As shareholders question ESG practices more than ever before, we spoke to our clients about how they are thinking about ESG when managing their funds. From reducing emissions to corporate culture and ESG risk assessments, the conversation highlighted the industry’s approach is not uniform but we are all grappling with the same issues.

Carbon production dominated the discussions. Depending on how you measure carbon, emission vs intensity, a portfolio can yield different results. When it comes to portfolio construction there are two schools of thought; exclusion and inclusion.

On the one hand, excluding carbon producing companies in a smart beta portfolio lowers the environmental impact of the overall portfolio but may create an unintended sector bias. Allocating more funds to low carbon sectors can result in unintended tracking errors.

On the other hand, an actively managed portfolio might invest in carbon producing companies that have sensible action plans in place. Once these companies have achieved an emissions reduction, or steered their operations towards a more sustainable future, they generate long term value and alpha for their investors.

As fund managers, we have a clear responsibility to avoid the worst impacts of poor ESG management to minimise the risk of losing client capital. As seen in the starkly different approaches to carbon emissions, there is not necessarily a single or correct way of mitigating ESG risks.

However a firm defines and measures ESG risks, identifying these risks requires in depth analysis and constant scrutiny of past and present decisions. Our fixed income strategies for example rely on ESG research from both external providers and our own global credit research team.

Our analysis shows a strong relationship between our ESG analysis and our internal credit ratings. In 2018, 40% of our internal credit ratings were lower than those of credit rating agencies S&P and Moody’s*, with 60% of these being rated high or very high ESG risk. This highlights a potential underweighting of ESG issues by the market.

30% of our internal credit ratings were higher than S&P and Moody’s ratings in 2018*, which again are partly a result of companies taking proactive steps to addressing ESG risk and implementing proactive safeguards. ESG in fixed income has mostly been focused on the risk of default, however a company’s ESG practices can also give investors greater confidence in the quality of management and the business, positively shifting the risk vs return ratio. 

We believe our strong ESG processes have contributed to our global credit income strategy having an average BBB security rating but delivering below AA default outcomes*.

Our research team actively scrutinises each issuer on a case-by-case basis against a range of ESG metrics. The risks are different in every sector. Warning signs range from safety lapses, regulatory fines and environmental breaches. In the electronics industry, they look for any signs of exploitation in a factories supply chain, while the biggest area of scrutiny for banking is lending.

If it appears a company is managing any of these visible risks poorly, then we don’t have confidence in other risks being well managed. We provide many company examples of this in our interactive case study map which includes over 100 examples from across our business.

One recent example was our credit research team downgrading Woolworth’s ESG risk assessment from low risk to moderate risk. While Woolworths has commendably exceeded its target to reduce carbon emissions and has partnered with Replast to address plastic waste, we hold concerns over the risks associated with allegations of underpaying employees found by the Fair Work Ombudsman. We anticipate that ongoing legal action from the Retail and Fast Food Workers Union, who are seeking damages of over AUD 1 billion in back pay, could trigger a structural change.

Ethical sourcing of products such as palm oil and seafood also remains a concern, but due to investor pressure and the Modern Slavery Act, policies are being adopted by Woolworths to improve the social supply chain standard.

We believe governance could be enhanced by aligning compensation with ESG factors.

Corporate culture is often touted as something that needs to change to support successful change and in the case of ESG we tend to agree. ESG is more than making a statement about carbon reduction or unveiling a new social policy that you are putting in place. ESG should be at the heart of everything that a company does and its corporate culture should serve as an incubator for lasting change.

These examples show that regardless of whether it is a smart beta strategy investing in thousands of companies or through bottom-up company analysis in a credit fund, ESG factors can be a powerful investment consideration that can deliver sustainable long-term returns and better social and environmental outcomes.

*  Source: CFSGAM, Investment Opinion Network as at 31 Dec 2018. Moody's and S&P annual default studies, based on number of issuer defaults.  Averaged cumulative defaults since 1983. 

Important Information
This document is issued by Colonial First State Asset Management (Australia) Limited AFSL 289017 ABN 89 114 194311, Colonial First State Managed Infrastructure Limited AFSL 240550 ABN 13 006 464 428, Realindex Investments Pty Limited 335381 ABN 133312017. This document is directed at persons of a professional, sophisticated or wholesale nature and not the retail market. This document has been prepared for general information purposes only and is intended to provide a summary of the subject matter covered. It does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an offer, invitation, investment recommendation or inducement to distribute or purchase securities, shares, units or other interests or to enter into an investment agreement. No person should rely on the content and/or act on the basis of any matter contained in this document. This document is confidential and must not be copied, reproduced, circulated or transmitted, in whole or in part, and in any form or by any means without our prior written consent. The information contained within this document has been obtained from sources that we believe to be reliable and accurate at the time of issue but no representation or warranty, express or implied, is made as to the fairness, accuracy or completeness of the information. We do not accept any liability for any loss arising whether directly or indirectly from any use of this document. References to “we” or “us” are references to Colonial First State Global Asset Management (CFSGAM) which is the consolidated asset management division of the Commonwealth Bank of Australia ABN 48 123 123 124. CFSGAM includes a number of entities in different jurisdictions, operating in Australia as CFSGAM and as First State Investments (FSI) elsewhere. Commonwealth Bank of Australia (the “Bank”) and its subsidiaries are not responsible for any statement or information contained in this document. Neither the Bank nor any of its subsidiaries guarantee the performance of the fund or security or the repayment of capital. Investments in the fund or security are not deposits or other liabilities of the Bank or its subsidiaries, and the fund or security is subject to investment risk, including loss of income and capital invested. Past performance is not a reliable indicator of future performance. Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell. Reference to the names of any company is merely to explain the investment strategy and should not be construed as investment advice or a recommendation to invest in any of those companies. First State Investments (Hong Kong) Limited (FSI HK) is exempt from the need to hold an Australian financial services licence under the Corporations Act 2001(Cth) and is regulated by the Securities and Futures Commission of Hong Kong under Hong Kong laws, which differ from Australian laws. Copyright © (2019) Colonial First State Group Limited. All rights reserved.

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