Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 298

ESG by new means, to new ends

As shareholders question ESG (Environmental, Social and Governance) practices more than ever, we spoke to some institutional 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 client discussions

Depending on how you measure carbon, especially emissions versus 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 good returns 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.

Credit risk analysis should focus on ESG as well as default risk

Identifying ESG risks requires a constant scrutiny of past and present decisions. 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.

However, 30% of our internal credit ratings were higher than S&P and Moody’s ratings in 2018*, which again is partly a result of companies taking steps to address ESG risk and implement 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 versus 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.

Research should scrutinise 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, investors should look for any signs of exploitation in a factory's supply chain, while the biggest area of scrutiny for banking is lending policies.

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. This interactive case study map includes over 100 examples from across our business.

One recent example was our raising 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, which is seeking damages of over $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 often needs addressing to support successful ESG practices. ESG is more than making a statement about carbon reduction or unveiling a new social policy. 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.

 

Pablo Berrutti is Head of Responsible Investment, Asia Pacific and Mark Nieuwoudt is a Business Development Strategist at Colonial First State Global Asset Management, a sponsor of Cuffelinks. This article is for general information purposes only and does not consider the circumstances of any individual (view full disclaimer here).

For more articles and papers from CFSGAM, please click here.

 

RELATED ARTICLES

Top 10 ESG issues for 2019

UNPRI ready to go to the next level

Beyond the acronym, navigating important ESG choices

banner

Most viewed in recent weeks

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

What to expect from the Australian property market in 2025

The housing market was subdued in 2024, and pessimism abounds as we start the new year. 2025 is likely to be a tale of two halves, with interest rate cuts fuelling a resurgence in buyer demand in the second half of the year.

Howard Marks warns of market froth

The renowned investor has penned his first investor letter for 2025 and it’s a ripper. He runs through what bubbles are, which ones he’s experienced, and whether today’s markets qualify as the third major bubble of this century.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

The 20 most popular articles of 2024

Check out the most-read Firstlinks articles from 2024. From '16 ASX stocks to buy and hold forever', to 'The best strategy to build income for life', and 'Where baby boomer wealth will end up', there's something for all.

Latest Updates

Investment strategies

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

Shares

The case for and against US stock market exceptionalism

The outlook for equities in 2025 has been dominated by one question: will the US market's supremacy continue? Whichever side of the debate you sit on, you should challenge yourself by considering the alternative.

Taxation

Negative gearing: is it a tax concession?

Negative gearing allows investors to deduct rental property expenses, including interest, from taxable income, but its tax concession status is debatable. The real issue lies in the favorable tax treatment of capital gains. 

Investing

How can you not be bullish the US?

Trump's election has turbocharged US equities, but can that outperformance continue? Expensive valuations, rising bond yields, and a potential narrowing of EPS growth versus the rest of the world, are risks.

Planning

Navigating broken relationships and untangling assets

Untangling assets after a broken relationship can be daunting. But approaching the situation fully informed, in good health and with open communication can make the process more manageable and less costly.

Beware the bond vigilantes in Australia

Unlike their peers in the US and UK, policy makers in Australia haven't faced a bond market rebellion in recent times. This could change if current levels of issuance at the state and territory level continue.

Retirement

What you need to know about retirement village contracts

Retirement village contracts often require significant upfront payments, with residents losing control over their money. While they may offer a '100% share in capital gain', it's important to look at the numbers before committing.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.