain to look at the battery manufacturers and their suppliers to get a deep insight of what is happening,” he adds.

If, however, these investigations throw up a few red flags it does not necessarily mean that firms such as Robeco will just walk away.

Newton is one such firm that will work with management to fix any concerns its team has. Most importantly, it will seek independent proof that progress is being made. “At the stage when we are getting some progress we will look for some proof, such as an independent audit,” Stewart says.

Newton is working with a company at the moment on an undisclosed supply chain issue. It raised the problem with the board and they agreed to fix it. After 18 months of working on the problem, Newton is speaking with management about independently-auditing their findings.

Robeco also engages with companies to improve their ESG behaviour. The structure of its process involves engagement specialists, a research specialist and an investment analyst to make sure the firm is on top of management’s progress.

There are four objectives Robeco looks at in each company. Carola van Lamoen, Robeco’s head of active ownership, names the objectives it would set an electric utility, for example, as a proactive environmental strategy, operational excellence in thermal generation, business model innovation and transparency in its lobbying. “During the course of the engagement we measure the progress of these objectives,” she says.

If three out of four of the objectives are met then Robeco would consider the engagement a success. More than 85% of the firm’s engagements are successful. “The good news is that the large majority of our engagement dialogue is closed successfully, so exclusions are not done too often, but we have excluded where we have not seen sufficient progress on UN Global Compact Breaches after three years of engagement,” van Lamoen says.

Divestment is the last resort if it is discovered that a portfolio company has not been  fulfilling its pledges. This is a rarity for Newton. It likes to know where the issues are before it invests, so it doesn’t get any nasty surprises. “As active managers rather than index-tracking investors, we only own a select group of companies,” Stewart says. “So those companies we do own, we make a positive decision to own them.

“Where we see companies with material issues that we think need to be addressed, we establish engagement plans with set timelines,” he adds. “If the companies do not improve we will divest.” Hengerer says that for Robeco it is not just about doing your homework; it is about doing it in the right way. “Foot-printing is popular, but is backward looking. It does not tell us what is going to happen at the company in the next few years.

“For that we have a range of forward looking indicators to make sure that we are looking at companies with solid plans to improve their footprint,” he adds. “Some companies may have looked good in the past but are at risk of deteriorating because the trend does not look good overall.”

It seems that when it comes to badly behaving companies, passive markets are not so passive. Index and analytics specialist MSCI will kick out any company from its suitability indicies if membership rules are breached. Things such as human rights violations, using child labour or increasing an investment in weapons, for example, could be grounds for expulsion. “So if a company that previously qualified became involved in something like that then at the next rebalance they would be excluded,” says Meggin  Thwing  Eastman, head of impact and screening research for MSCI ESG Research. “That is pretty bread and butter for us in terms of how we do things,” she adds.


It is not just investors that are concerned about the lack of credible information, which is also easy to obtain. Regulators’ have taken an interest and some have made it compulsory to publish non-financial information. They have realised that there is a problem in identifying the risks that do not usually appear in a company analysis.

The European Union’s Non-financial Reporting Directive requires companies of public-interest, which are mainly banks and insurers with more than 500 employees, to disclose information on how they manage social and environmental challenges, such as reducing carbon footprints,respecting human rights and board-level diversity.

The problem is that this only covers a small number of companies meaning that it is not a solution to the lack of widely-accepted global standards that define the materiality of ESG impacts.

Professional services firm Aon is attempting to offer investors some help. It has developed an ESG-rating system, where after a thorough review of all materials, data and policies managers will be awarded a score. This is about determining whether the manager’s process is credible, robust, consistently applied and repeatable.

Charles explains that the ratings are focused on whether a company is “walking the walk or just talking the talk”. “What we are trying to rate is to what level they are actually doing what they say they are doing in terms of ESG integration,” she adds.

Tim Manuel, Aon’s UK head of responsible investment, describes the new system as “under the bonnet due diligence”. “When you start to dig a little deeper, many managers do not always put into practice some of those practices that they are talking about,” he adds. “Many are struggling to provide the evidence to show how their policies are flowing through into portfolio-level decisions.”

Manuel believes that this does not mean that all of these managers are not doing what they said they would. “They are just struggling to show the evidence in a systematic way because their systems are not connecting the dots.”

The ratings could help active fund managers prove that they are effective stewards of investors’ capital if the mandate goes beyond the balance sheet. It seems that putting capital to work at building a better world is not an easy task.

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