ESG investing becomes mainstream

The increasing client expectation from investors to not only deliver investment return, but to achieve this by considering Environmental, Social and Governance issues has escalated rapidly over the last 12-18 months. Some in the industry are pushing for this to become a fiduciary duty. For early adopters in the Responsible Investing sector, the evolution to get to this point has taken a long time. What was once a specialised investment thematic (Socially Responsible Investing) begrudgingly tolerated with a large amount of scepticism, is today increasingly becoming mainstream.

The focus on ESG integration into investment processes is having an increasingly positive effect on corporate behaviour. The banning of non-reusable plastic bags by the big supermarkets, capital allocation decisions by energy companies to invest in renewable energy, major banks stopping funding of predatory pay-day lenders and the acknowledgment there is a genuine need for diversity targets in the workforce are all examples of how investors are influencing corporates to be aware of their ‘social licence’ when it comes to delivering returns to shareholders.

The ‘two strikes’ law certainly heralded a new era for Governance

The ‘two strikes’ law (that came into effect on 1 July 2011) designed to hold directors accountable for executive renumeration was the first big step that had a major impact on ESG considerations in investing. This rule was initially met with scepticism from boardrooms across Australia. It required Boards (especially Chairperson and Chairs of the Remuneration Committee) to have a dialogue with shareholders at least once ahead of their AGMs. As time has passed, it has certainly emboldened Boards to have more influence around management renumeration, strategy and appointments – all of which have no doubt led to better investment returns for individual companies and the broader market.

Some of the Board scepticism is well founded

One of the key reasons for the scepticism by Boards was the lack of consistency and short termism shown by investors in their approach towards governance issues. By way of example, a very well-regarded Director was Chairman of two ASX 100 companies. The share price of one had done exceedingly well and the other quite poorly over the same 12-month period. An independent survey of investors rated the same person as one of the country’s top Chairmen for one company and at the bottom for the second underperforming company. The view among some Boards was that the Remuneration report was being used as a protest vote against poor short-term share price performance rather than any real focus on governance (and ESG issues) that was going to benefit shareholders in the long term.

The Banking Royal Commission has made the topic of ESG very real

The significant adverse impact on the share prices of banks and wealth managers from the Royal Commission fallout has focused the minds of investors and asset owners on ESG-related issues. The chart on page 2 presents the share price performance of CBA and AMP over the last 12 months. Despite both companies posting reasonable earnings, the impact on not focusing on their ‘social licence to operate’ has resulted in big fines, damage to their brands, increasing capital requirements and earnings headwinds. These consequences are starkly reflected in the material share price underperformance for both these companies.

Relative Share Price Performance

Source: IRESS

Climate Change is top of mind for domestic insurers and energy intensive companies

The discussion around rising energy prices in Eastern Australia in the last 12 months following the closure of the Hazelwood coal fired power station in Victoria last year has certainly brought the impact of climate change closer to home. The brown outs in South Australia, the shortcomings of the National Electricity Market and constant political and regulatory intervention has made investing in the domestic energy sector almost impossible, with no certainty around longer term returns.

Regulators globally have been focusing on climate change related risks to the finance industry, encouraging greater disclosure. In recent years, Australia has been regularly impacted by natural disasters that have taken a toll on its insurance companies such as Suncorp and IAG. Companies such as Rio Tinto and BHP have been focused on reducing their carbon intensity by largely divesting non-core assets – in the case of Rio Tinto, their sale of Coal & Allied thermal coal assets resulting in a lower carbon footprint. These companies are certainly aware that negative screening on ESG related issues was resulting in a structural increase in their cost of capital.

Reporting and analysis have some way to go

Somewhat ironically, CBA had been named Australia’s most sustainable business on the Global 100 Index (100 most sustainable companies globally assessed by Corporate Knights and announced annually at the World Economic Forum) for three consecutive years. It was also ranked first among banks worldwide. Until the AUSTRAC civil proceedings against the company in August, this assessment would have been echoed by most local investors in Australia. The recent APRA report following its prudential inquiry into CBA has delved into issues of its governance and culture that have not previously received adequate attention from investors. Consequently, we expect enhanced disclosure by all corporates around risk and governance and Boards will likely ensure these key values are considered an integral component of executive remuneration going forward.

Investors need to focus on longer term outcomes

Akin to the earlier example of the Director who thought investors were being schizophrenic, we as   investors need to take our share of responsibility for not focusing on longer term outcomes. The increasing evidence of using ESG for tactical alpha opportunities will result in these issues getting greater focus –the recent media reporting and Senate inquiry into franchising businesses is an example of that.

We consider that many successful Australian companies within high profile essential and semi-essential industries (e.g. Banks & Utilities) are entering a challenging period of increased scrutiny. Historically most local industry leaders have enjoyed the benefits of good market structures with strong barriers to entry and hence great returns over a prolonged period. Since the GFC, a lack of top line growth has meant sustaining those returns has been more difficult, and recent hopes of synchronised global economic growth as a fillip to revenue has dissipated such that Australian corporates have had to show their dexterity by improving efficiencies and reducing costs to maintain returns.

Against this backdrop of no, or at best low top line revenue growth, community concerns (amplified by the media and politicians) around social and environmental issues, have put the spotlight on bad behaviour and cultural issues – forcing incumbents to simplify their businesses and shed inertia revenues which is significantly impacting returns. A good example of a company that has been in the eye of the storm more recently is Telstra.

Sustainability of returns is the key

At WaveStone, our investment process helps us consider and integrate ESG into our investment decisions. Capital allocation is a key tenet of our investment process, so on the governance front, we are well aware of the benefits of good governance that can result in sustainable returns for our investors. We will certainly be focusing more on Environmental and Social factors in future. This will include trying to identify proactively where there are cultural issues in an organisation, questioning management on their approach to risk management, monitoring decision making and how they deal with potential environmental risks that challenge their long-term prospects.

Author: Raaz Bhuyan, Principal and Portfolio Manager