Measuring what matters: impact, ambition and trust
With ESG reporting in its infancy, many investors take ESG scores at face value. In doing so, they risk missing what really matters. Toby Ross, co-manager of our Global Income Growth strategies explains.
The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.
We have a confession to make: two popular ESG ratings providers consider that a company we hold poses a high environmental, social and governance (ESG) risk, and so may be unsuitable for a responsible investor.
We disagree. The company is Albemarle, a leading supplier of lithium, a key component in the lithium-ion batteries that power electric vehicles. The company produces around 20 per cent of the world’s battery-grade lithium and is scaling up its production five-fold to meet growing demand from car companies. Without this, companies such as Tesla, Toyota and Volkswagen will struggle to scale up the production of electric vehicles globally.
The ESG rating providers Sustainalytics and MSCI are right to highlight the risks involved. Lithium production can be water-intensive, and some of Albemarle’s production is in arid areas of Chile. For any producer, managing its relationships with its stakeholders is vital – whether that’s local communities or the national governments that provide a licence to operate. And Albemarle’s production processes inevitably entail some greenhouse gas emissions. But we believe that this is a narrow and backwards-looking way to assess whether Albemarle is a responsible investment.
Albemarle is a good example of why ESG scoring systems should not be taken on face value. First, there’s their heavy bias to ESG risks, not opportunities. Water consumption in the Atacama is a risk, but the impact on global carbon emissions of Albemarle’s capacity increase, if successful, will be material. That is a complex trade-off, which a simple metric does not convey.
Second, the scores tend to lean very heavily on what companies report, which is often limited by what can be measured. Disclosure is important, but as equity investors with a long-term time horizon, we recognise it is not everything. What often matters more is the direction of travel at a company and where it will be in five or ten years. We should be giving at least as much thought to the emission savings enabled by a company’s products by 2025 or 2030, as we do to the emissions of that company today.
Finally, there’s an important component that is hard to calibrate: can investors trust the people running the company? It’s easy to score a company on the gender diversity of its board, or whether there is a dual-class share structure. But trust goes beyond the board’s form. What matters is who those individuals are and whether the board operates in a constructive way that is aligned with long-term investors. Do they challenge the executives? Do they have a track record of delivering on the company’s commitments to shareholders and other stakeholders?
This isn’t some technical debate about what to score and how to do it. Most investors agree we should move beyond sector-based exclusions to define what a ‘responsible’ or ‘sustainable’ investment is, but there’s no consensus as to what that is. With ESG covering such a vast range of interconnected areas, an easy shortcut can be to outsource your thinking to a third party that hoovers up all the available data into a massive matrix of scores, ruling out the companies that fall below a certain level along the way. Many of the largest ESG or sustainable funds operate so, particularly passive funds.
In our view, this is the opposite of responsible long-term investing, because it pulls capital away from the likes of Albemarle – the very companies that could be making the biggest difference.
So when evaluating ESG risks and opportunities at potential holdings, we place little emphasis on these scores. Our framework instead favours values-driven, forward-looking, critical judgements over backwards-looking numbers. The three foundations of our ESG framework – Impact, Ambition and Trust – align with our investment approach.
We begin with the question: what is a company’s impact on the environment and society at large?
We analyse whether the company’s products or services contribute to a more sustainable society. For some holdings, this is easy to answer positively. For instance, the lithium that Albemarle produces. Or, the next-generation obesity medications pioneered by Danish pharmaceuticals company Novo Nordisk, which could improve the quality of life of millions of overweight people around the world.
Understanding these impacts is important because they can create a tremendous tailwind. Products that improve peoples’ lives tend to be in continual demand, supporting strong volume growth or pricing. Conversely, those that cause major environmental or social issues are often fighting a consistent headwind of regulatory intervention.
We also need to consider what the impact is of the company’s operations. Does producing and shipping a product cause physical harm to the environment? Is the treatment of its direct stakeholders constructive and positive? This requires thinking holistically about where the most material operational impacts of a company are – which varies massively company by company. In the case of logistics business UPS, for example, it lies in the emissions produced by its vehicles, as well as its relationships with its large workforce.
One approach to calculating ESG risks is to seek and document statistics for every conceivable way a business might have an impact on stakeholders. This may explain Sustainalytics’ 73-page-long Novo Nordisk report. While there’s value in being aware of all the potential risks, we think that our job as investors is to focus on materiality. The question we should be asking is,
“What are the areas of impact that have the potential to make a significant difference to the investment case? Where is this company’s impact on society potentially outsized?”
There is the risk that we misjudge or mistake what matters: but the same could be said of any investment question. Plus, we think this risk is outweighed by the fact that once we’ve identified what the one or two most material factors are, then it opens the door to a genuinely productive engagement discussion. We think that there is enormous value for both shareholders and society in our engaging with companies and helping them to address an area of significant impact – but this starts with focus.
In analysing a company’s impact, we’re often considering where it is starting from. However, where the company is going is equally important. How might it look in five or ten years?
So we ask – are their ambitions commensurate with the scale of the challenges and the opportunities? Sometimes the answer is ‘not yet’. Then our role as a supportive long-term investor is to encourage them to raise their ambitions. Going back to the Albemarle example, we noted earlier some of the generic challenges that lithium producers face. Over the past few years, we have been engaging with Albemarle at several levels to encourage it to set the standard for what a responsible lithium producer looks like – encouragement that the company has taken to heart. Leading the industry will mean that Albemarle is more likely to realise its volume growth ambitions and not be derailed by an issue that compromises its licence to operate. The impact on the growth rate will not be immediately obvious but will be telling over the many years that we hope to hold the shares.
On top of that, the market also tends to notice when a company is improving and its risk profile is reducing. This is likely to become increasingly true over the next decade: companies operating at the fringes of acceptable practice will find fewer and fewer willing buyers, and the premium for businesses that are proactively addressing, for example, the climate risks in their businesses are likely to be rewarded. We want to encourage our companies to be on the right side of this change.
So, investing in an ambitious company is important to us. However, gauging ambition isn’t easy. Some of the questions we might consider are:
- How stretching are the company’s goals? Do they address the most material opportunities and challenges?
- What difference would the company’s success make?
- How personally invested are management and the board? Do they see the goals as a core part of company strategy?
- How consistent are these goals over time? Does management honestly discuss progress?
Just as when assessing impact, it’s important to focus on the most material opportunities. In the course of our work on Novo Nordisk, both non-profit organisations (NGOs) and academics told us that its programme to increase access to insulin in less developed countries was the best on offer. But they also pointed out further opportunities for Novo to build a bigger presence as these countries develop and as the demand for more complex therapies increases. We’ve discussed this question with the company’s management and encouraged them to be bold in their ambitions, even if the financial benefits may take a long time to emerge.
Finally, there’s the issue of trust. Can we trust the people running the business to meet their commitments to investors and other stakeholders? This question is often overlooked in the rush for ever greater ESG disclosure. Like most things that matter, it’s hard to quantify. But it is one of the most basic and important questions we ask when we’re making an investment decision: do I trust the people on the other side of this table?
Lots of companies are making commitments to reduce the climate impact of their operations. Many will have some form of 2050 target. However, for some, it will be because their ESG consultants have told them to. The skill for investors over the next decade will be to differentiate between the companies that are greenwashing and those that will deliver on their commitments – and keep stretching themselves.
Knowing the companies in which you invest well helps, as does being skewed towards companies whose governance structures allow them to take that long-term view.
It is not easy to distil the robustness of governance structures into simple metrics. The proxies that are the easiest to gather data on, such as board tenure, are often not strong indicators. We look to understand the level of challenge the board offers the executive: do directors have experience of engaging with the company’s most material issues in other contexts? We try and probe the level of thought that the board has given its sustainability commitments – our conversations with chairs and non-executive directors are often revealing. Finally, a company’s track-record matters for earning our trust: some companies are better at making promises than keeping them.
We use our Impact, Ambition and Trust research in several ways. As with Albemarle, it helps us to define our engagement priorities and gauge what success would look like. With limited time and with stakeholders pulling in many directions, it’s vital our engagement focuses on the issues that can make a significant difference to the company’s future success. We don’t want to waste anyone’s time with demands for ever more reporting, which is why debating where the greatest opportunity lies, and how we can help the company achieve it, is such an important part of our process.
Our research also weeds out those companies where there may be a material challenge that isn’t being confronted with sufficient urgency, or where we don’t trust their commitments. We have a strong bias to being patient and engaging – but unresponsive and unambitious companies facing material challenges are unlikely to be a good fit for a responsible long-term investor.
Finally, and perhaps most importantly, our research seeks to identify the real leaders. Considering holdings through our Impact, Ambition and Trust lenses has in several cases bolstered our conviction in the company’s long-term potential and encouraged us to take larger holdings.
Building an ESG process around a third-party score from a rating agency can be appealing: it’s easy to audit and the reams of data can give the illusion that all possible risks have been considered. And, when challenges emerge, it provides someone else for the fund manager to blame.
But if you have a long-term time horizon as we do, then sustainability issues all tend to be investment issues in the end – and this analysis should not be outsourced. How you measure ESG risks and opportunities needs to be aligned with your investment philosophy, and there is rarely any substitute for thinking for yourself.
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in May 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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