For Jack Deino, who comes from the fixed incomes side, ESG is nothing new. “It’s something we have always focused on in our investment process. In fixed income, we mostly look at avoiding default and drawdowns. We want to detect early warning signs. We have put in place a comprehensive multi-faceted investment process that includes liquidity and relative value screening, income statement analysis and cash flow forecasting. The quantitative part of it is robust. There are, however, specific tangible qualitative aspects about an investment in fixed income that are quite important and that the initial quantitative assessment is not going to highlight. ESG analysis is, from our perspective, an invaluable tool to understand the quality of management, and to understand the vulnerability of a credit that could result from qualitative and less tangible risks.”
Juan Salazar comments from his point of view as an ESG analyst: “ESG management can be an indicator of management quality. That is something that my portfolio manager colleagues have been drilling down into. They want to get to know management to be able to trust them with our clients’ money and have an essential conversation about anything that might matter for the business going forward. With the incorporation of the ESG factors, what probably has changed the most is, that we now try to direct that engagement with companies towards a more long-term focus. And in emerging markets, in particular, companies are very concerned about their day to day business. What is the P&L going to look like? What are the cash flows going to look like in the next month 2 or 3 months? Getting to a long-term mindset is difficult but bringing in ESG factors into the discussion has helped to an extent to get that dialogue started.”
For someone on the private equity side, like Rik Vyverman, ESG can have slightly different implications: “In private equity, we get heavily involved in our investment companies. We believe that our ESG-focused approach is part of the value we create with these companies. On the one hand, we create better-run companies, but on the other, we can also add directly to the bottom line by improving the way companies are run. For example, we can help them to optimise the use of water or energy, by changing sources of energy… ESG has become part of our value creation as, and it is no longer only about the ESG-related risks. Of course, no manager or investors want to be exposed to the negative effects that a lack of sustainability can generate, but there is a positive side which we can capture as well. I have been doing this for 20 years and looking back, 20 years ago, the approach on ESG was predominantly a risk-focused one. Investors didn’t want to get into the newspapers due to an investment company polluting this or that. Now ESG has turned into a much more positive approach where investors can add value to the companies, to be managed better also, from a sustainability point of view, operating at a higher level and improving their bottom line.”
Salazar agrees on the direction of the change that Vyverman described, but he believes there is still room for improvement. “I think that shift is on the way, but there are still a lot of people that remain focused on the risk end of ESG, which is not by any means the wrong one, but they may be missing out on many of the opportunities.”
Deino retorts that one may not preclude the other: “While focusing on the risks, you may identify downside and upside opportunities. As per downside, I have seen companies where both management as well as investors are heavily focused on the short-term P&L and cash flow. Let’s say that there is an IPO of a steel mill and the analyst from the investment bank says, ‘Jack, what’s not to love about this? It’s generating significant free cash flow.’ But then I’ll look closer, and I’ll see that there is a problem as capex is well below what depreciation is. I’ll go down to the company for a visit, and I’ll see a rolling mill where employees that are probably earning $1 or $2 an hour are running a broken rolling mill on a stationary bicycle! At the end of the day, if a management team is so acutely focused on free cash flow, the company will be more vulnerable.”
“On the other hand, you may find other companies where a management team is concerned about more long-term issues such as minority shareholder rights (because minority shareholder rights have long-term repercussions), or about how they interact within their community, that they worry about their employee relationships and employee retention, and the environment. You could probably bet that these guys have their eyes on the ball – offering medium to long term stability and potential improvement in credit metrics.
“One of the things that we have entrenched in our DNA,” Deino adds, “is that we don’t want to be investing in countries and companies only for the sake of a superior ESG rating. Our focus in not building a portfolio that has a triple-A weighted average ESG rating. If we wanted to do that, we would only invest in countries like Sweden. Instead, we want to identify companies that perhaps some of the agencies, like Sustainalytics or MSCI score poorly at present, but that have identified their ESG weaknesses and are determined to improve. So, for us, what is more important is not that we are going to maintain a triple-A rated ESG portfolio, but a portfolio where we could have an actual impact as far as an improving delta.”
Kristofer Dreiman who selects fund managers at Länsförsäkringar AB believes that the risk part of the ESG equation is still a significant component. “It is highly relevant to discuss ESG risks specifically with the managers because we still meet those that don’t necessarily have a holistic idea on how to identify and address those risks. We need to keep that focus, especially in emerging markets, where the inherent risks are much greater than in Sweden, for example. We often share our views on what we refer to as inherent ESG risks in the country or countries where the fund invests, to stimulate the discussion, but also to test the manager and see if they have conducted a similar analysis or not.”
Cecilia Kellner who identifies sustainable strategies for Nordea’s Life & Pension’s portfolio agrees. “For our part, we don’t want to look only at the risks, but at the combination of risks and opportunities, especially in emerging markets, because there is a country risk that investors are not necessarily exposed to in developed markets, such as the Nordics. Country risk is not considered an issue in places like Germany or Sweden. We don’t have to scrutinise companies about corruption to the same extent as we do when investing in emerging markets.”
Identifying what risks matter to an investor is also crucial a part of the investment process for Kellner. “There are many different views on what ESG is,” she says. “Everyone has their own view of what is important, and therefore we need to define and communicate clearly what matters to us and, in particular, which risks we don’t want to be exposed to. Still, opportunities are quite significant, especially in emerging markets, when it comes to E, S and G because there is so much room for improvement. This is why we always look at the risks in combination with the opportunities.”
ESG can bring risk management and opportunity seeking closer together, especially in emerging markets. Vyverman builds on that point: “In Sweden, Germany as well as Switzerland, legislations exist, and they are implemented. In some places, be it in Africa or Asia, we need companies to comply at a minimum with their local regulations, and we need to ensure that it is indeed the case. That is a minimum requirement, but it doesn’t mean that we don’t have an opportunity to lift those companies to internationally accepted standards. That is an important part of the discussion: how do you get companies up the curve? That is a process, and it needs an engagement.”
Cultural differences and no-go zones
Kellner opens up the discussion and brings up different shades of acceptable standards. “A tricky part is to consider the difference in business culture. Take Nordic companies, for instance, which are exposed to emerging markets. They will face different regulations and legislation in those countries, but also different business practices. If a Swedish construction company is to build something in an emerging country, their processes will be different than at home. In many countries, you can hardly conduct any business unless you follow that country’s practices which may not at all times comply with our way of conducting business. Some things are not acceptable from our point of view. Others are. We cannot have an entirely rigid approach when looking at how businesses are run in emerging markets, but we need to be firm and determine where we draw the line, even if this means that we will not be able to invest everywhere.”
“There are clear no-go zones,” Vyverman agrees. “If you come across a company that has to pay for getting access to something and they do pay that is a no-go zone. No corruption under whatever form can be accepted.”
Deino shares his experience in the matter of grey zones and corruption across public and private investments: “Being part of BlackRock, there are many things that we absolutely cannot get involved in, because it just does not meet our standards. We are definitely held to a higher standard than several other investors, from my perspective.”
“On the other hand, I have seen how some of the anti-corruption campaigns such as those we are seeing to varying degrees in Argentina, Brazil and Mexico can be enormously disruptive for business, but lay the groundwork for a more transparent field of play for the longer-term. Suddenly, companies that were simply conducting business in a way that was culturally accepted for years may face losses. Business could become paralysed. Take a country like Brazil, where an ongoing anti-corruption campaign is generating an endless stream of unpredictable and disruptive headlines. Any local officer, approving a hospital project, for instance, may be terrified to sign off on it. There can be negative side-effects, even if the progress, in the long run, should be positive. In some countries, for example, the anti-corruption campaign may be a score-settling among political factions, as opposed to something more tangible. In many places, however, slowly but surely, we see some improvement in the landscape.”
Starting with ‘G’
For Folksam’s Fund Selection Manager, Susanne Bolin Gärtner, the ‘G’ in ESG may be a good starting point. “If you think about emerging markets then, G is a good starting point. For us to be able to move forward, there needs to be a governance structure in place. Chinese companies that are now in the MSCI index, for example, have suddenly needed to shape up in the way they report. If you start asking questions, the discussion gets going, and the situation improves, as the dynamic changes.”
Salazar nuances Bolin Gärtner’s assessment: “I agree that ‘G’ is the most sensible entry point. And yet, dealing with family-run companies or state-owned enterprises makes the challenges related to governance look very real, and some things are challenging to overcome. Having said that, I have been engaging with companies in emerging markets for ten years, and the keenness that most companies demonstrate to learn what foreign investors have to say or ask and their willingness to enter into a dialogue has changed almost unrecognisably. Ten years ago, you would not have been able to go to a company in Asia and ask them about the absence of independent directors on its board.”
“We often need to start with the basics,” adds Vyverman. “And when talking to family-run businesses, this means installing proper accounting principles and appointing reputable auditors.”
“When I started in this business some 25 years ago,” Deino explains, “we had to learn local accounting standards for each individual country. Now we benefit from standardization using IFRS accounting. One may think that it is a one-size-fits-all solution, but in reality, it is not. The level of knowledge is not homogeneous across finance departments of companies in different countries, and the same goes for external auditors. On the other side, a high number of family-run companies, or companies where the incentives are based on EPS and the stock price, focus very much on the short term. Companies can hence record several expenses above and below the operating line, among other measures to enhance EBITDA, net income as well as EPS. We have also seen multiple accounting and alleged fraud scandals in EM in recent years. I do think that emerging markets have come a long way these past 25 years, but it still isn’t the same as investing in some of the world’s most advanced economies.”
The local presence is, therefore, a crucial element when selecting managers, Dreiman emphasises. “That’s why boots on the ground is an essential component, from our perspective, when we talk to managers, given that the risks are higher, and the disclosure level might not even be there, or is still not on par with developed markets.”
What about ‘E’ and ‘S’?
Salazar goes back to his experience with certain sectors to illustrate the challenges he faced: “I can think of Human Rights, for example, when I used to cover the mining stocks. Engaging in conversation with mining companies about environmental issues was straightforward – you either comply with the regulations or you don’t. But bringing up social issues such as Human Rights when trying to engage with companies domiciled in countries with poor human rights records was a bit of a struggle. I quickly learned how weighted the words were. To start a conversation about Human Rights, I couldn’t mention the term ‘Human Rights’. Employee relations, relations with the community, stakeholder management, those were terms that made dialogue possible. Again, the understanding of the local context is crucial to open a conversation that is constructive and productive. Boots on the ground are imperative. When my colleagues in Hong Kong started to grasp ESG as a component of their investment process, it was a game changer. They could go and speak in their native language to the companies, and that makes a huge difference. It is all about making it relevant to the companies you cover.”
ESG analysis cannot be applied on an apples to apples basis across countries. “It requires quite a bit of soul-searching,” adds Deino. “For example, going to the Middle East and talking to a company about gender equality, and having female members of the board of directors, may not be the same conversation as with a firm in the US or Sweden. There are some countries and some companies that are making solid inner roads, even there. To some extent, however, we may have to draw a line before becoming culturally invasive, and imperialist. We also need to try and understand what the mind frame and the cultural nuances are for the CFO, the CEO or the Chairman, standing in front of us.”
“The industry matters as well, particularly in emerging market,” Deino continues. “The banking industry is one that I follow particularly closely. There is a real shortage of qualified, basically educated potential employees in many countries. The education system is not always adaptable or adapted to the current economic climate. In this context, we want to make sure that companies are doing everything they can to retain their best employees. We are very focused on understanding Mexican state-owned enterprises, for example. The recently inaugurated left-of center government in Mexico has proposed placing a salary cap on all public sector employees. We are working to understand if this threatens a meaningful ‘brain-drain’ for government-controlled entities.”
Considering country risk
Looking at governance risks such as corruption, Bolin Gärtner wants to know if, in emerging markets, certain countries should be avoided altogether, or engage more with the government. Salazar believes that it is indeed an important question. “We, as fund managers, have a responsibility to engage with policymakers in the countries that we are investing in. We have a frontier strategy, and we are exposed to countries such as Zimbabwe, Egypt, Nigeria, Pakistan, which are not the easiest countries to invest in. Like in the other emerging countries, we take the dialogue beyond the companies to the policymakers and local investors to try to move the needle in a way that is going to be beneficial for everyone. In the more established markets like South Africa, China, Brazil where the authorities are working on raising the bar in terms of reporting governance, it is perhaps easier. However, going to less-developed countries, we have the opportunity to be a significant voice in instigating change, even if it won’t happen from one day to the other – it takes time. It also has to be a consistent and concerted effort together with other investors and stakeholders.”
“In our investment process, we use a purely a bottom-up approach and do not exclude countries just because they’re too risky from an ESG perspective,” Salazar concludes.
Kellner also finds it difficult to look at ESG from a country’s perspective. “How easy it is to get access to the government in Pakistan, or other frontier countries?” she asks. “The usual entry point for us is through the stock exchanges,” says Salazar. “Then we may go to securities regulators and then the ministry of finance. If you have done your homework right then you can get to that level, but it’s not easy.”
From ESG to SDGs
Bolin Gärtner suggests that, especially when looking at the Social dimension of ESG, the Sustainable Development Goals are a useful framework. “We meet a lot of external managers, and it is exciting to see their different approaches to the SDGs. We see different examples such as spiderwebs, as they try to map their funds’ exposure to each goal, and some funds are cherry-picking some of these SDGs and working more towards those. It is a good starting point because everyone can relate to something in these 17 goals and their 169 associate targets, which have been broken down even further into with sub-targets now.”
Both Salazar and Dreiman question the sincerity of some of these managers. “A lot of people have jumped on the train without really understanding what it is,” says Salazar. “I agree that the SDGs constitute a great framework, something that everyone can relate to one way or another but perhaps in this mad rush to get to the top, people are misusing it.” “We find a lot of SDG washing,” Dreiman agrees.
For Bolin Gärtner, SDGs may not represent a perfect absolute base for measurement, but they can be useful in relative terms. “The interesting part is the change,” she says. “If a manager says one thing the first year, what will happen the year after? We have set up a yearly due-diligence process, and if we receive the same answer every year, that means they are not moving upwards on the experience curve. We are all beginners, and we need to get started somewhere. Everyone can have a different starting point. Some may stay in their spiderweb forever, while others might jump to some conclusions and focus on some specific SDGs.
“For instance, for me as a fund selector,” Bolin Gärtner continues, “when I look at our sustainability work within Folksam and for external funds, I have found that goal number 3 (Good Health and Wellbeing for People) is very useful because we want all our investments to be tobacco-free. I can lift the debate from Folksam up to the SDGs. This is a way to use these broader goals in our internal discussion. It is yet another way of opening the communication channels and highlight issues.”
Dreiman concurs but remains somewhat sceptical. “For example, we can link goal number 13 (Climate Action), to the exclusion criteria we have implemented on thermal coal for instance, but also to our involvement in investor initiatives like the Climate Action 100, and lastly, climate mitigation in individual fund strategies. We can easily relate to the framework in different discussions, both on ESG integration and engagement strategies, but a key point remains that many managers may have just jumped on this three-letter term now, opportunistically. Some may have just changed the name of an existing strategy, and suddenly, it has become an SDG strategy.” “Many companies have done the same,” adds Deino. “developing a narrative using the goals, instead of generating impact or having a concrete action plan. It has become reactionary.”
This conversation is part of a roundtable discussion. Read the report here.
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