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ESG moves to the centre of investment decision-making

STANLIB ESG
Nicholas Naidoo

Nicholas Naidoo

Head of Credit at STANLIB Credit Alternatives

Zeyn Ismail

Zeyn Ismail

Head of STANLIB Credit Alternatives investment team

Changes in ESG investing

Although it will take time before ESG is widely adopted and suitable standards are established, it has been noticeable over the past two years that more investors are requiring their asset managers to integrate ESG factors into their decision-making, Naidoo said.

 

Traditionally, credit teams based their risk assessments on the “five Cs” of Credit:

  • Character
  • Capacity
  • Capital
  • Collateral; and

Character refers to the track record of the borrower’s management team. Capacity refers to the borrower’s solvency and liquidity; and its ability to take on debt. Capital refers to the amount of “skin” that shareholders have at risk. Collateral is the security the borrower can offer. Conditions highlights the importance of a sound legal agreement.

 

“But there is a sixth ‘C’. Conscience, or ESG as it is widely known in the investment community,” Naidoo said. “It is the duty of investors to invest in a responsible, sustainable manner.”

 

Although ESG is usually used as a collective term, the reality is that environmental and social risks (E&S) are closely related, but governance risks remain somewhat different, he said. While governance risks are well understood by investment professionals, assessing E&S risks require a different approach towards analysing a company. For example, a food retailer has a very different E&S risk exposure to that of a uranium miner. E&S risks tend to be longer term in nature and may extend well beyond the tenor of a loan. They are contingent risks, based on the question: “if something goes wrong, what would be the impact?” Governance risks tend to manifest in the short term, if left unmitigated.

 

Impediments to widespread ESG adoption

There are several impediments to ESG’s widespread adoption in the short term, Naidoo said. One is that it is quite difficult to quantify ESG risks in practice. Different ESG rating agencies use different criteria in assessing these risks, which can result in a wide range of scores, unlike credit ratings, which tend to stay within a narrow band of outcomes.  This is in part because ESG is still in the early phases of adoption, but also is influenced by the materiality and subjectivity required in making these judgements, which requires expertise.

 

A second impediment to adoption is the inconsistency of disclosure. Partly because adoption of ESG reporting is relatively low across industries, it can be difficult to compare companies within a peer group. One company might focus on one ESG risk while a second company focuses on another.

 

The United Nations Principles for Responsible Investment (UNPRI) and the Task Force on Climate-related Financial Disclosures (TCFD) framework are both helping to set high standards as well as ensuring consistency in the way ESG is assessed. This is an area where the auditing profession can play a role, as they already have the infrastructure and expertise to ensure the consistency of financial information. The global ratings agencies could also assist in standardising ESG ratings.

 

A third impediment is that ESG risks are not priced into loans, Naidoo said. If a borrower with a higher ESG risk pays the same risk premium as one with a lower risk, borrowers will not take ESG seriously. In Europe, if the ESG risk is considered too high, investors have the option to disinvest, but in a smaller emerging market, like SA, this is not always a plausible option for credit investors. Naidoo said, STANLIB adopts the initial approach of active engagement to achieve positive results. Should this not yield the desired outcomes, disinvestment is typically the ultimate consideration.

 

The fourth impediment is a lack of oversight and regulation. In Europe, central banks are showing an appetite for getting more involved in ESG risks and its potential impacts on the financial sector. The South African Reserve Bank (SARB) currently applies oversight to banks’ loan book risks, under the Basel accord and it would not be a stretch for the SARB to incorporate ESG risk assessment into this discipline as well, Naidoo said.

 

Integrating ESG into investment processes

Ismail said when considering ESG in portfolio construction and management, it is worth noting that ESG straddles several approaches from integration to socially responsible investing to, more recently, impact investing.

 

Integration refers to the analysis of ESG factors as part of an investment process. Socially responsible investing applies the lens of conscience, where investors are concerned with how returns are earned. Impact investing refers to the generation of financial returns while igniting positive and measurable social impact.  Impact investing also represents an evolution of socially responsible investing, as investors transition from the principle of “do no harm” to the principle of actively “doing good”.

 

The UNPRI highlights three approaches for incorporating ESG into one’s investment processes: integration, screening and thematic.

 

Screening refers to the application of relevant filters when analysing investment opportunities. There are in turn several approaches to screening. These include being negative, positive or adopting a norms-based screening approach.

 

Negative screening is geared towards avoiding the worst performers from an ESG perspective. This implies that certain sectors or issuers would be excluded based on specific ESG criteria. Examples would be the avoidance of weapons manufacturers or the alcohol or tobacco industries.

 

Positive screening requires the asset manager to seek out companies that demonstrate a higher level of ESG commitment and performance than their peers. Under norms-based screening, issuers are measured against minimum standards of business practice based on international norms.

 

The thematic approach to investing entails deliberately channelling capital towards areas that generate compelling financial returns while also positively contributing to chosen environmental and/or social factors. Impact investing falls into this category. STANLIB has embraced all three approaches by incorporating integration and screening into their investment processes, and recently launched the STANLIB Khanyisa Impact Investment Fund to align with the critical role that impact investing will play in SA’s economy in future.

 

Conclusion – the way forward

Ismail said some of the challenges in integrating ESG into STANLIB’s investment approach have been the lack of investor awareness, the lack of standardisation and appropriate frameworks, and the fact that binary decision-making based purely on ESG factors is not appropriate for developing economies. A pragmatic approach is needed in engaging with borrowers on ESG issues rather than shunning them, because the investment universe is not as broad as in developed economies.

 

Ismail concluded that sustainability through investing is non-negotiable and what investors are focused on now is no longer the adoption of ESG, but rather how to improve the application of ESG investment principles. 

 

Naidoo added that investors have a fiduciary responsibility to their clients to generate sustainable long-term returns. Change in awareness, behaviour and attitudes can be driven by capital allocators, but that requires a unified approach by the investor community.

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