This article is part of NordSIP Insights – ESG Integration Case Book 2020. Read or Download the entire publication here.
by Ann Kristin Brautaset and Annie Bersagel, Folketrygdfondet
Folketrygdfondet is the manager of the Government Pension Fund Norway, and the largest financial investor on the Oslo Stock Exchange. As a result, we are constrained from commenting on the investment case for a specific company, but have nonetheless chosen an industry case to demonstrate how we apply a financial approach to ESG investing.
Norway: a Goldilocks environment for salmon
Constrained by geography and climate, the salmon farming industry flourishes in only a select few regions across the globe. Unless and until largescale land-based farming is a reality, only a few fjord-rich countries account for the majority of global supply.
Norway is by far the largest producing country, owing to the unique combination of water temperatures and currents suitable for commercial salmon farming. At the risk of oversimplifying: too cold, and the salmon struggle to grow, too warm, and some combination of lice, sickness and/or algal blooms threaten to wipe out production, not to mention the consequences for the local environment or for fish welfare.
As a result, salmon farmers face significant operational risk related to fish biological development. The financial impact of companies’ handling of environmental issues is readily apparent, as survival rates directly affect the bottom line. Moreover, as buyers pay a premium for the largest salmon, operational measures that negatively affect salmon growth, such as the stress from harsh lice treatments, have a corresponding negative impact on company earnings.
The emergence of ESG concerns
In the early 2010’s the salmon farming industry formed only a small fraction of the total market cap on the Oslo Stock Exchange – less than 2% of the OSEBX benchmark. Folketrygdfondet was itself only a few years into its formal integration of ESG in the investment process, but recognized that environmental concerns posed a material risk to the growing industry.
In 2011, Folketrygdfondet engaged with management in the salmon farming companies in which we were invested on the following issues: salmon lice, escapes, sustainable feed, and the industry’s reputation.
Our approach was more proactive than prescriptive, leaving responsibility with the companies to determine how best to address the risk.
As described in that year’s ownership report:
“It is not our role to tell companies how they ought to address various challenges, but rather, to make them aware of the financial risk we observe and encourage them to manage these issues responsibly in order to avoid negative consequences for the company’s long-term value creation.”
In general, the companies’ response to Folketrygdfondet’s engagement reflected that they were not accustomed to fielding questions on lice, escapes and feed from investors. The majority of the companies acknowledged the financial risks, however, and explained the operational and strategic measures undertaken to address these challenges.
Reputational risk management
In the early 2010’s, the companies were primarily concerned about the threat to the industry’s reputation from frequent NGO-organized campaigns. The industry gradually recognised the need for a more constructive approach to stakeholders– both to encourage legitimate criticism and to address misinformation.
The Global Salmon Initiative was founded in 2013 as a partnership between salmon-farming companies, to mitigate environmental impacts and move towards a more sustainable industry far more quickly than would be possible through individual initiatives.
Time to pile up
In 2013, Folketrygdfondet spent much of the year building a major overweight position in the salmon farming industry. The industry had been cyclical for years due to significant supply growth without corresponding demand growth, resulting in volatile, but low prices. The change in 2013 was that government-regulated quotas designed to limit the industry’s impact on the wild salmon population finally began to constrain supply.
Given advances in production methods, salmon farmers were now able to produce more than the regulations would allow, leading to increased salmon prices as the steady growth in demand outstripped supply. Salmon farmers capable of handling the biological challenges faced a unique competitive position due to supply constraints.
Seeing is believing
Internally, portfolio managers point to this investment decision as a turning point in Folketrygdfondet’s approach to ESG, as a clear example of the link between ESG and financial risk. The 2014 annual report notes that Folketrygdfondet achieved 50 basis points of excess returns from this bet alone, as the Oslo Stock Exchange-listed salmon firms achieved an industry return of 64 percent.
Keeping the pressure on
Throughout the decade, the environmental challenges related to salmon remained a key focus area for Folketrygdfondets’s engagement activities. As then-CEO, Olaug Svarva explained at a 2014 seminar:
“Folketrygdfondet has clear expectations for the fish farming industry. We believe in the industry and contribute with capital, but there are challenges that have to be solved. We are impatient. Because the stock market tends to focus on the short term in its evaluations and choices, Folketrygdfondet believes that it is an advantage for the fish farming industry to have large, active and long-term owners. In the short term, lower growth can be necessary to secure long-term value creation.”
Folketrygdfondet also raised concerns about the incentive structure in existing regulations. In a comment letter to the Department of Trade and Fisheries in 2015, Folketrygdfondet advocated for a licensing regime with capacity constraints linked directly to the development of environmental parameters.
Stricter environmental limits led to a significant increase in costs, as the companies were not sufficiently prepared to cope with the regulatory changes. Concerned about the companies’ handling of sea lice challenges, Folketrygdfondet sent letters to the Boards of
Directors of all of the salmon farming companies in the portfolio, calling on the Boards to ensure the companies implemented measures to secure sustainable value creation over the long term.
Time to harvest again
In 2015, Folketrygdfondet again built an overweight position in the salmon industry, which was further increased further following a severe algal bloom in Chile in 2016 that eliminated a major share of that country’s salmon production. Although the industry was aware that the Chilean sector faced substantial operational risk, owing to a looser environmental regulatory regime, the proximate cause of the algal bloom was El Niño-related change to the marine habitat.
In Folketrygdfondet’s estimation, the market underweighted the potential price effect for the Norwegian salmon farmers of this external shock to supply. Folketrygdfondet reaped the benefit of this investment decision in 2016, as higher salmon prices and a weak Norwegian krone led the sector to a return of 43.4 percent for the year. The excess return to Folketrygdfondet’s portfolio for 2016 from this sector alone amounted to 70 basis points.
A new sustainable consumer trend
Throughout this period, farmed salmon’s reputation among consumers as a protein source improved. Although not without controversy today, the industry faced significant reputational challenges at the start of the 2010’s owing to the environmental issues identified.
The industry experienced a steady positive development over the decade, as more research on the health benefits of farmed salmon emerged. The environmental profile of salmon compared to other protein sources also received a boost from increasing focus on climate-friendly food choices, as the emissions profile of farmed salmon compares favorably to other animal protein sources, at roughly 2.9 kilograms of CO2 per kilogram of edible meat, compared to 30 kilograms of CO2 per kilogram for beef production.
Recommendations from the UN Food and Agriculture Organization (FAO) and various health authorities worldwide to include Atlantic salmon in a healthy diet as a protein source rich in essential fatty acids also contributed to build consumer demand.
Folketrygdfondet’s engagement with the salmon farming industry continues. Over roughly the past decade, the industry’s share of the Oslo Stock Exchange grew from two to fourteen percent. We intend with this case to illustrate first what we view as the mutually reinforcing roles of active management and active ownership. Our goal for active ownership is for us to know the companies and for them to know us.
Although we are not able to comment publicly on specific cases, Folketrygdfondet’s engagement with the salmon farming industry over the better part of a decade coincided with several examples of concrete improvements from individual companies. This case is also indicative of our active ownership work in that it can take time to reach solutions in accordance with our principles. It is not unusual for engagement processes to extend over several years, involving multiple challenges and dilemmas along the way.
ESG integration: the Folktrygdfondet way
With this case, we offer an example of how we integrate ESG into the investment process. Folketrygdfondet is an active manager with a Nordic investment universe and a team-based investment philosophy.
Given that we view ESG factors in conjunction with our broader investment analysis, we do not engage in an isolated ESG analysis or scoring methodology.
In our experience, the most successful examples of ESG integration have arisen through a combination of industry and ESG expertise to identify material risks that may escape traditional financial analysis.
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