Guide to ESG
November 2019
Investors are increasingly keen to know that their returns have been generated in a sustainable fashion. This dramatic societal shift, which has accelerated since the global financial crisis, has meant fund groups are now expected to ‘show their work’ when it comes to environmental, social and governance-based investing. In the wholesale market, fund selectors have an enormously important role to play, with sole responsibility for evaluating and scrutinising what’s on offer, and interpreting the puzzling number of approaches. This guide aims to identify some of the priority themes that are close to investors’ hearts and considers the approaches being adopted by leading investment institutions. It is our hope that by keeping a close watch on market developments, fund selectors will be fully informed about what to ask and where the industry is heading.
First word
Joe Mcgrath, ESG content editor, Last Word
Contents
1. Sustainability goals
Guide to ESG, November 2019
Contents 1. Sustainability factors With so much choice, how should fund selectors shop the ESG market? 2. Sponsored content Nordea on how protecting the planet can also be a sound investment 3. Global poverty Can strategies that will transform communities also ensure stellar returns? 4. Sponsored content Lyxor’s key to using passive ESG and putting sustainability front and centre 5. Infrastructure What fund selectors should look for from a renewable infrastructure investment 6. Sponsored content The debate should not be about ‘if’ we use plastic but ‘how’, says T. Rowe 7. Fixed income ESG integration in the fixed income space is gathering momentum 8. Sponsored content The move from fossil fuels to renewable energy is in full flow, says Schroders 9. Corporate governance Fund selectors must dig deep to get the wider picture 10. Future of ESG How can fund selectors spot the strategies likely to prevail in the long term?
2. sponsored content nordea
3. global poverty
4. sponsored content Lyxor
5. infrastructure
6. sponsored content T. Rowe
7. Fixed income
8. sponsored content Schroders
9. Corporate governance
10. Future of esg
The big shop
Demand from investors has fostered significant innovation in European ESG approaches. With so much choice, how should fund selectors shop the market?
Measuring impact
Sustainability factors have never been more central to investors’ thinking than they are now. Since the United Nations set out its 17 Sustainable Development Goals (SDGs) in 2015 – targeting improvements in a range of areas including health, education, equality and access to food and water – fund managers have been aligning their product offerings with the UN’s aims. The range of products available is expanding rapidly. Savers can invest in passive or exchange-traded funds that track a huge number of indices, from benchmarks excluding tobacco or fossil fuel companies, to those comprised of companies promoting gender equality. In addition, there are a growing number of dynamic funds, based on scoring systems to assess companies’ environmental, social and governance credentials. MSCI’s Leaders range of benchmarks scores, ranks and monitors companies according to its own scoring system, rewarding businesses that improve their ESG ratings with a greater weighting in the index. KBI and Pictet offer thematic funds that specialise in water or nutrition, for example, and there is a plethora of funds investing in companies seeking to address climate change. A growing number of managers aim to give investors access to a wider range of themes aligned to the SDGs, and BMO Global Asset Management, Robeco, Hermes and DWS have all launched such strategies in recent years.
While the majority of ESG and SDG-related funds are focused on the listed equity market, fund managers are starting to turn their attentions towards other asset classes. Data is not as readily available for other types of investment, such as private equity or fixed income, but work is progressing to change this. Organisations such as the Global Impact Investing Network and the Sustainability Accounting Standards Board are attempting to standardise measures and reporting frameworks to improve the information provided to investors across asset classes. At a recent responsible investment conference in London, Christian Kopf, head of fixed income at German fund manager Union Investment, said investors should ensure that bond contracts include requirements for reporting sustainability metrics such as carbon emissions. “We have faith that the investor community has a part to play in the global sustainability transition,” says EQ Investors’ Salge. She adds: “Only with transparency can we build the necessary momentum of capital shifting into ‘solutions’ to the challenges that the UN SDGs outline.”
Shift to transparency
Percentage of FTSE 100 companies detracting from UN’s Sustainable Development Goals
33%
‘Asset managers tend to pick and choose the metrics and stories that will put them in the best light’
Hortense Bioy, director of passive strategies and sustainability research, Morningstar
SUSTAINABLE FACTORS
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However, ensuring funds – and the companies in which they invest – really are aligned to the SDGs can be difficult. Financial planning firm EQ Investors recently carried out research into how aligned the world’s biggest listed companies are with the SDGs. It found that 16% of the MSCI World index’s constituents were detracting from the goals, while a third (33%) of FTSE 100 companies detracted from the SDGs. Louisiana Salge, an impact specialist at EQ Investors, believes transparency is the key element to understanding funds purporting to be sustainable. In many cases, investors will be shocked to learn the real contents of their investment portfolios, she adds. Hortense Bioy, director of passive strategies and sustainability research at Morningstar, says measuring the impacts of funds remains problematic for investors and fund selectors. In particular, she highlights the difficulty of measuring social aspects of investments, such as education and health improvements. “At the moment, we’re seeing a lot of creativity around the metrics that portfolio managers use to communicate to their clients the impact they’re generating,” she says. “Asset managers tend to pick and choose the metrics and stories that will put them in the best light.”
Source: EQ Investors
Not one day passes when climate and environmental topics aren’t in the news. Recently, we have watched in disbelief as the Amazonian rainforest burned out of control largely due to a dramatic increase in deforestation. About 17 per cent of the rainforest has been destroyed over the past 50 years and losses are on the rise . This trend isn’t limited to Brasil, forests all over the globe are disappearing at an alarming rate. According to the World Bank, between 1990 and 2016 the world lost 1.3 million square kilometres of forest, an area larger than South Africa. If society wants to ensure our planet’s forests and rainforests will be here for future generations, we must get serious about protecting them – and investors can play an important role here. While the great forests of the world may seem distant from our everyday lives, consumers and corporates have the ability to effect meaningful change. Consumer demands, expectations and buying decisions are powerful and drive increasing business momentum towards more sustainable and less environmentally harmful solutions.
Into the woods
‘While governmental assistance and incentives are important, most of the progress we are witnessing is coming from the corporate sphere’
SPONSORED CONTENT
root and branch
Protecting the forests is not only necessary for the future of the planet, it can also be a sound investment. Nordea’s Henning Padberg and Thomas Sørensen explain how
In association with:
New solutions are needed but even more importantly, we must increase adoption of already existing solutions that are superior when it comes to optimising resources and safeguarding nature. While governmental assistance and incentives are important, most of the progress we are witnessing is coming from the corporate sphere, with many leading companies already delivering value-added solutions to real world problems. In Nordea’s Global Climate and Environment investment strategy, we try to assess the impact of the underlying climate solutions and focus on companies that effect positive change. When it comes to deforestation, Weyerhaeuser , a leader in sustainable forest management, is making a real difference. As one of the world’s largest private timberland owners, the company manages millions of hectares of land. Its entire timberland portfolio is certified to the Sustainable Forestry Initiative Forest Management Standard. This means the company manages its forest to ensure a sustainable supply of wood for customers while protecting other benefits the woodlands provide, such as clean water, clean air and habitat for wildlife. Weyerhauser is a solid investment case because the company is dedicated to harvesting trees in a responsible and renewable way. The wood produced is sold to its customers as an alternative to other carbon-heavy materials like steel and cement, thereby contributing to a more sustainable society. Weyerhauser stands to benefit from increased awareness about sustainable products as well as from its sustainable business model.
New technologies can also be leveraged to protect our forests. For example, Trimble’s eCognition Essentials software supports time-based analysis for imagery and graphic information system (GIS) data. The new capabilities allow remote sensing and GIS professionals to determine imagery changes over time, supporting applications such as vegetation change, deforestation or urban planning. Trimble technologies are also used in the construction, agricultural and transportation sectors, which offer great long-term potential for increased adoption of climate solutions as penetration rates are relatively low. Trimble has generated solid returns over time; we see further market consolidation opportunities and increasing recurring revenue that should be positive drivers for the investment case.
Essential tools
Get smart
‘With the agricultural sector just beginning on its path of innovation, investors have a rare opportunity to share in the long-term growth of an industry’
Finally, smart farming is another effective method of preserving our forests. Productivity-enhancing solutions in agriculture are helping to improve resource efficiency and reduce our environmental footprint, while also advancing the competitiveness of farmers. AGCO focuses on the development of innovative agriculture equipment to mitigate climatic shifts due to rapid urbanisation and deforestation. AGCO helps farmers to leverage advanced technology such as GPS and telematics in their tractors to enhance the agricultural productivity in the global market. There is major potential in smart farming, which is already proving its worth in delivering more sustainable agricultural production. With the agricultural sector just beginning on its path of innovation, investors have a rare opportunity to share in the long-term growth of an industry that can have a positive impact on preserving our planet’s vital resources.
National Geographic, February 2019 Please note that references to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A. and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and representative offices. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. This document may not be reproduced or circulated without prior permission. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or representative offices.
As climate change becomes an increasingly critical issue, we see many investors moving from traditional benchmark-driven strategies towards those with exclusion criteria or ESG screening/integration approaches. But we believe positive ESG selection or impact strategies can have a more direct influence on environmental and sustainability factors. Nordea’s Global Climate and Environment strategy focuses on companies that offer products and services with an attractive value proposition, both in terms of environmental benefit and economic return. We truly believe that investing in companies that use technology and innovation to save resources and improve efficiency makes economic sense.
Economic sense
1
2
social endeavour
How can fund selectors ensure stellar returns while identifying strategies that will genuinely transform communities, stimulate social mobility or improve levels of self-sufficiency within societies?
Material world
The first of the UN’s Sustainable Development Goals (SDGs) stresses the need to stamp out poverty across the world. It estimates that around 700 million people globally live under poverty, lacking access to primary needs such as water, sanitation, education and healthcare. The UN highlighted 17 different SDGs, with the intention of achieving a better and more sustainable future for all by 2030. The goals were adopted by all UN member states in 2015, and as all the SDGs are integrated, there is just over a decade left for meeting the deadline to achieve them all. “The areas that need higher concentration include growing resource demands, climate vulnerability, depleting natural resources and rural-urban migration, among others,” says Kunal Sawhney, CEO at Kalkine. “These could be the investment strategies to make stellar returns, while simultaneously looking to transform communities.”
According to a recent report compiled by Octopus Investments, based on a survey of investors representing $5.9trn under management, 71% stated that they believe investment strategies could be used to make a material difference to climate change outcomes. Spurred on by moves such as European governments’ commitments to a net zero target, and high-profile campaigning activity including Extinction Rebellion and Greta Thunberg, a further 44% have reconsidered their investment portfolio over the past year. Nina Roth, a director at BMO Global Asset Management, explains that one angle of BMO’s approach to poverty reduction is through its engagement with holding companies. “A focus area this year is living wage, focusing on retailers in the US, Canada, the UK, Japan and Germany. Paying fair wages will allow employees to not worry about affording daily necessities or the need for a second job,” she says. In turn, they show enhanced performance, while companies have higher retention rates and happier customers. It’s also beneficial for broader economic growth. Roth adds that through the holding companies BMO Asset Management raises awareness about the concept of living wage, highlights the benefits and advocates for overall fair remuneration. It also asks for details about underlying financial methodologies of wage level determination and demands that social criteria are taken into account. “All in all, more transparency on workers’ wages, employee satisfaction as well as turnover rates is needed across all industries,” she says.
According to Sawhney, the United Nations Development Programme has put in place four dedicated streams of work to support countries in their efforts to design policy and programmes for the future, access and generate finance, source and analyse data, and drive innovation and learning. “It is aligning public and private finance and investments with poverty, environment and climate actions. From the investor’s point of view, first SDG-enabling businesses needs to be identified, and then a cross-sector connection needs to be built for creating the immense potential of investment returns regarding contributing for the development of the future,” he says. However, it is not the role of fund selectors and financial institutions to help investors embrace sustainability goals, according to Matthijs Baan, founder of MJ Hudson Spring, who says investors must make that decision themselves. “It is important to identify to what goals the companies can contribute. Next, measurable targets should be set in line with the SDG sub-goals and progress towards these measurable targets must be professionally monitored,” says Baan. “Fund selectors should not accept activity in the general area of the goals as an acceptable outcome and should push the fund managers they invest with to ensure sustainable principles have a material impact.”
Measurable targets
‘Fund selectors should not accept activity in the general area of the SDGs as an acceptable outcome’
Matthijs Baan, founder, MJ Hudson Spring
GLOBAL POVERTY
of investors believe investment strategies can make a material difference to climate change outcomes
71%
of investors have reconsidered their investment portfolio during the past year
44%
You might hear that active managers are best placed to implement sustainable strategies – such as environmental, social and governance (ESG) – because they can make considered decisions to buy or sell companies based on their behaviours. Yet you could also hear that index funds can achieve the same results (or better) for a fraction of the cost. It’s become increasingly important to explore this question, and not only because of recent high-profile controversies within active management. Sustainable investing is going mainstream and passive investments are taking an ever-larger share, growing three times faster than active over the past five years . As the money invested in sustainable strategies rises, the stakes get higher and the more investors explore which approach works best for their goals. They are faced with a choice, on which could rest the makeup of their portfolios and their contribution to a sustainable future for the planet. Passive investing’s low costs and transparency are increasingly dominating the mainstream investing world, do the same arguments stand up in ESG? In this article, we outline three factors that we believe support an index-based approach for ESG investors in 2019 and beyond.
1. Better data means ESG indices match key sustainability goals
‘Sustainable investing is going mainstream, and passive investments are taking an ever-larger share, growing three times faster than active over the past five years’
WHY Passive ESG is good to grow
If you want to invest sustainably, should you go with an active or index fund? Lyxor offers three key reasons why passive ESG’s growth surge will put it front and centre
There are very few ESG investment objectives that can’t be achieved using the right indices built with the right data. Trillions have flowed into passive funds over the past decades stimulating hugely increased investment by index providers into the quality, innovation and breadth of their range. Take indexing giant MSCI, for instance. The company employs 185+ dedicated ESG analysts, provides ESG ratings for over 6,500 companies and runs over 1,000 equity and fixed income ESG indices. With MSCI’s 40 years of experience collecting, cleaning and standardising ESG data, even active managers rely on their data to create sustainable strategies . Improvements in data quality mean that indices now reflect all sorts of ESG policies, from exclusionary screens to values-based investing, selection based on global ESG ratings or carbon ratings and alignment with the UN’s Sustainable Development Goals (SDGs). Some ESG benchmarks can be used as portfolio cores and can easily substitute traditional market-capitalisation weighted indices with limited tracking error. Others are more values-oriented or based on sustainability themes and are therefore used as diversifiers whenever implementing those convictions justifies a higher tracking error. Overall, better indices mean better ways to invest sustainably in a consistent, targeted, rules-based way, an important consideration for ESG investors looking for sustainable positive change.
Another aspect of sustainable investing is ‘impact’, which means assessing an investment’s social or environmental effect alongside its financial return. The concept of impact investing is often associated with private and community investing achieved through private loans and private equity. Yet while it is true that active funds are well placed to invest in private debt and equity, the same principles that support investing in private assets – intentionality, additionality and measurability – are also found in publicly listed assets. Not only that, the liquidity of these listed assets – and of ETFs invested in them – brings scale and scalability, which are missing from private investing. It enables larger amounts of capital to get to work and this adds up to private impact, especially when indices are designed for specific sustainable goals. Examples from Lyxor include funds contributing to the UN’s SDGs, including climate action, water, clean and affordable energy and gender equality, or that invest in companies with a rising ESG trend, and not only the best-rated ones as we believe it is more impactful to reward companies actively making changes.
2. Passive makes ESG investing scalable
3. Passive managers can have an active voice
‘Whether you favour an active or passive approach, one thing is clear, the change in mindset of investors means that ESG investing is here to stay’
One concern among investors assessing active and passive strategies for sustainable investing is shareholder engagement. How can a passive investor hold portfolio companies to account? Many of the major passive managers, Lyxor included, have tackled this by setting up voting policies like an active manager. These policies and voting records are public, as Lyxor is accountable to its fund holders. Lyxor’s shareholder engagement policy also involves a direct dialogue with companies to communicate expectations, for example with respect to governance. Lyxor votes when it retain over 0.1% ownership in a company, and last year it voted negatively for 22% of the resolutions in general meetings it participated in, which is slightly above industry average. From an AUM perspective, it voted on €13.8bn of equity positions in 2018 . Therefore, it is possible to exert influence and encourage positive behaviour through passive investing, if that investment is with an ‘active’ passive manager.
Morningstar data to H1 2019. MSCI ESG Research as of November 2018. Includes full time employees and allocated staff performing non-investment advisory tasks. Source: Lyxor International Asset Management, as of 31/12/2018. FOR PROFESSIONAL CLIENTS ONLY. CAPITAL AT RISK. This communication is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets in Financial Instruments Directive 2014/65/EU. These products comply with the UCITS Directive (2009/65/EC). Société Générale and Lyxor International Asset Management (LIAM) recommend that investors read carefully the “investment risks” section of the product’s documentation (prospectus and KIID). The prospectus and KIID are available free of charge on www.lyxoretf.com, and upon request to client-services-etf@lyxor.com. Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).
The combination of better data on ESG, the scalability of index-based ESG investing and increased engagement of passive managers with the companies they hold means investors can comfortably look to passive ESG strategies to make a difference in their portfolios. But whether you favour an active or passive approach, one thing is clear. The change in mindset of investors – particularly those of the ‘millennial’ generation who can be as old as 38 – and indeed, the change in their day-to-day practices such as purchasing decisions based on the sustainability profile of their preferred brands, means that ESG investing is here to stay. In the same way that ETFs caused an unquestionable shift in the investment landscape, Lyxor is delighted to see a similar shift towards better, greener portfolios. Choices abound for investors seeking to reflect their personal values in their investments. Explore Lyxor’s range if you’re ready to embrace ESG.
Choices abound for the responsible investor
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building for the future
An increasing number of renewable infrastructure investment opportunities have emerged in recent years, so what should fund selectors be looking out for?
Growth industry
With investors increasingly interested in alternative asset classes, infrastructure has enjoyed significant interest in recent years. Renewable energy infrastructure, according to a recent report from Octopus, is set to benefit significantly as investors ramp up portfolio allocations to this sector between now and 2029. The Octopus report suggests this increased investment into renewable energy infrastructure represents $643bn over the next 10 years. “Transitioning to a renewable energy future is challenging but vital, and we still need to make bolder commitments on this front. Investors can play a critical role in reaching this global goal by galvanising capital towards renewable energy infrastructure,” says Alex Brierley, co-head of Octopus Renewables. “While there is significant work to be done here, we are optimistic about the future. Our research shows an increased demand from global respondents for greater access to renewable energy infrastructure. We are seeing a growing awareness that the asset class can both generate long-term, stable returns for investors and have a positive impact on climate change.”
Kunal Sawhney, CEO at Kalkine, agrees the popularity of infrastructure funds among the investor community has been growing for some time. “There are various infrastructure funds that invest in the publicly traded shares of companies that own or operate infrastructure, as the revenues from these assets are uncorrelated to global markets and in many cases offer a degree of inflation protection, as revenues come to them from assets that are on inflation-linked contracts with the government,” he says. “Investors have started recognising the benefits of this asset class, which provides access to long-term, inflation-linked and government-backed cashflows, but on the same time investment in infrastructure funds should be considered a long-term investment that may bear higher risk.” Sawhney cites the FT Foresight UK Infrastructure Income Fund as one of the standout performers, a fund that was also selected by Fidelity International to feature in its ‘Select 50’. He says: “As per the latest available data the fund has outperformed its target return and delivered a full-year yield of 5.35%, surpassing its one-year target of 5%.”
In spite of this seemingly positive outlook for infrastructure, specifically renewable energy, the aforementioned report from Octopus suggests a smaller proportion, some 23%, of investors remain resistant to tackling global warming through their investment strategies, however. Of the global institutions surveyed for the report, 45% said energy price uncertainties were of major concern, followed by a lack of renewable energy investment skills within their own organisation and liquidity issues. For Octopus, these findings demonstrate the need for specialist managers to widen renewable investment products for investors, particularly at a time of diminishing government subsidies. “Our children’s futures will be shaped by decisions that are made now by the global investment industry. Given the scale of the challenge and the limited time we have to make a change, the guardians of trillions of dollars of capital have a crucial role to play in averting a climate crisis,” says Matt Setchell, co-head of Octopus Renewables. “It’s disappointing that the proportion of capital divested from these assets and reinvested into climate-saving causes such as renewables and clean tech isn’t higher. If we are to unblock investment into these areas, investors will need to become comfortable with different types of investment risks.”
Unblocking investment
Expected investment into renewable energy infrastructure over the next 10 years
Source: Octopus
£642bn
‘Our children’s futures will be shaped by decisions that are made now by the global investment industry’
Matt Setchell, co-head, Octopus Renewables
infrastructure
Since their introduction in the early 1900s, plastics and plastic packaging have become integral to modern life. Global demand for plastics has increased 20-fold over the past 50 years and the International Energy Agency predicts that demand will grow by an additional 45% by 2040, with nearly two-thirds of that growth coming from Asia (International Energy Agency, World Energy Outlook, 2018). The obsession with plastic is easy to understand – cheap, lightweight and durable, the material is beneficial to society in a multitude of ways, including:
The role of plastic in a sustainable world
PLASTIC people
The sustainability debate should not be about ‘if’ we use plastic but ‘how’ we use it, says Maria Elena Drew, T. Rowe Price director of research, responsible investing
‘The prolific use of plastic and negative consequences of its disposal are major sustainability problems the world needs to solve’
Given the magnitude of the disposal problem, we believe the plastics industry will be fundamentally reshaped in four key areas: 1) reduced usage; 2) increased recycling; 3) increased incineration (waste-to-energy) and 4) replacement by plastic alternatives and/or new biodegradable plastics. Today, the primary focus in terms of reducing plastic waste is on single-use plastics. This is a shift from past decades where the focus was on reducing material usage through making plastic packaging lighter-weight. Consumer goods companies are now turning their focus to packaging alternatives and/or redesigning packaging to make it recyclable. On a global basis, only 14% of plastic packaging is collected for recycling and only 10-15% is ultimately recycled.
Percentage of all global plastic production used for packaging in 2017
36%
In 2017, some 36% of all global plastic production was used for packaging. Demand for plastic packaging has been driven by increasing applications including food and beverages, personal and household care, consumer electronics and construction. General estimates for future growth sit at around 4% compound annual growth (CAGR), with food & beverage applications growing at a slightly faster rate than other categories (Source: Grand View Research, 2018). While GDP growth will be a key driver of growth in plastic packaging, it is also true that regulators, companies and consumers are all showing interest in addressing the end-of-life problems that come with plastic packaging. This is especially the case for food and beverage applications, so we believe key drivers of success among packaging companies will be product innovation and the ability to develop a circular business model – ensuring that plastic materials are retained within productive use, in a high value state, for as long as possible. The prolific use of plastic and negative consequences of its disposal are major sustainability problems that the world needs to solve. However, we would caution that the media hype around plastic’s imminent demise is grossly overstated. Indeed, as we consider the various business impacts that could come from moving to a more sustainable world, plastic does not reside in the highest risk category. This is because cost-effective substitutes are not readily available, and many of the companies targeted will likely be solutions providers as packaging products are adapted to solve their end of life problem.
Despite the many benefits, the vast consumption of plastic is a major sustainability problem that the world must solve. At an industrial level, plastic packaging is the main driver of all primary plastic production creating vast new amounts each year. Meanwhile, most plastics have a very short lifespan (less than one year), yet they can take up to an estimated 450 years to break down, creating a major environmental impact if not disposed of properly. Accordingly, we believe that the sustainability debate should center on how, not if, we use plastic and, most importantly, how we dispose of it.
For investment professionals only. Not for further distribution. Important Information This marketing material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. Capital at risk. The views contained herein are as of August 2019 and may differ from those of other T. Rowe Price group companies and/or associates. The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction. EEA ex-UK – Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only. UK - This material is issued and approved by T. Rowe Price International Ltd, 60 Queen Victoria Street, London, EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only. Switzerland - Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only. DIFC - Issued in the Dubai International Financial Centre by T. Rowe Price International Ltd. This material is communicated on behalf of T. Rowe Price International Ltd by its representative office which is regulated by the Dubai Financial Services Authority. For Professional Clients only. © 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc. 201911-1004365
Addressing the growth in plastic packaging
Reducing food waste by extending freshness period
Lowering vehicle emissions by making cars lighter
Increasing energy efficiency through improved building insulation
Figure 1: Global plastics – where does it all end up?
Global plastics end use
Global plastics disposal
sign of the times
Those keen for ESG factors to be considered across all asset classes are encouraged by evidence that integration in the fixed income space is gathering momentum
Impact factor
‘The clearest demonstration of how fixed income has embraced ESG factors is in the growth of the impact bond market’
Historically, investors have better understood how to incorporate environmental, social and governance (ESG) criteria into equities rather than fixed income. This is supported by recent NN Investment Partners (NNIP) research, which reveals only 26% of the 290 professional investors polled have a clear responsible investment target for their bond allocations, compared with 49% of investors who report a clearly defined responsible investment policy for equity allocations. However, ESG integration in the fixed income space has come a long way in recent years. According to Morningstar, European investors have poured $34bn into sustainable fixed income funds during the past three years to the end of June 2019. Jose Garcia-Zarate, associate director, passive strategies at Morningstar, says while there is “a growing array” of bond funds that either consider or fully integrate ESG factors into the investment process, there is an important differentiation to make between “consideration” and “integration”. “Consideration means ESG is just one of many aspects investment managers look at but it is not the driving force in the selection process,” he explains. “By contrast, integration means ESG drives bond selection and thus defines the bond investment proposition that is put forward to us as clients. Then, within this umbrella of ESG bond funds, you can find those with a broad mandate or those which target very specific ESG objectives.” He lists the following as examples of ESG bond funds with a broad mandate: the BMO Responsible Sterling Corporate Bond, Kames Ethical Corporate Bond and M&G EM Corporate ESG Bond funds. Examples of ESG impact bond funds are iShares Green Bond Index and UBS Sustainable Development Bank Bonds ETF.
Joshua Kendall, senior ESG analyst at Insight Investment, says: “Perhaps the clearest demonstration of how fixed income has embraced ESG factors is in the growth of the impact bond market, in which bond proceeds are used to support environmental and/or social progress.” In 2019, impact bond issuance is set to hit a new record, according to Kendall. There is a perception that bond investors do not have as much scope to influence corporate behaviour through corporate stewardship and engagement, as equity investors do. NNIP research found 70% of respondents believe equity investors could positively influence companies through engaging and voting shares, while 65% feel it is harder for bondholders to exert a positive influence. Garcia-Zarate calls it a misconception that bond investors lack clout. “Because they don’t have shareholder rights, they have a stronger duty to engage with the companies in order to advise and influence corporate behaviour, and protect their investments,” he says. “Though bond investors cannot vote, they retain the ultimate weapon of divesting.”
Flows into sustainable fixed income funds in the past three years to the end of June 2019
Source: Morningstar
£34bn
fixed income
Carlo Funk, EMEA head of ESG investment strategy at State Street Global Advisors, says while debtholders have limited leverage with companies on a day-to-day basis, SSGA influences the ESG practices of companies through issuer engagement. Judging which is the best ESG approach in fixed income can depend on investors’ own interpretations, while a lack of data is also a challenge. A Morningstar report published in August 2019 found the track records for most sustainable fixed income strategies “are generally short, as are the lifespans of ESG fixed income benchmarks, which makes performance evaluations difficult”. Insight’s Kendall says: “The next challenge for investment managers will be in offering evidence to investors of the difference that integrating ESG factors makes to analysis and engagement, and, ultimately, to their bond portfolios.”
Engagement insight
Joshua Kendall, senior ESG analyst, Insight Investment
The world’s renewable energy transition has now begun and it is only going to accelerate as governments, consumers and investors recognise that switching to more sustainable energy is not only essential to stop climate change, but makes sound economic sense too. The entire value chain for how energy is generated, stored, distributed and used will need to be radically transformed. This will result in unique investment opportunities across industries and sectors.
Unique investment opportunities
‘In the past 18 months, major tipping points have been reached, spurring the uptake of cleaner technologies’
positive energy
The transition from fossil fuels to renewable energy is now in full flow, opening up a brave new world of investment opportunities while building a brighter future
Energy transitions are long-term structural transformations in the way energy is produced, distributed and consumed. They are caused by new technologies, superior economics and changing social trends. These ‘technological transitions’ are rare and disruptive events that radically change the existing energy infrastructure and have significant implications for both companies and society as a whole. Although the transition to renewables has only just begun, it is expected to be equally, if not more, transformational than the previous transitions (to coal and then to oil and gas). Given the size and importance of this structural investment need, companies directly involved and actively contributing to the energy transition will be well-placed to generate sustained real returns on their investments and grow earnings and cashflows in the long term. This should provide investors with the potential for strong and consistent returns on their equity. However, the complex, evolving and wide-ranging nature of the transition means that identifying those companies with the greatest potential to benefit from this theme, and those with the purest exposure, is not easy.
There are three fundamental forces driving the energy transition. The first is the need to protect the environment and help limit global climate change. If the world is serious about meeting its globally agreed goals of limiting temperature rises to less then 2°C (in accordance with the 2015 Paris agreement), emissions must be reduced by 33% by 2030 . In 2018, global emissions increased to record levels enhancing the need for a large incremental policy push over the next decade. New policies to encourage renewables are vital, as an increase in extreme weather serves to highlight how severe the impact of climate change could be. Crucially, after a decade of inconsistent and often patchy support, the global policy landscape is improving. Governments and local authorities around the world have set clear targets to encourage the adoption of clean technology. Policymakers are starting to take action, and support is only likely to get stronger going forward.
The second driving force is economics. There has already been a transformative shift in the cost of renewable energy. Although regional differences still exist, the cost of renewable energy has collapsed compared to traditional forms of power. The cost of solar and onshore wind power is now below coal and on a par with combined cycle gas turbines (see graph above). Offshore wind costs have fallen by almost 50% in recent years and are converging on coal. Whereas it was once the case that renewable energy was dependent on subsidies, this is no longer true. Although policy support is helpful, economic motivations such as this can be even more powerful at bringing about change. Utilities across the globe are replacing legacy fossil fuel generation with new renewable assets due to their superior economics. Corporates are also getting involved, with Amazon, Apple and Google arranging bespoke agreements with renewable power producers to provide clean, cheap electricity directly to data centres and buildings . The absolute cost of residential solar power has also fallen, making it a viable economic option for consumers across the globe. At all scales, renewable energy has become the economic choice for utilities, governments and consumers and is starting to drive investment into this space.
Consumer demand for new technologies powered by clean electricity is the final driver of the energy transition. Although a number of technologies are seeing rapid uptake, two in particular stand out. The first is the rapid growth in sales of electric vehicles (EVs), which grew by nearly 90% in 2018. This has taken the worldwide EV fleet to more than five million. In the next few years, major auto manufacturers are launching new ranges of cheaper EVs. This supply, coupled with growing consumer demand and commitments from an increasing number of countries to phase out the petrol engine in the next 10-15 years, will sustain this momentum. The second is the increased installation of energy storage. While falling costs have been a major contributor to this trend, equally relevant has been the growing desire to be less reliant on an electrical grid that is increasingly fragile and have more control over energy use.
Driving forces
Learning from the past
‘The rapid growth in sales of electric vehicles (EVs), which grew by nearly 90% in 2018, has taken the worldwide EV fleet to more than five million’
Changing landscape
When examining technology transitions throughout history – whether it be the emergence of the internet and digital technologies, the widespread adoption of the automobile or the increased use of modern medicine – consumer demand and falling costs have always been the key drivers. The energy transition is the same, but with the added benefit of potentially significant incremental policy support which will force the transition to unfold.
Global energy transformation: A roadmap to 2050. IRENA, 2019. https://www.irena.org/publications/2019/Apr/Global-energy-transformation-A- roadmap-to-2050-2019Edition The Paris Agreement. UNCC, 2018. https://unfccc.int/process-and-meetings/the-paris-agreement/the-paris-agreement Google signs first Asian renewable PPA with Taiwan solar array. Recharge Transition, 2019. https://www.rechargenews.com/transition/1682423/google-signs-first-asian-renewable-ppa-with-taiwan-solar-array This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results, prices of shares and the income from them may fall as well as rise and investors may not get back the amount originally invested. Schroders has expressed its own views in this document and these may change. Schroders will be a data controller in respect of your personal data. For information on how Schroders might process your personal data, please view our Privacy Policy available at www.schroders.com/en/privacy-policy or on request should you not have access to this webpage. Issued by Schroder Investment Management Ltd., 1 London Wall Place, EC2Y 5AU. For your security, communications may be taped or monitored.
In the past 18 months, major tipping points in the energy landscape have been reached, spurring the uptake of cleaner technologies. Policy support has also improved with ambitious targets set at both national and local levels across the world. Over the next 30 years, the world’s energy system will shift from one largely based on fossil fuels to one dominated by renewable electricity. Achieving this transition will require significant investment. Between now and 2050, it is estimated that $120tn will need to be invested throughout the entire clean energy value chain . Renewable energy is only one aspect of the change, the way we use electricity, the way it is stored and how it is distributed must also be completely transformed.
The cost of energy
Chart shows levelised cost of energy (LCOE), which is the cost of production without the use of subsidies.
deep dive for transparency
While corporate governance is one of the most researched areas of ESG, fund selectors should ensure they dig deep to get the wider picture
Paper trail
Many ESG investment approaches select companies based on how well they score when it comes to corporate transparency and governance. Governance accountability is easier to measure and for that reason is more tangible than environmental and social factors. Poor corporate governance makes headlines for all the wrong reasons, so many investors feel they know what it looks like and how to spot it. Adrian Lowcock, head of personal investing at Willis Owen, says: “Companies that suffer from the bad behaviour of their management team and crisis at the top can cause major distractions, as well as damaging good will and brand value.” Marc Hassler, sustainable investment analyst at Schroders, believes integrating corporate governance and scoring well on corporate governance is crucial. “Our experience tells us that companies looking at corporate governance make better investments over the long run,” he says.
There has been a plethora of academic studies and research linking good governance and superior long-term returns. According to a paper from Schroders, Corporate Governance: thinking fast and slow, corporate governance is the most researched pillar of ESG. The paper claims there are several ways in which corporate governance can affect company performance: “From an operational perspective, it is argued that firms with weak corporate governance can be less efficient, have lower labour productivity and suffer from higher input costs. This is in line with studies providing evidence that companies with strong corporate governance experience lower cost of capital.” “Historically, out of ‘E’, ‘S’ and ‘G’, corporate governance has been the one that has been integrated or has been considered for investment for by far the longest period of time, compared with environmental and social,” says Hassler. “If we look at academic research, corporate governance as a topic has been examined far longer historically than environmental and social.” This is mainly because there simply has not been the same volume of data on environmental and social factors, although these are catching up. Hassler adds: “For most of our investors, the ‘G’ is a natural part of the investment process, to consider corporate governance structures when they make investment decisions.”
Just because there is a wealth of research on corporate governance, it does not mean all of it is valid, however. The Schroders paper points to one study by Core, Wayne & Rusticus (2006), which found “firms with weak shareholder rights exhibit significant operating underperformance”. But Schroders points out that the final results of the academic study do not support the hypothesis that weak governance causes poor stock returns. One of the main problems is that often there is no definition of what ‘good’ corporate governance is or what it looks like. Hassler agrees corporate governance is largely dependent on context. “The context might be region, industry or even time. Corporate governance issues have risen in importance and declined in importance over time,” he says. “Even things like business cycle can influence the way corporate governance is thought about. It’s highly context dependent, so finding a ‘one size fits all’ answer to what is good corporate governance is pretty tricky.”
Context theory
‘Our experience tells us companies looking at corporate governance make better investments over the long run’
Marc Hassler, sustainable investment analyst, Schroders
corporate governance
on the right road
With ESG approaches differing substantially between asset managers, how can fund selectors spot the methods likely to prevail over the long term?
Early adopters
‘The effective incorporation of ESG into mainstream fund selection will lift the whole industry. Those that don’t use ESG are missing a tool to boost performance’
There has been a proliferation of investment products that either take into consideration ESG factors or specifically target ESG outcomes. But, as definitions of ESG investing differ between asset managers, so have their investment approaches. Carlo Funk, EMEA head of ESG investment strategy at State Street Global Advisors, says that for decades, asset owners have used exclusionary strategies to exclude securities not in alignment with their values from their portfolios. “Increasingly, investors are embracing ESG due to the long-term ‘value’ it offers. They are looking at ESG factors not as separate considerations but as complementary data to be integrated alongside traditional financial information,” he says. Funk points to other growing trends in the space, one of which is investment strategies powered by multiple sources of ESG data; another is the evolution of climate solutions to include adaptation alongside mitigation.
Darren Kelland, global head of private client services at Hawksford, says while the US and Asia are lagging behind Europe and other parts of the world when it comes to ESG investment, markets that have adopted it early have their own challenges. “Some of the earliest efforts into ESG were rushed – aimed at achieving a virtuous, or clearing a, conscience and did not pay enough attention to impact and result. Measurement was poorly or inconsistently applied,” he says. A survey by American Century Investments of 1,003 US adults and 1,004 UK adults found that millennials, defined as those aged 21 to 28, had a heightened interest in impact investing in both the US and UK, at 65% and 72%, respectively.
So, which of the various approaches to ESG investing are likely to prevail, given the changing demographic of investors? According to Adrian Lowcock, head of personal investing at Willis Owen, there are two approaches that will win out in the long term. “The effective incorporation of ESG into mainstream fund selection will help lift the whole industry,” he says. “Those that don’t use ESG are missing a tool to analyse companies and potentially boost performance, so ESG here is a way for fund managers to gain a competitive advantage.” “The positive selection approach has been critical to the fresh interest in ethical investing as it looks for companies which are changing the world, instead of avoiding those that are damaging it. The more proactive approach has contributed to the positive perception,” adds Lowcock.
Competitive advantage
future of esg
Marc Hassler, sustainable investment analyst at Schroders, believes asset managers must take an active approach to ESG integration. “It’s really important to use our long-term sector-specific knowledge and to take an active stance – be an active owner. To engage with the companies, to vote accordingly to drive these companies to make changes helps the business model and its long-term success,” he says. Kelland agrees the best ESG investments are those where the goal is not to have a clear conscience but to make a difference. According to Lowcock, social and governance factors are perhaps the most highly prized within ESG, but ethical and environmental remain “a bit of a quagmire”. He says: “The main issue is that ethics is constantly evolving as we learn the impact of different business practices over time. What was ethical five years ago might not be ethical practice today.”
Actively ethical
Millennials have a heightened interest in impact investing
US
UK
65%
72%
Source: American Century Investments
Adrian Lowcock, head of personal investing, Willis Owen