German car giant Volkswagen used to make a show of its environmental, social and governance credentials. The company exhibited its Volkswagen Golf TDI at car shows with ‘Clean Diesel’ emblazoned on the side. It received awards for its environmental leadership. Moreover, its share price had been performing strongly.
But for Marc-Olivier Buffle, a portfolio manager at Pictet Asset Management, something was amiss. Pictet employed an ESG scoring system to flag up areas of concern; it raised questions about the Volkswagen’s governance and Pictet shunned the company’s shares.
In September 2015, the US Environmental Protection Agency accused Volkswagen of fiddling with its diesel engines to bypass tests causing eleven million vehicles to break emissions standards. In the fall out, Volkswagen’s CEO resigned, the company’s share price collapsed, and the carmaker was fined $2.8bn (€3.2bn).
“To be fair, we didn’t know it was a pollution issue at the time,” Buffle said. “But we detected issues with the company’s governance and therefore we did not invest.”
Pictet’s ESG analysis combines research and metrics from third-party providers. Its ESG scores can help fund managers detect management failures – but do not necessarily highlight the exact problem. “It is not a silver bullet,” Buffle said. “If it was that simple you could do ESG scores and immediately make money out of it. You need to integrate this knowledge along with financial information.”
Buffle continued “There is not a one-size fits all process for ESG integration – it varies from one team to another.
“The European sustainable equities team, for example, integrates ESG in a different way to the fixed income team.”
Open to interpretation
Environmental and social governance (ESG) has become a chief concern in the asset management industry over the last couple of years. Investor signups to the UN’s Principles for Responsible Investment initiative has risen to risen to 2004 signatories this year.
Many analysts claim socially-responsible investing can result in returns on a par with, or even better than, conventional investments and cite academic research to support this. But questions about what constitutes an ESG investment and how to successfully integrate the criteria into investment portfolios remains open to interpretation.
Franklin Templeton began to integrate ESG criteria into its investment processes in 2013, when it established a centralised ESG team.
Before the ESG team’s establishment, Franklin Templeton already assessed corporate governance factors – such as the composition of the board – and their impact on valuations. But environmental issues such as climate risk were less considered.
Although its ESG initiative was established five years ago, the investment teams are still working on integrating the ESG factors, said Julie Moret, London-based head of ESG at Franklin Templeton.
“ESG integration is tailored within each investment groups because they need to reflect their own unique investment approaches,” she said. “It’s about understanding how these additional new data sets aid investment decision making,” she said.
The firm’s global macro team, for example, has developed a proprietary ESG country index, which formalises ESG evaluations at a country risk assessment level. Within the index, the team developed 13 sub-categories, which cover governance indicators (such as corruption), social indicators (such as human capital) and environmental indicators (such as resource scarcity) that they use to score individual countries on a scale of 0-10.
In equities, the centralised ESG group has been working with the global equity group to develop a proprietary climate assessment risk framework, where it would identify companies that are well placed to benefit from a transition to a lower carbon economy, she added.
A slow process
Dutch asset manager Robeco’s first foray into ESG was in 1999, with the launch of its first sustainable equity fund. However, the firm has not yet integrated ESG factors into all its strategies, according to Masja Zandbergen, the firm’s head of ESG integration.
In 2005, the firm acquired Sustainable Asset Management (now Robeco SAM) which gave the group a centre of expertise in sustainable investment and research, Zandbergen said.
In 2010, firm began to use Robeco SAM to integrate ESG into the investment processes for all assets it manages. “Each investment process requires its own approach,” Zandbergen said.
For example, for government bonds, an ESG report is made at the country level. Country scores are based on 17 indicators, such as environmental risk, human development, political risk and aging.
“Incorporating this type of information in the investment analysis gives us additional information that is not easily obtained via other data sources. It helps us to spot problems as well as opportunities in countries well before they are reflected in spreads or are picked up by rating agencies,” Zandbergen said.
For Robeco’s equity teams, it links ESG factors to value drivers, such as sales, margins and cost of capital. The starting point of the linking process is having an understanding of the nature of the business and its most important stakeholders, which in turn should allow an analyst to identify the most material issues. For example, for a bank, it would be corporate governance, while for energy companies, it is eco efficiency.
After identifying material issues, the analyst then assesses how the company performs on these issues relative to its peers, whether or not the company will derive a competitive advantage from its most material issues and how that affects its value drivers.
In March, the firm also decided to exclude investments in tobacco from all of its mutual funds.
Responsible investing policy
BNP Paribas Asset Management took different steps before deciding to integrate ESG factors into the investment process, according to Helena Viñes, head of sustainability research.
It first established an ESG research team in 2002, but that team was responsible for socially responsible investment funds, which invest in companies that have a social and environmental impact.
In 2012, the firm developed a responsible investment policy, with the goal of strengthening engagement with the companies a fund invests in and eliminating companies that have repeatedly violated one or more UN responsible investing principles.
However, the firm did not implement ESG factors into its fundamental research until last year.
Like Franklin Templeton and Pictet, ESG integration is different across investment teams. For equities, some teams have assigned an ESG scoring system that will help them identify problems and if they would need to engage more with the companies they invest in.
A separate scoring system determines the weighting of investments, Viñes added, noting that the scoring may vary from one team to another.
“In some teams, they will not invest in a certain score. For others, it may be an indicator for more engagement to encourage them to improve on their practices,” she said.