The increased focus on environmental, social and governance (ESG) issues is transforming investment approaches. Companies and asset managers are changing the way that they engage with each other, resulting in a positive outcome, both for investors and society as a whole.
For years, meetings between a corporation’s executive team and active investment managers have followed the same format. Investors sit down with the chief financial officer (CFO), or chief executive officer, and discuss the outlook for the company.
However, the trend towards sustainable investing is finally driving a change to this formula.
Now a CFO might bring seven or eight directors to talk about how their respective departments are addressing concerns - from gender inequality to carbon emissions, to supply chain risks.
Such a trend illustrates the seriousness with which corporate managers are taking ESG concerns, integrating them into decision-making at all levels of the business. We believe it also shows that the forum for driving real change is in the boardroom, rather than from solely behind a computer screen.
Corporate engagement forms a central pillar of the active approach to sustainable investing, and a policy of regularly talking to and meeting corporate decision makers has some advantages over other approaches.
Firstly, and perhaps most importantly from the viewpoint of sustainable investing, is that a strategy of engagement provides a setting in which to raise concerns about how a company manages the impact it has on the society or environment in which it operates.
This can take several forms. Engagement often starts with questions submitted to a company’s investor relations team. These concerns can be escalated to discussions with management, and ultimately be expressed in voting patterns and shareholder resolutions.
Beyond the balance sheet
Secondly, an engaged asset manager is more likely to spot the sort of risks and opportunities that don’t show up on the balance sheet. These non-financial risks can have a real financial impact on a firm over time.
Interacting with corporate managers gives a good sense of the culture of a company. A poor culture giving rise to issues such as employment discrimination or product safety, which is a source of risk that is likely to materialise in the form of fines or recall costs later on.
There are important qualitative, as well as quantitative impacts. For example, companies that ignore the importance of a diverse board and workforce may find it harder to recruit and retain the most talented employees. Similarly, a leadership whose values are at odds with their employees’ risks harming morale and motivation among their staff, hampering the company’s ability to innovate and outperform its competitors.
Meanwhile, companies with poor governance face increased reputational risk, which when realised, can severely depress stock prices in the short and medium term. Active asset managers have a role to play in holding corporate management accountable and minimising these risks.
Engagement is a two-way street
According to an academic study1, ESG engagements generate an excess return of 1.8 per cent over the year following the initial engagement. Engagement on corporate governance and climate change themes was found to be the most profitable, generating excess returns of 8.6 per cent and 10.3 per cent respectively.
The report also found that interactions with investors on ESG issues focused the minds of corporate managers. “After successful engagements, companies experience improvements in operating performance, profitability, efficiency, and governance,” the study, published in the Review of Financial Studies in 2015, said.
Engagement provides a forum for collaboration between asset managers and executives where they can discuss how best to realise their ESG objectives.
For example, now-nationalised Dutch bank ABN Amro capped the salary of its CEO at around €700,000, and with zero bonus, to limit expenses and curb risk-taking behaviour following the 2008 financial crisis. Engaged asset managers were able to help the company realise how important it was to promote the cap publicly as a best practice and make it more likely to be kept in place in the future.
This was a long-term benefit to shareholders, in that by amending the remuneration scheme, it reduced the executive’s incentive to pursue risky business strategies that have the potential to undermine the financial strength of the firm.
A shared approach
There are several ways to approach sustainable investing, however the paths share the same aim: to combine the investor’s ESG priorities with maximised investment returns.
Regular engagement can help to create value and manage risk, with the aim of improving outcomes for both the investor and society as a whole.