This article is part of NordSIP Insights – ESG Integration Case Book 2020. Read or Download the entire publication here.
Talking to us from New York, Guillaume Mascotto, Head of ESG and Investment Stewardship at American Century Investments (ACI), describes his ESG integration case study as a revelation. “We had a Eureka moment. It is rare to find a company that can reinvent itself, but we found a European refiner that was bridging the gap from fossil fuel-based diesel to renewable diesel, moving us closer to a circular economy. At the time, in late 2017, people were mainly interested in the risk component of ESG analysis, most particularly risks facing upstream majors such as Exxon Mobil. But ESG also offers opportunities, and so when we heard about this company’s downstream opportunity proposition, it piqued our curiosity.”
Identifying this opportunity, assessing its investment suitability and finally making the investment decision was the result of a well-established multi-layered process that informs American Century’s asset management, Mascotto explains.
Materiality and Fiduciary Duty: Towards Core Integration
“At ACI, we believe that an investment-led and materiality-focused ESG integration process is most optimal for investors, as it offers increased portfolio diversification and maximizes the integration of both ESG quality and alpha-related inputs.” Mascotto dubs this “core integration.”
American Century’s ESG integration framework was designed to align with the firm’s fundamental research process and fiduciary duty. “Our goal here is not to substitute fundamental analysis but rather to augment it,” says Mascotto. He extrapolates from this a general rule his group follows: “To achieve core integration, the ESG and financial verticals of analysis must always talk to each other.”
“That is why our ESG views are considered in the context of fundamental research, with a focus on investment implications,” Mascotto explains.
The financial materiality of the ESG analysis is supported by proprietary research. “We consider third-party ESG ratings and understand the drivers underpinning these opinions, similarly to how investors are aware of credit rating agencies’ views. But as an active manager, our clients come to us for our in-house expertise and variant ESG views.”
ACI’s ESG team has developed a proprietary scoring methodology which generates scores based on material sector-specific ESG indicators reported by issuers – “We don’t use estimates. We need to be able to defend the data when elevating ESG views to PMs,” Mascotto explains. The system also captures whether the issuers’ practices are improving or worsening over time.
“Our framework generates ESG assessments that are not static in time,” Mascotto says. Rather, the ESG views elevated to portfolio managers are both “risk-based and forward-looking” in order to assess what Mascotto calls “downside ESG risk propensity” and to capture “ESG upside potential.”
A Solutions-Driven ESG Platform
In addition to being focused on materiality and fundamental analysis, core integration must also be flexible and adaptable to evolving client-specific values and guidelines. ACI’s ESG platform is solutions-driven and flexible in the options it offers its clients, Mascotto explains. “Some in the market take an evolutionary view of ESG as a journey that starts with negative screening and ultimately leads to impact investments. We disagree,” he says, as, for him, there is no one-size-fits-all ESG approach. “In our experience, clients expect a core ESG integration process from which they can pick, choose and potentially combine different ESG approaches, be it negative screening, positive/best in class, thematic investing, impact investing.”
According to Mascotto, there will continue to be strong demand for various ESG approaches, most notably impact investing and best-in-class solutions. With that said, Mascotto advances that as “ESG gains more market experience and the investor learning curve continues to improve, we foresee an increased demand for contrarian-like ESG solutions.” This involves, Mascotto explains, identifying “disconnects” between an issuer’s ESG fundamentals relative to consensus. This is when the exercise of “opening the issuer’s black box” comes into play, he continues. Such an investment solution requires a research-heavy, security-per-security evaluation that takes full account of ESG macro conditions (i.e., sustainability megatrends), but at the same time, scrutinizes issuers fundamentally to find subtleties not captured by the ESG ratings agencies.
The Cornerstones of American Century’s Global Non-US Discipline
The case of the European renewable diesel refiner that Mascotto chose to highlight as an example of successful ESG integration falls into the ACI’s international growth equity strategy within its global non-U.S. equity discipline. “The investment philosophy in this strategy is based on an alpha generation engine comprised of four cornerstones dubbed ISGV”:
I for Inflection: Company is at an inflection point in its growth cycle;
S for Sustainability: High conviction that both the growth inflection and the company itself are sustainable
G for Gap: Indication of an exploitable gap in earnings expectations relative to consensus estimates;
V for Valuation: Attractive relative valuation.
ESG factors are integrated as part of the sustainability cornerstone, Mascotto says. “This is where our fundamental analysts work closely with the ESG team to ensure that any ESG risks identified by our ESG integration process are not financially material to the investment thesis.” Although ESG is often characterised as a risk input, Mascotto adds that “the ISGV engine also allows, where relevant, our ESG analysts to include ESG opportunity assessments”.
Advancing Towards a Circular Economy
“The theme we were interested in was climate change. Refiners are fundamental to our overall energy systems. We wanted to see how companies in the energy value chain can react to the paradigm shift from crude to renewable refining.”
The company Mascotto’s team identified was able to develop a system using 100% waste and residues to generate renewable diesel, a type of biofuel. The raw materials of renewable diesel include animal fat from the food industry, waste fat from fish processing, residues and waste from vegetable oil, technical corn oil and used cooking oil.
“From these materials, the business can extract triglycerides, which correspond to propane in fossil fuels. These are resources that come from the ecosystem and can allow societies to generate energy in a circular-economical way,” Mascotto comments.
The company holds a privileged position in the context of the broader climate change megatrend, which is reinforced by the fact that it is in sync with the regulatory demands of the EU and the increasing environmental concerns of European consumers. “The company focuses on different types of industries in the value chain that have traditionally been left out of the climate debate, including polymers, petrochemicals and the aviation sector,” Mascotto says.
“The business is working with some of the most significant airlines to facilitate the transition to sustainable aviation fuel, as renewable diesel can reduce carbon emissions by as much as 80% in aviation compared to fossil fuels. That is a reduction over and above the 50% decrease recommendation by the European Commission. The renewable diesel can also be used in shipping, where its lower sulphur content can contribute to a decrease in water pollution.”
The investment can also help reduce the amount of plastic waste by recycling it into raw material for new plastics. “The company has also started to target projects that use liquefied waste plastic as a raw material into fossil refinery. We can only create a circular economy by finding ways to create value in a close-looped system,” Mascotto explains.
“With almost 30 million tons of plastic waste generated in Europe annually, one of the inflection points is that European regulators are likely to increase their requirements to recycle and reuse plastic packaging. We consider the company to be well-placed to navigate new recycling targets for plastic in Europe by 2025, even as the target rate of plastic recycling is expected to increase to 55% by 2030.”
Considering these facts together, Mascotto’s team concluded that there was an underestimated investment opportunity. “When we put the pieces together, we had a Eureka moment. Our analyst’s projection of the company’s renewable diesel segment was growing faster than its conventional refining segment.
Additionally, Europe’s toughening environmental regulation and shift in consumer preferences toward lower carbon products would serve as a catalyst for growth in renewable energy. In the case of renewable diesel, the growth was not yet captured by the ‘ESG street’ given the focus on upstream oil and gas extraction relative to downstream.”
Adjusting KPIs for materiality
Beyond the company’s alignment with climate change regulatory and consumer trends, the assessment of the sustainability of the company’s growth and governance prospects also considered several key performance indicators (KPIs). “Our model is sector specific for environmental and social factors, but it is sector agnostic when it comes to governance,” Mascotto explains.
“Although a company’s environmental and social exposure will vary across sectors, our governance indicators are always relevant, regardless of what a company does.”
The companies are different because they have unique sustainability attributes that ACI considers would yield “positive social and environmental dividends.” That being said, all investments within the same strategy follow the same ESG assessment process.
“In terms of sustainable growth for the energy sector, our material KPIs include the efficiency of the business’s inputs and outputs, measured as energy, water and carbon emissions intensities relative to sales or unit of production. We also look at R&D expenditure on research into renewable energy or raw materials as well as negative-emissions technologies. On the social front, we are mindful of human capital strategic planning, employee safety rates, long-term injury rates and fatalities, because workers in refineries handle and manipulate dangerous substances,” explains Mascotto.
“Our model incorporates various KPIs for the governance dimension,” Mascotto says. Among these, the team considers board independence, especially the independence of the audit and compensation committees, board entrenchment, negative votes against directors, accounting irregularities as well as severe ethical controversies such as fraud or corruption.
“These KPIs have to be contextualised over time and place. Performance is often subject to the idiosyncrasies of the country where a company is operating. It is necessary to compare a company’s performance with its domestic and global peers separately as well as to consider their performance over the last three to five years to assess the path that the company is on.”
According to Mascotto, the final ACI proprietary ESG score of the company is a relative percentage rank assessment of the company across these indicators, but also the corresponding trends. “In all instances, we were impressed with the performance of the European renewable diesel refiner,” he explains.
The Benefits of Hindsight
“This stock has done very well for us. It outperformed the local market index and our benchmark year-to-date (demonstrating resilience amid the current COVID-19 crisis) and by approximately over a three-year period. We feel that our investor thesis that combined ESG and financial strength helped us succeed and get a strong risk-adjusted return,” Mascotto says. “Of course, there is always room for improvement.
Looking back, we could have been more mindful of the potential clustering risk of this ESG trade. Once the trade becomes public, its success attracts other investors, eventually leading to concentration and overpricing risk for the client. We could have looked for a similar refiner to try to find one that was at an earlier stage of its energy transition or on the verge of improvement following a business misconduct controversy,” Mascotto concludes.
The opinions expressed are those of the portfolio team and are no guarantee of the future performance of any American Century Investments portfolio. This information is for an educational purpose only and is not intended to serve as investment advice. References to specific securities are for illustrative purposes only and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice. American Century Investment Management (UK) Limited is registered in England and Wales. Registered number: 06520426. Registered office: 12 Henrietta Street, 4th Floor, London, WC2E 8LH.
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