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Burning banknotes is bad for climate change too

29 July 2021 Gareth Stokes

Investors who fail to take account of environmental, social and governance (ESG) factors when adding listed equities to their portfolios may just as well throw banknotes into a furnace. And throwing banknotes in a fire, as we all know, is bad for carbon emissions and hastens climate change. Our tongue-in-check introduction uses this banknote, climate change and fire imagery to remind you and your clients that investing in companies with poor ESG track records can cause tremendous damage to long-term portfolio returns. Siboniso Nxumalo, Portfolio Manager at Old Mutual Investment Group, recently confirmed our concern, telling an audience at The Investment Forum 2021, an event hosted by The Collaborative Exchange, that ESG had a significant impact on company valuations. 

ESG controversies cost shareholders billions

“As listed players, and as fundamental analysts in a listed market, we have to pay attention to ESG; it is not something we can leave to private market and impact investors,” said Nxumalo, before commenting on the more than US$500 billion market valuation wiped from global listed companies due to ESG controversies in recent years. One high profile example of the intersection of environmental and governance failings comes courtesy German car manufacturer, Volkswagen. Around €15.6 billion in market capital was destroyed immediately following a September 2015 announcement that the firm had fiddled US vehicle pollution tests over many years. By March 2020, the firm had paid €31.3 billion in fines and settlements stemming from the scandal. 

South African investors have suffered a litany of governance losses in recent years, with the most significant being the financial ‘smoke and mirrors’ around dual-listed Steinhoff. Governance failures at Steinhoff cost investors around R217 billion with the more recent troubles at African Bank causing market devaluations in the region of R9.9 billion. The point is that investors have to pay attention to ESG because the consequences of missing an E, S or G pitfall can be dire. “Your clients lose money when ESG failures take place because share prices go down,” said Nxumalo. His presentation, titled ‘ESG integration into listed equity analysis’ investigated some of the latest thinking in pricing equities to accurately reflect ESG risk. 

Investment T&Cs for millennial consumers

The current obsession with ESG investing stems from a mindset shift among consumers, who are introducing a few terms and conditions of their own before handing money to asset managers. They still want risk-appropriate growth from their assets; but additionally demand that this growth be achieved responsibly and sustainably. According to Old Mutual Investment Group, it is difficult to meet this ESG requirement in the South African listed equity space due to a dearth of quality shares. One cannot simply proceed on the basis of excluding shares that have high carbon emissions, for example, because that would mean zero exposure to JSE stalwart such as Sasol, which has provided good returns at times. 

“Eliminating companies based on emissions or other ESG factors leaves a narrower pool of assets to invest in,” said Nxumalo. And there are practical arguments against exclusionary equity strategies too. Imagine a South Africa where all investments into coal mining and oil refining were summarily stopped. You would end up without electricity as Eskom’s coal-fired power stations fizzled out, while motorists would be left ‘high and dry’ as local garages ran out of fuel. Another consideration is that firms often have diverse exposures to both clean and dirty industries, while some apparently dirty businesses produce commodities that are essential for a clean future. A copper or lithium mine, which will typically have a poor environmental impact, produces inputs for batteries for electric vehicles and solar storage, for example. 

Maximum return, maximum impact, minimum risk

Modern day asset managers have to manage clients’ funds to achieve an ESG trifecta of maximum return, minimum risk and maximum impact. But how do they go about evaluating shares to identify and quantify the risks inherent in firms’ ESG shortcomings? “Our ESG decision tree is simple,” said Nxumalo. “We begin by separating ESG information that is non-material from that which we believe to be material”. Once this first stage is complete, the asset manager’s analysts put the material information under a microscope to determine whether the information is quantifiable, such as a carbon tax on a share like Sasol. If an ESG factor is considered material, non-quantifiable, the process becomes more difficult. 

“Almost every one of the scandals referred to in this presentation stemmed from non-quantifiable risks,” said Nxumalo. “We have a valuation or price on the one side of our model and a positive or negative theme on the other; a company with a negative theme will raise flags no matter how wonderful the price is”. This process is further assisted by an independent ESG team that analyses and ranks each JSE-listed company based on various ESG factors. This Old Mutual ESG Profile or Ranking serves as the basis for the asset manager’s systematic equity process; fundamental risk screening; and listed equity stewardship. 

Choosing funds with conscience

Financial advisers can refer to a unit trusts’ MSCI ESG Rating, which more and more asset managers are now including on their fund fact sheets, to ensure they invest in line with a client’s environmental and social conscience. “Active engagement and stewardship is important in a market as narrow as ours,” concluded Nxumalo. “That is why we are taking a more active role in caring for our clients funds … managing ESG-related risks demands that we step up and engage with the companies we invest in”. 

Writer’s thoughts:
There were a number of ESG-focused presentations at The Investment Forum 2021, with most pointing out that listed companies that address ESG concerns / perform well on ESG measures tend to outperform. In other words there is a high correlation between active ESG and return. Given what you know about ESG investing, are you comfortable that asset managers can accommodate environmental and social concerns without compromising your client’s investment return? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].

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