Interview with Alex Everett, Investment Manager at Cameron Hume
It’s a mistake to regard ESG investing as a short-term or future trend. Investors and corporates are no longer able to ignore the urgency in prioritising sustainability – both for economic and existential reasons. According to the CFA Institute’s ‘Future of Sustainability’ report, in 2020, 85% of their members took ESG into consideration regarding investment decisions following increased demand from their client base. The demand for transparency in corporates will only continue as firms are held responsible for their business policies and/or practices – and those who eschew accountability will get left behind.
Investment management companies are all approaching the issue from different perspectives. We spoke with Alex Everett from Cameron Hume, a leading fixed income specialist with a dedicated focus on ESG integration.
Why is integrating ESG factors into fixed income investing important?
Integrating ESG factors into our investment process makes us better fixed income investors. The insights we gain help us to better serve our clients by understanding investment opportunities more fully.
Our decision to invest is based on whether the yields on offer are attractive. Views on credit quality strongly influence this decision, with higher yields demanded for lending to riskier borrowers. ESG provides insights into the sustainability of that credit quality, by considering risk exposures (E and S: Environmental or Social exposures, policies or practices) that are poorly managed (G: Governance). However, the bond market has been a little slow to fully integrate ESG considerations. On average, companies that manage ESG factors poorly do not pay more than their peers who manage ESG factors well.
The fixed income market is a very important source of funding for sovereigns and corporates alike. For example, during 2020 the US equity market raised the most money in 20 years, yet the US bond market raised 5 times this amount! Bond investors should vote with their feet: lending if ESG risks are reflected appropriately and choosing other bonds or issuers when they are not.
Why do you think the bond market has been a little slow to fully integrate ESG considerations?
The Credit Crisis drew attention to the importance of ESG factors, and investors first turned to tried and tested practices for implementation. Changes to listing rules and regulations gave shareholders a say on a broader range of topics than previously. This in turn encouraged ESG integration in equities, leading to greater corporate engagement.
There was no comparable extension of rights for bond holders. It has taken time, not to mention creativity, to work out how to integrate ESG into bond investment decisions. It is clear to us that the way in which we integrate ESG should reflect the character of the bond market, rather than replicating approaches better suited to other asset classes. We may not have votes, but the sheer scale of the bond market gives us both choice and influence upon issuers – that is the opportunity. In fact, some sources (such as the CFA Institute) suggest that bond investors may have more influence on ESG outcomes than equity investors. Attitudes are beginning to change.
What is influencing this change in attitudes?
I think change is coming from the realisation that whatever the motivation for integrating ESG (to improve returns, to make a particular impact or both,) bond investors should demand yields which really do reflect the ESG risks the borrower is choosing to run with.
The climate transition is a good example. Climate change is likely to affect companies’ operations and the regulatory frameworks within which they operate. Yet, some companies are making only loose commitments, or avoiding the issue altogether. This is a governance failure. If management are not considering and acting on this risk, their credit may be damaged. Lenders may lose out, so yields should be higher for borrowers who fail to manage transition risk well.
More positively, others are preparing for the future by taking significant, measurable steps towards net zero. By acting now to increase their resilience to physical, liability and transition risks posed by climate change, they become more credit-worthy (all else equal). By demonstrating good governance, these companies should pay less than their peers to borrow, particularly for longer dated bonds.
What are the barriers to ESG integration?
Integration is difficult! ESG must be part and parcel of investment decisions for its influence to be positive. Investors must also be long-term in their thinking, considering investment decisions in the round.
Consider the hypothetical scenario of a company investing heavily now in green technology and changing business practices to suit. Executing a successful climate transition will be expensive. Short term profits may fall and the management may choose to raise more debt, cut other capex or cut dividends to fund the transition. How the management acts – or rather how the market expects them to act – will affect the returns of equity and bond investors. For example, cutting dividends may benefit bond holders by preserving the credit-worthiness of the company, but simultaneously cause the share price to fall.
Ongoing investment and orderly management of the transition will be required. These issues are long-term and complicated, which makes strong governance more important than ever.
How can fixed income investors integrate all of this into their decision making?
We started by building ESG into our investment processes. This meant going right back to basics, looking at how we make decisions and how ESG factors would feature.
Bond investment decisions are based on a comparison of an issuer to its peers. If we are to integrate ESG, then we need information on both the issuer and its peer group and that ESG information must be comparable and consistent. This means that some work has to be done to ensure that equivalent definitions and criteria are used across sectors, geographies, asset classes and so on. We believe that to integrate ESG we need to establish new practices and habits in a re-designed investment process supported by data.
Can you tell us more about integrating ESG data?
ESG data provision is now a huge industry. A recent paper reports that at the end of 2019 there were 70 different firms providing their own ESG ratings, never mind the investment banks and government-linked organisations with similar offerings. Furthermore, many investors have developed their own internal investment teams, complete with proprietary methodologies to add to the mix.
At Cameron Hume, our favoured approach is to engage the services of an external ratings provider. Using third party data provides independent verification of ESG integration to our clients, our board, our regulators and others. You don’t have to just take our word for it when we say we have integrated ESG factors.
We use MSCI, but other providers would be suitable. The key point here is transparency of approach. By this I mean that detail on how the agency arrives at a ratings decision is widely available. From here, managers can follow their own investment processes to consider ESG factors as part of their wider investment analysis.
Does that mean there’s no place for internal ESG teams?
Quite the contrary. In the same way that risk management is the responsibility of all investors (not just the Head of Risk Management), ESG integration is the responsibility of all investors. Most importantly, ESG should feature alongside other factors as part of decision-making, not as an afterthought. Internal ESG teams can certainly support this effort.
What evidence have you seen of the pandemic accelerating interest in ESG?
One of the positives to come out of the pandemic is that we are collaborating more. The concept of being ‘all in it together’ applies to ESG integration, whether in encouraging better working practices, raising governance standards or sharing integration approaches. There is also an effort to become more proactive rather than reactive, which is welcome.
How do you think bond investment will evolve over the next decade? What do you think will cause investors’ priorities to shift?
I think we will see bond portfolios used as a more explicit mechanism for change and impact. As I mentioned above, the bond market is a significant source of funding, and therefore offers significant influence on issuers. Regulation might push for this, too. For example, the UK Stewardship Code is a framework for sustainable asset management, which may well be strengthened if the market doesn’t fill the vacuum itself. The UN PRI’s Inevitable Policy Response is a good example.
Are there any countries that are proving to be leaders in ESG investing?
The EU is setting standards through its recovery-focused SURE programme, not to mention the mooted climate amendments to the ECB’s bond-buying policy. However, the power of asset owners is growing considerably. I would point to active and often vocal investor bases in Australia, the Nordics and some pension funds in the UK. These investor bases have kickstarted conversations which have encouraged wholescale shifts in corporate strategy and also humbling public apologies. Better visibility of investments and improved dialogue between investors and end clients are doubtless developing the ESG investment agenda.
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