Aiming for the best client outcomes by investing responsibly and sustainably
The Multi-Asset team’s view on bonds, equities, commercial property and other assets will affect asset allocation over the coming months. When making these asset-allocation decisions, we first consider the outlook for each asset class (e.g. government bonds), followed by views within that market (e.g. the US versus Europe, or European core economies against peripheral countries). The views of individual asset class teams may differ to this multi-asset view.
TAA Model Allocation - as at 24 September 2019
As CEO of Standard Life Aberdeen, I am very pleased to say that this edition of ASI’s Global Outlook is entirely devoted to the environmental, social and governance (ESG) aspects of investment. These issues are increasingly, and correctly, front of mind. This is demonstrated by the many global climate protests around the world in recent weeks, by the efforts which many companies are taking to improve their own ESG credentials, and also the wave of investment opportunities in ‘green’ areas which are now being offered.
The myriad of issues that sit under the ‘ESG’ moniker have many causes, while solutions will necessarily involve individuals, businesses and governments. Investors will certainly have a key role to play, both as owners of existing capital and as suppliers of new capital. How investors exercise stewardship of companies they own or lend to, and how they behave in communities they serve, will have a major impact on outcomes in these complex areas. I am pleased to say that ASI has always taken its responsibilities seriously, as demonstrated by the length of time we have had a sizeable ESG team and how ESG analysis is now embedded across the investment process. Individual investors and investing institutions have a key role to play. By putting their hard earned savings or capital to work they are helping to create a better future. This is not only in terms of financial returns and traditional benefits such as jobs or wealth created, but increasingly in terms of investing for a better future for the planet as guided by the UN’s Sustainable Development Goals (SDG)
This issue of Global Outlook demonstrates two key aspects of our engagement with ESG investing. The first is ensuring a better understanding of those issues that impact investments and therefore affect financial returns, for better or worse. The second is creating a sustainable outcome or product, where the investment strategy embeds greater consideration of sustainability factors.
A series of articles consider these issues. ESG investing is rarely considered from a ‘top down’ asset allocation perspective, rather than ‘bottom up’ engagement with a company or sector. Craig Mackenzie redresses this imbalance examining how ESG factors are some of the key drivers of long-term returns and therefore are highly important for Strategic Asset Allocation decisions. ESG issues affect equity and bond markets, private and public. Sarah Norris and Dominic Byrne consider the evolution of impact investing, an area of investment that is attracting more interest. Lulu Wang and Nalaka De Silva reflect on the significant nature that private markets can bring to bear on the companies in which they invest. Much ESG analysis is focused on the role of equity holders; Thomas Leys counters an argument often made that debt investors have little influence over the companies in which they invest.
Turning to some specific aspects, Eva Cairns considers the interaction of climate change and population growth on the use of land. The food industry requires a revolution in order to deliver future food security. Kate McGrath develops this theme by examining issues caused by the production of four big agricultural products: cattle, palm oil, soy and paper/wood products. Last of all, climate change is much in the news but only one aspect of the UN’s broader SDG. Amanda Young takes an honest look at progress towards these goals and considers the work still to be done.
The point of SAA is to consider the long-term structural factors that affect investment returns across asset classes, sectors and regions; and to build a resilient portfolio that will deliver returns in spite of the many uncertainties the future holds.
ESG issues like climate change, economic inequality, and ageing populations are among the world’s most important structural factors. They should have a central role in SAA, and in the long-term return forecasts it is based on. Excluding ESG factors from SAA is a missed opportunity
‘We are developing robust methods to include realistic climate-transition scenarios into our long-term return forecasts, reshaping our portfolios accordingly.’
Global warming poses both long-term physical risks as the climate changes, as well as nearer term risks as the energy sector shifts from fossil fuels to low-carbon alternatives.
In the long run, we expect: more severe storms; more frequent and severe droughts; more wild fires; rising sea levels and melting permafrost. This could prompt political instability in some countries; conflict over water and other scarce resources; and large-scale migration from the most climate-stressed regions.
This will affect the performance of some asset classes. For example, real estate and infrastructure in areas prone to flooding, storms and wild-fires are at particular risk. Agriculture and forestry will be impacted too. The worst of these risks are in the distant future, but the energy transition is already well underway. Ten years ago the UK generated 40% of its electricity from coal. Now it is less than 10%.
But, as chart 1 highlights, this energy transition is only just beginning. As it gathers pace it will likely have material negative effects on the long-term investment returns of sectors, regions and asset classes with heavy fossil fuel exposures. It will benefit those strongest in renewable energy and other parts of the low carbon economy.
Chart 1 – Annual energy-related CO2 emissions, 2010-2050 (Gt/yr)Source: Irena, 2018
There is still considerable uncertainty about how fast the transition will occur and what shape it will take. But the outline is becoming clearer. We are developing robust methods to include realistic climate-transition scenarios into our long-term return forecasts, and to reshape our strategic portfolios accordingly.
Regulators are putting growing pressure on investors to look hard at these risks. The Bank of England’s Prudential Regulation Authority (PRA), for example, has published regulations requiring insurers to evaluate their exposure to climate risk, and to make use of scenario analysis to do so.1 There are similar regulations targeted at pension funds in the UK and France.
While climate change is the most visible issue, there are even more important ESG factors for asset allocators. Perhaps the single most important challenge for strategic asset allocation today is the fact that interest rates remain stubbornly low (Chart 2). As a result, long-term government bond returns are also likely to be extremely low, particularly in Europe and Japan.
Chart 2 – The extraordinary decline in bond yields
10-year nominal yields (%)Note: Chart shows yield on 10-year maturity government bond in each country
The past versus the future - real interest rates remain close to today’s levelsForecasts are offered as opinion and are not reflective of potential performance. Forecasts are not guaranteed and actual events or results may differ materially.
What does this have to do with ESG? Many economists argue that interest rates are low because of a chronic ‘savings glut’.2 Essentially, too much global saving is chasing too little demand for investment. This pushes down interest rates. The savings glut is caused by various factors, but according to some influential studies among the most important are two factors associated with the ‘S’ in ESG: aging populations and income-inequality.
Put simply, the large baby-boomer generation has reached peak savings at the same time that sluggish global growth deters investment. In addition, income inequality means a greater share of incomes goes to the rich, who tend to save a larger percentage of their incomes.
These factors help explain why our forecasts for long-term returns of government bonds, and some other asset classes, are significantly lower than forecasts made 20 years ago. While there is still much debate about the persistence of long-term interest rates, our view is that these demographic and inequality drivers are likely to be long term. Lower expected returns will be with us for many years. As a result, we have significantly reduced our use of government bonds in our growth portfolios.
Equally important is the impact of ESG factors on the long-term returns for equities and other growth-dependent assets. One of the biggest factors depressing our long-term view of equity returns is the major demographic shift that is occurring in many economies. Working age populations are shrinking in Europe, Japan and much of East Asia.
Standard ‘supply-side’ models of economic growth tell us the potential growth of an economy is a function of the growth in its labour force and in productivity. So, all else being equal, a shrinking labour force is likely to result in lower rates of growth in these economies. Of course, faster productivity growth could make up for worsening demographics, but there is little sign of this so far.
Lower growth rates mean less demand for products and services, resulting in lower revenue and earnings growth for companies. Other things being equal, lower earnings growth means lower equity returns. Lower equity returns mean we must lean more on alternative sources of return in strategic asset allocation. Once again, the ‘S’ in ESG is a key driver of SAA.
Surprisingly, perhaps, diversity in the workplace also has an important role to play in the potential economic growth story. Japan and some European economies have successfully mitigated the impact of their shrinking workforces, by adopting policies that attract a greater share of older and female workers into the workplace. As chart 3 shows, labour force participation rates have risen in these two regions.
By embracing and encouraging more workplace diversity, these regions enjoy higher potential growth, while their companies benefit from higher earnings than they would have otherwise. Other countries, most notably the US, have been less successful at encouraging diversity. Workforce participation there has fallen, retarding potential growth.Note:labour-force participation rate (15-64 year olds)
Corporate governance can also be very important for SAA. Perhaps the biggest event for asset prices within the last 80 years – the Global Financial Crisis – was largely caused by systematic failures of governance in the global banking industry.
The governance failings were numerous. The mis-selling of subprime mortgages, their indiscriminate bundling into ‘CDOs’, which were then incorrectly assessed by the credit rating agencies and bought by banks with poor risk controls, and without sufficient capital buffers to protect themselves against defaults. Then, once defaults started to occur, a total collapse in liquidity led to widespread bank failures and a global credit crunch. These governance failures have had massive implications for SAA. The sluggish recovery from the ‘balance sheet recession’ which followed the crisis, and the reliance of central banks on quantitative easing (QE), have had dramatic effects on asset class returns – good and bad.
One of the lessons from the crisis is the need for long-term asset allocators to be more attentive to systematic governance risks, particularly in the financial sector. This is by no means easy to do, but it is possible to stress test portfolios against various financial shock scenarios.
Governance is also relevant to long-term returns for more routine reasons. Our forecasts for Japanese equities have been significantly boosted by the governance improvements we have seen in corporate Japan in recent years. Better governance, with greater emphasis on shareholder value, has resulted in structurally higher returns on equity and profit margins.
After languishing far below the rest of the world for decades, Japan has nearly caught up. This has also resulted in more cash being returned to shareholders via dividends and buybacks. Consequently, our return forecasts are over 2% per year higher than they would have been otherwise.
Governance is, of course, not solely an issue for corporations. We devote considerable effort to evaluating the quality of governance of monetary and fiscal policy when gauging sovereign bond issuers, particularly in our EM debt portfolios.
Our view that economic governance has been improving in many emerging economies is a major reason why we forecast relatively high returns for EM bonds (and why we are willing to make large allocations to them in our SAA portfolios).
The discussion above is not intended to provide a comprehensive survey, but merely to indicate the relevance of ESG factors to SAA. As we make clear in our annual Long Term Investment Outlook report, we believe that ESG factors are among the most important drivers of long-term investment returns. The strategic asset allocation we perform for clients and our multi-asset portfolios is materially different as a result of taking these issues into account.
‘We are developing robust methods to include realistic climate-transition scenarios into our long-term return forecasts, reshaping our portfolios accordingly.’
Land is both a source and sink of greenhouse gas (GHG) emissions and plays an important role in climate change mitigation. The Intergovernmental Panel on Climate Change (IPCC) delivered a stark message in its August 2019 report: humans’ reliance on land for food security is at risk, and climate change exacerbates this risk.
‘Investment in expected growth areas like protein diversification and innovative technologies can generate return and value.’
Our warming climate is leading to land degradation, water scarcity and soil erosion due to heavy rains in many regions. This affects harvests and diminishes crop yields. The agricultural sector is particularly vulnerable to climate change: it uses around 70% of the world’s fresh water and relies heavily on crops to feed livestock. Agriculture is also a significant contributor to climate change. The AFOLU (agriculture, forestry and other land use) sector generates a quarter of global GHG emissions. The largest contributors are China, India, Russia and Brazil. The sector emitted 44% of global methane emissions and over 80% of nitrous oxide emissions from the use of nitrogen fertilisers during 2007-2016. These gases have a much higher warming potential than carbon dioxide (CO2).
While agriculture contributes substantially to emissions, thus far, it has not attracted sufficient attention in climate mitigation policies.
The way we consume and use land is unsustainable. We are depleting the earth’s resources faster than they can regenerate. Earth Overshoot day is when nature’s resource budget for the entire year is depleted. This year, it was 29 July, and it happens earlier every year.
So, what is our land used for?
We use around 50% of habitable land for agriculture. The rest comprises forests (37%), shrubs (11%), urban areas (1%) and fresh water (1%). The main competing demands are:
Around 77% of agricultural land is used for animal agriculture, including grazing and crops for animal feed, mainly soy and corn. Livestock is the biggest driver globally for changing land use and habitat loss. Yet it provides just 17% of the world’s calories and 33% of its protein – so it’s a very inefficient use of land3. Additionally, livestock requires significant amounts of water: per kilogram of protein, beef consumes 48 times more water than vegetables4. GHG emissions related to livestock are 14.5% - similar to emissions from the whole transportation sector. Nearly half of that is methane emissions from the digestive system of cattle.
Chart 1 – Sources of GHG emissions in livestock farming
If we increase land use for one purpose, something else must give – a difficult balance to strike. Continued deforestation and use of land for livestock will no doubt worsen the climate crisis. Using land for bioenergy crops is also questionable when it could be used to feed a growing population.
23% of agricultural land is used to grow crops for human consumption. HSBC estimates that 40% of all cereals grown are fed to livestock, and this will rise to 50% if meat consumption continues at the projected rate. This is land we could use for crops for human consumption, producing less resource-intensive protein sources.
Only a small proportion of land is used to grow crops for bioenergy. Where land is used for that purpose, crops for consumption are displaced. Growing crops for energy also distorts demand and prices. Ultimately, food security should take priority, but Paris-aligned scenarios to keep warming below 2°C have quite ambitious assumptions around bioenergy use. Ideally, crops for bioenergy should be grown on land that would otherwise have no purpose.
Forests are important carbon sinks and make up 37% of habitable land. Deforestation is a significant issue, driven by demand for grazing and growing soy for cattle, as well as palm oil and paper/wood products. Severe forest fires such as those recently experienced in the Amazon release significant amounts of carbon and are exacerbated by hotter, drier conditions. Afforestation efforts are commendable, but not the most effective option when climate mitigation action is urgent. It takes decades for trees to grow to absorb levels of carbon that offset emissions from deforestation.
Chart 2 – Greenhouse gas emissions by gram of proteinSource: Our World in Data, Clark and Tilman 2017, Aberdeen Standard Investments (as of September 2019)
Since 1961, average calorie consumption per person globally has increased by one-third (IPCC). This growth has been very uneven: two billion adults are overweight/obese while 821 million are undernourished. The latter often live in regions most vulnerable to the impacts of climate change, so the imbalance will only worsen. The IPCC report states that climate change is already affecting food security in drylands in Africa, and mountain regions in Asia and South America.
Today’s population of 7.7 billion is expected to grow to 10 billion by 2050 – mainly in developing countries such as India, Nigeria and Pakistan. How can we produce sufficient food for the growing population without exhausting resources or emitting significant amounts of GHGs?
We believe that there are three things the food industry must do.
Innovation for sustainable farming
We need to change the way food is produced. This will involve more sustainable and efficient farming practices, particularly around soil regeneration, water management and emission reductions – for example, via manure management. Innovative technologies such as automated ‘smart’ farm equipment and the use of artificial intelligence can improve efficiency. Food retailers have a responsibility to manage and influence their supply chains to ensure sustainable practices are in place. The challenge is that profit margins in agriculture are low and R&D spending is limited. Public and private investment are essential to encourage innovation.
The IPCC report highlights that eating less meat and dairy could reduce current CO2 emissions by 15%. Consumer preferences are shifting, particularly across Europe and the US. Historically, animal welfare was the main driver for meat/dairy exclusion. Now, there are growing numbers of ‘flexitarians’ who cite environmental and health reasons. A 2017 report by market researcher Mintel showed that 49% of British respondents reduced their meat intake because of health concerns and 23% for environmental reasons.5
Demand for non-animal protein sources is increasing. Plant-based milks, for example, rose from a 1% share in the US a few years ago to 13% today. Plant-based meat alternatives are growing at a rate of 25% per annum and could reach an estimated 10% of the market in 10 years’ time, worth $140 billion.6
The food industry needs to diversify into different protein sources to benefit from this growth and mitigate the risks related to animal agriculture.
Beyond Meat is the first plant-based meat company to go public. Its IPO in May 2019 raised an impressive $240million and the share price almost tripled on the first day of trading. Its revenue increased from $16m million in 2016 to $88 million in 2018. The company has helped shift perceptions of growth and investment opportunities in protein diversification.
Cutting food waste
Around 25-30% of all food produced is currently wasted. Between 2010-2016, this contributed 8-10% of global GHG emissions – roughly matching emissions from the entire European Union. The food industry needs to reduce wastage to avoid unnecessary land use and emissions.
Investment in sustainable land management to regenerate soil and forests is a vital part of the solution. So, too, is managing food supply and demand. Governments have a critical role in setting policies that encourage adoption of these solutions. For example, Germany has proposed a meat tax. In 2020, countries are expected to update their Nationally Determined Contributions in accordance with the Paris agreement. This may encourage governments to review food-related policies and set more ambitious goals for cutting GHG emissions from livestock.
Consumers will experience a food revolution, with a growing range of innovative meat-free alternatives to consume proteins such as meat-free burgers that taste and bleed just like meat. Highly processed products that mimic meat may not be the healthiest option. However, they are a good ‘transition food’, allowing meat-lovers to reduce their environmental impact without shifting entirely to lentils and chickpeas.
Prices must increase to reflect the environmental damage inflicted by food, in a similar way to carbon pricing. This would increase the consumption of alternative proteins purely for cost reasons even for those who are not pro-actively choosing to do so. Consumers need to be more aware of the impact of diet on the environment. Therefore, plant-based proteins should become a core part of a healthy, balanced diet promoted by policymakers.
Investors must assess some potentially overlooked risks and opportunities regarding their investments along the food value chain. Questions to consider include:
Those involved in the animal agriculture supply chain must be more transparent about the risks and how to manage them. That includes emissions, deforestation, water, waste and antibiotics use.
The 2019 FAIRR index7 assesses ESG risks for 60 of the world’s largest protein producers. It reveals that 77% of firms do not measure all GHG emissions and have no meaningful targets to reduce GHGs. Active investors have responsibility for influencing disclosure levels and business strategy, by engaging with the food industry, including production, transportation and retail.
More positively, investment in expected growth areas like protein diversification and innovative technologies can generate return and value. This is essential to help transform the food system and promote food security in already vulnerable developing regions. It will also limit the flow of migrants fleeing climate poverty and hunger.
‘Investment in expected growth areas like protein diversification and innovative technologies can generate return and value.’
When concerned shareholders of US retailer Dick’s Sporting Goods, filed a resolution in December 2017 demanding tighter control of gun sales, management listened. One month later, the firm removed assault rifles from shelves and, today, is considering banning the sale of guns entirely. The firm’s shareholders exercised their control over management to address social concerns and make an impact.
‘Not only can fixed income investors make a difference, their contribution to achieving global sustainability goals is essential.’
As owners of a company, shareholders are able to exert pressure on managers to address environmental, social and governance concerns. But can credit investors – with no company ownership and therefore no vote – steer management along ESG lines?
Powers to remove directors and drive shares into takeover territory afford shareholders considerable influence. So, equities naturally come to mind when we hear mention of topics like impact Investing and ESG, which involve investors wielding influence to promote good corporate behaviour.
Perhaps more surprising is that the rapid growth of ESG and ‘impact investing’ in recent years has not been limited to equity funds. According to UBS, 83%, 60% and 74% of UK, US and EU investment-grade corporate bond funds (respectively) are managed via ESG considerations.
Corporate bond investors wield their collective clout by negotiating the interest rate a company has to pay on its debt and, ultimately, determining its access to finance in the bond markets. Tobacco companies are all too familiar with this. On average, they pay an extra 0.8% on euro-denominated debt compared to other companies with the same credit rating. By making demands on management, corporate bond investors can promote sustainable business practices. And, using ESG analysis, they can skew portfolios in favour of sustainable companies.
Moreover, beyond this simple bilateral relationship, fixed-income investing comes with additional, important tools of influence unavailable to equity investors. Access to private companies allows corporate bond investors to make an impact where equity investors cannot. Furthermore, the use of covenants in bond agreements can legally bind companies to act in a certain way – an under-utilised, but powerful tool in impact investing. Not only can fixed-income investors make a difference, their contribution to achieving global sustainability goals is essential.
Chart 1 – Investment grade and high yield corporate bond issuers (by number)
Nearly a fifth of companies (19%) issuing US dollar-denominated corporate debt are private entities. For euro-denominated debt, 26% are private companies and for sterling debt, it is even higher at 39%. This gives credit investors influence over a universe of companies that is out of bounds to traditional equity investors.
Take giant commodities player Trafigura, one of the largest private companies in the world and still insider-owned. Bond issuance is an important source of capital for the firm: it has over US$3 billion of corporate bonds outstanding in US dollars, euros and Swiss francs. As a miner of metals and extractor of fossils fuels across the globe, environmental issues permeate Trafigura’s activities and those of its suppliers.
This presents an opportunity for concerned bondholders to engage with the company on their policies and behaviour. Armed with the threat of divestment, bond investors could together induce Trafigura’s management to undertake certain actions and implement improved environmental policies.
Trafigura is just one example. There are many more companies worldwide where listed equity holders or institutional private equity holders have no influence – here debt holds the key. For global ESG or impact initiatives like the Principles for Responsible Investment’s (PRI) “Sustainable Development Goals” fixed income investors’ participation is critical and substantially widens the sphere of influence.
A corporate bond legally binds the borrower by the terms of its indenture or trust deed. The terms outline generic details of the debt, such as the interest rate and maturity date. They also describe more specific restrictions on the company’s activities – known as ‘covenants’.
Covenants cover anything from maximum permitted levels of indebtedness to minimum disclosure requirements. If a company breaches even one covenant, the consequences can be as severe as in the event of default – that is, allowing bondholders to seek their money back through legal action.
There is no reason why covenants could not be used as an ESG or impact lever. For example, investors could demand covenants banning polluting activities or requiring a minimum level of board diversity. If certain ESG covenants were to become market standard, (e.g. requiring a company to disclose in line with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations), the impact would be seismic.
This may sound like wishful thinking. Yet, green bonds are already available. Green bonds restrict the use of funds specifically to ‘green’ projects such as building solar panels or financing mortgages for energy-efficient homes.
By contrast, the covenants of traditional bonds require, at most, compliance with local environmental regulations. ESG-conscious bond investors should look beyond green bonds and seek tighter covenants that engender good corporate behaviour more widely. Encouragingly, there are signs this is already happening. In May this year, Spanish telecom operator Másmóvil Ibercom issued debt with an interest rate that falls if S&P’s ESG assessment of the company improves.
The sceptic’s view of corporate bond investors as simple lenders, with minimal corporate influence, is misplaced. Not only can bondholders invest in companies that are inaccessible to equity investors, they have the means to impose legally binding ESG principles on a firm. This makes bond investors critical players in the transition towards a more sustainable economy.
‘Not only can fixed income investors make a difference, their contribution to achieving global sustainability goals is essential.’
The United Nations set an agenda for sustainable development at the start of 2016, with the aim of eradicating poverty, and addressing climate change, growing inequality and cutting unsustainable production and consumption. It has decided on 17 goals and 232 specific targets to be achieved by 2030. These SDGs (see Figure 1) will guide global policy and funding for a 15 year period.
Figure 1 - The global goals for sustainable development
The SDGs are ambitious and estimates of the cost of achieving them range from US$5 trillion to US$7 trillion per year. This can only be done through partnership between governments, regulators, academia, philanthropists and the corporate world. Global asset managers – with over $80 trillion of assets under management – will have an increasingly important role to play if the SDGs are to be met.
Next year will be the five-year anniversary of the introduction of the UN’s 2030 Agenda for Sustainable Development and the 17 Sustainable Development Goals (SDGs). On 24 and 25 September 2019, heads of state and government gathered at the United Nations Headquarters in New York. The purpose of the meeting was to comprehensively review progress in the implementation of the 2030 Agenda for Sustainable Development and the 17 SDGs. The event is the first UN summit on the SDGs since the adoption of the 2030 Agenda in September 2015. The summit made headlines for a number of reasons so from our perspective as investors; we thought it timely to think about how the goals are being adopted by governments, corporates and asset owners.
In 2015, the 193 member states of the United Nations formally adopted the SDGs. Later that year, the Paris Agreement on climate change was drafted. It was signed in 2016, with a goal of limiting temperature rises to under 2%. A number of activities have taken place on the back of the adoption. However there is an increased sense of urgency that the problems we face are bigger than we initially thought. Climates are changing at a pace that the signatories hadn’t envisaged. At the same time some progress has been made at getting people out of poverty, however the member countries are at very different stages in progressing with the goals.
Progress has been slow and we are battling to make sufficient change to align the world to a 2 degree warming scenario. Next year is also when the Conference on the Parties (COP) 2020 is in Glasgow. It will be the most important gathering on climate change since the Paris agreement in 2015. It will be a major crossroad in the battle against global climate change and a chance to review progress against promises to cut emissions. Why is 2 degrees so important? Changes between a 1.5 degree world vs a 2 degree world = 70% of world coral lost by 2100 vs virtually all lost by 2100.
As we have seen at the September summit opinion is changing, particularly on the environmental front, supported by a wave of consumer awareness (the David Attenborough effect)
PWC produced a report ‘SDG Reporting Challenge 2018’ which states: “Policies and regulations help to frame country narrative around the SDGs but businesses also play a key role in helping nations attain the SDGs- individual businesses can help or hinder country progress and widespread buy-in across operations and outputs is required. Policy flows through into business practice: “According to PwC 19th Annual Global CEO Survey, 69% of CEOs say that governments and regulators have a high or very high impact on business strategy, so when it comes to the SDGs, it is natural to assume that business will be keeping a watchful eye on government initiatives to achieve the 17 goals by 2030”
SDGs have seen companies review operations and in some cases shift their business focus so that government policies and priorities become internalised within business practice. For example, Danish energy company Ørsted, originally an oil and gas exploration company, has been transitioning to 100% renewable generation. Most recently, this culminated in the sale of their power grid and residential distribution business to accelerate this transition.
The PWC report states, “pursuing sustainable and inclusive business models could unlock economic opportunities worth at least US$12 trillion a year by 2030 and generate up to 380 million jobs, mostly in developing countries. But the total economic prize from implementing the Global Goals could be two to three times larger still, assuming that the benefits are captured across the whole economy and accompanied by much higher labour and resource productivity.”
But we still have a long way to go: “We studied both the corporate reporting of more than 700 global companies, analysing their commitments to individual Goals and how their reporting reflected on integration into business strategy. What we discovered is that there remains plenty of work to be done if business is really to help meet the goals and benefit from them. While 72% of companies mention the Goals in their reporting, just 27% include them in their business strategy”. And even then, companies are poor at stipulating exactly how their businesses are reducing the problems or contributing to the solutions.
As for top-level leadership – just 19% of CEO or Chair statements mention the SDGs in the context of their business strategy, performance or outlook. This leads to the conclusion that the SDG’s are picking up traction in terms of being used for corporate reporting, but more needs to be done to make sure they are embedded at the heart of a business and therefore influencing future investment and strategy.
SDGs were not set up for investors. However, they provide guidance for the industry as a whole. ESG integration into investment processes is a proven way to help manage investment risk and improve risk-adjusted returns. The advent of the SDGs and broad country and corporate buy-in has led asset owners to align ESG process with the global goals and view environmental, social and governance issues through an SDG lens. This goes beyond assessing investments for risks to the positive allocation of capital.
A BNP Paribas Securities Services survey of asset managers and owners incorporating ESG strategies reveals further ESG integration by investors. Over 65% of respondents align their investment framework with the UN Sustainable Development Goals (SDGs). Data and technology costs remain barriers, but investors are optimistic, with over 90% predicting more than 25% of their funds will be allocated towards ESG by 2021.
As mentioned in my article last month, from Process to product, ESG concerns and considerations are embedded in our process and philosophy. In practice this means that we evaluate material environmental, social and governance issues and the financial implications for our investments “ESG integration is not making a moral judgement about an investment but rather thinking about ESG issues in relation to how they would affect a company’s ability to generate sustainable returns”.
Beyond ESG and SDG integration into investment philosophy and analysis, key asset owners are developing platforms and products to align investment outcomes with environmental and/or social objectives. Socially responsible investing, ethical investing and development finance are not new concepts but have been associated with philanthropists or niche investment products. One way to support the aims of the SDGs is through impact investing. This involves investing capital for a financial return into the equity of companies that have environmental or social objectives at the heart of their commercial strategies – mission-led businesses.
Institutional investors generally accept the case for impact investing but lack a framework for applying it. Sarah Norris and Dominic Byrne show in our next article that the UN’s SDGs and targets provide widely accepted measures that can be used to unlock impact investing for mainstream investors.
Impact investing has really come to the fore in recent years. Its sudden rise in popularity is at least partly due to the UN’s Sustainable Development Goals (SDGs). We examine the goals in more detail in the previous chapter. The SDGs guide policy makers, regulators and corporates on strategy and focus for sustainability initiatives. They also help investors to allocate capital to the most pressing global issues.
‘Savers are paying more attention to the potential wider effects of their investments.’
Two elements combine to define impact investing. First, it means deliberately buying an asset that, alongside producing a financial return, has a positive effect on the environment or society. Second, that positive effect should be measurable.
Over the past five years institutions have been thinking and acting with impact investing in mind. Savers are also paying more attention to the potential wider effects of their investments. A recent study by the Rockefeller Foundation (suggests that wealthy individuals will have a lot of money to invest: $100 trillion by 2020. And the number of options available to investors is growing. Companies are starting to consider how their strategies impact society and the environment.
Chart 1 – Impact themes by number of funds**Note: funds can target more than one impact theme
In the past, most for-profit impact investment strategies were unlisted. But impact investing is being democratised. Higher demand means that retail and institutional investors can now undertake it using listed vehicles as providers develop new products. No longer is impact investing confined to private equity and venture capital, or social enterprises and foundational funding. Instead, public equity, corporate bond and real estate offerings are available. An annual report into the industry shows strong growth in recent years. According to the Global Impact Investing Network (GIIN) survey, assets under management grew at around 13% per year from 2013 to 2018. By the end of last year, they had reached $502 billion.
Meanwhile, the GIIN now lists 442 active impact funds, including both public and private vehicles, in its database. Private assets or venture capital is still the largest category by far, but the number of fixed income, multi-asset and public equity offerings is growing. Newly launched strategies by Wellington, Hermes and Aberdeen Standard Investments, among others, are widening the playing field.
But could this wealth of choice be confusing for investors? How can they make sure that the investments they select meet with their environmental and social aims? Some approaches to impact investing may only try to address one or two of the UN SDGs. Others may not mention them at all at all. Fund managers need a well-defined impact objective, investment framework and analysis process, as well as clear measurement targets, to make an impact investing strategy successful. Impact-investing specialist Bridges Ventures is working with asset managers and investors to create a common language. Its Impact Management Project aims to make sure there is a clear understanding across the industry about impact principles and objectives. In turn, this should help measure how impact investments are performing. Historically, assessing the overall performance of an impact investment in a measurable way has been difficult.
There are several points to consider when it comes to financial returns:
The non-financial results of impact investing can be more difficult to quantify. There are no set templates or standardised measures. As such, the subject generates a lot of debate.
One of the hottest topics under this banner is ‘additionality’ and how it contributes to measurable impacts. For an impact investment to have additionality, it must consist of fresh capital. It also must fund an initiative or project that would not otherwise be possible. The theory is that equity impact investing cannot have the same additionality as investing in private markets. This is because companies could pursue their own strategies, regardless of what investors want. If this were the case, investors would have little influence.
Our view is more nuanced. Whether an investment is listed equity, private equity, or something completely different – is irrelevant to the measurable impact that it may have. The level of additionality may vary, however. Different investors (ASI included) have different levels of additionality. As public market investors, we can make changes by working with companies to improve disclosure and impact reporting. So engagement is a cornerstone of ASI’s approach to equity impact investing.
In this same vein, we don’t want to make the case that one investment vehicle/asset class/fund can have more impact than another. We shy away from comparisons because we are not the ones experiencing the impact. Instead, we think it is more useful to understand how different portfolios across the asset classes align their intentions and investments with impact objectives. As part of its Impact Management Project, Bridge Ventures1 has categorised portfolios by three aims or ‘ABCs’:
More information can be found at: https://impactmanagementproject.com/investor-impact-matrix/
Chart 2 – Target returns and impact theme by number of fundshttps://www.impactbase.org/learn-more-about-funds, Aberdeen Standard Investments, (as of September 2019)
Bridges Ventures goes into further detail about the strategies investors might use to meet one or more of these goals. Each investor might choose to:
Signal that impact matters by choosing not to buy or favour certain investments.
Engage actively by using their expertise and networks to improve the environmental/societal performance of businesses. Engagement can include a wide spectrum of approaches. It ranges from dialogue with companies to investors taking board seats and using their own team or consultants to provide hands-on management support.
Grow new or undersupplied capital markets by taking up new or previously overlooked impact opportunities. This may involve taking on additional complexity, illiquidity or perceived higher risk.
Provide flexible capital by accepting disproportionate risk-adjusted financial return in order to generate certain types of impact. For example, providing capital where only a full or partial return of principal is expected in order to ensure an enterprise reaches a certain demographic.
ASI has several equity strategies that fall into the C ‘contribute to solutions’ category. Above all, however, we believe that measurement is crucial to any impact investing strategy, across all asset classes. As such, we have worked to align our own reporting on the impact our investments can have. This is in addition to the engagement we have with assets to the UN’s own SDG Report.
If we want to make impact investments readily available to all investors, we have to respond to questions and concerns about performance, risk, and scalability. Broader access will follow satisfactory answers to these questions. But in a world where there appears to be increasing scepticism of the traditional capitalist model and the benefits to broader society that derive from it, there would seem some urgency in doing so.
Chart 3 – Number of funds by impact themehttps://www.impactbase.org/learn-more-about-funds, Aberdeen Standard Investments, (as of September 2019)
‘Savers are paying more attention to the potential wider effects of their investments.’
Deforestation linked to growing commodities demand presents significant risk of loss for investors, but also opportunities to benefit by engaging companies and adding to pressure for stricter policy actions.
‘Ultimately, companies dealing effectively with deforestation and sustainability issues will perform better than those that aren’t.’
In our earlier chapter, ‘Sustainable Development Goals (SDG’s) - progress for our future’, we discuss the SDG’s and how this presents both opportunities and challenges for investors. Work to preserve forests contributes to the achievement of many of the UN’s 17 Sustainable Development Goals (SDGs) for 2030, including climate action (SDG 13), eliminating poverty and hunger (SDG 1&2), and responsible consumption and production (SDG 12). SDG 15 ‘life on land’ is specifically designed to: “Protect, restore and promote sustainable use of terrestrial ecosystems, sustainably manage forests, combat desertification, and halt and reverse land degradation and halt biodiversity loss”.
Deforestation relates to unmanaged, unsustainable or illegal logging in areas of high conservation value. Harmful consequences include climate change, land grabs, community displacement and food insecurity. Net forest loss disproportionately affects rural populations in low-income countries. By contrast, well-managed renewable forests can be sustainable and bring vital social, environmental and economic benefits.
Recent fires in the Amazon highlight the precarious state of the Earth’s rainforests. Over the past 50 years, 17% of the Amazon rainforest has been destroyed8. This has been linked to growing global demand for just four commodities: palm oil, cattle, soy and paper/timber products.
‘Ultimately, companies dealing effectively with deforestation and sustainability issues will perform better than those that aren’t.’
Historically, demand for palm oil is attributed to the commodities productivity, versatility and value, this will likely continue. Asian demographic growth should see further growth in demand. Presently, Asian diets consume less palm oil than Western diets, yet with changes in dietary habits, increased consumption is emerging markets is likely. Moreover, rising hostility and policy against GMO-based oils in Europe and an outright ban on trans-fat foods in the US has resulted in a migration away fro soybean and sunflower oil towards palm oil as a raw material base in food.
The market for unsustainable practices is shrinking The large majority of global palm oil traders and refiners have implemented No Deforestation, No Peat, No Exploitation (NDPE) sourcing policies in recent years. Violations of such policies have repeatedly led to suspensions of oil palm growers and supply chains Since 2015, equity values of four NDPE non-compliant growers (Sawit Sumbermas Sarana (SSMS), Austindo Nusantara Jaya (ANJ), Tunas Baru Lampung (TBLA), and Indofood Agri Resources) declined by combined USD 1.1 billion due to repeated suspensions.
The majority of deforestation is driven by demand for cattle, palm oil, soy and paper/wood products. Other contributors are coffee, cocoa, sugar and processes such as mining and shifting cultivation.
Indonesia and Malaysia account for 85% of palm oil production. The ubiquitous oil is contained in everyday products from chocolate and oven chips to cosmetics.
Palm oil production accounted for 2.3% of global deforestation between 1990 and 2008; 12,000 premature human deaths in 2015 caused by air pollution across Indonesia; the loss of critically endangered orangutans; and exploitation of workers and child labour. It underscores serious supply-chain issues.
However, the commonly held view that palm oil is unsustainable is a misconception. In fact, palm oil is critical for global food security; replacing it with other oils would only necessitate more deforestation.
Palm oil yields more per hectare than any other edible oil crop9. It makes up 35% of all vegetable oils, grown on just 10% of the land allocated to oil crops10. Moreover, it is the cheapest source of vegetable oil and an important food product for low-income groups worldwide.
Palm oil also has health benefits relative to other oils. It is naturally trans-fat free, while fortified palm oil is used by governments in Sub-Saharan Africa and Southeast Asia to combat Vitamin A deficiencies.
Boycotting palm oil to combat deforestation is not a solution. Alternatives would require more land and could have negative health consequences. Instead, action should focus on making production less harmful.
The conversion of forest to cattle pasture creates 80% of new deforestation in the Brazilian Amazon, driven by demand for beef and leather products. Beef production – which accounted for 7% of Brazil’s GDP in 2016 – is set to rise to meet global demand.
Media and regulators have focused on the Amazon biome, which has meant policies and initiatives across South America have become fragmented and unequal. Disjointed regulations merely displace the problem elsewhere. New frontiers are emerging across Latin America, and land clearance continues.
Additionally, growth in demand from developing countries across Asia and Africa puts pressure on beef production in South America. These markets have lower regulatory expectations, meaning unsustainable deforestation practices continue11. Investors must be mindful of exposure to these new supply chains.
Demand for paper-based packaging is expected to rise as an alternative to plastic packaging. A challenge for companies will be to ensure that virgin fibres used in products originate from sustainably managed sources.
Most paper comes from “production forests” – fast wood-growing operations with harvesting cycles of 5-10 years. These can have a positive environmental impact, as seedlings and growing trees capture carbon more effectively than the agricultural land these operations may have replaced.
However, in Indonesia the drive for wood pulp has resulted in deforestation to create new ‘fast wood’ monoculture plantations such as acacia 12. Investors should encourage companies to increase use of recycled paper and waste wood to meet increasing demand.
Separately, it is estimated that up to 30% of timber trading globally is illicit, while logging represents 50-90% of forestry activities in key producer tropical forests such as the Amazon Basin, Central Africa and Southeast Asia13.
Illegal timber is often laundered into the legitimate global timber trade. Traceability certifications – such as the Forest Stewardship Council (FSC) or the Programme for the Endorsement of Forest Certification (PEFC) – are necessary to prevent this.
But these certifications tend to be applied in bulk weight, making it easy to mask the origin of a piece of timber. While certifications are beneficial, it’s time for governments to tighten regulations and demand better supply-chain disclosure.
Soybean production was responsible for 5.5% of global deforestation between 1990 and 2008, double the amount attributed to palm oil. World soybean production has more than doubled in the past 20 years due to demand for soybean meal as animal feed, biofuels and products such as meat substitutes.
The fastest growing soy importer is China, where rapid meat consumption points to a steep increase of soy imports for animal feed14. New tropical regions are also being exploited increasingly as advances in farming methods and crop varieties make it possible to grow soy in tropical soils.
Evidently regulation has a part of play. Brazil has enforced a new Forest Code; the EU has extended action on deforestation to soy; and international climate efforts are leading to stricter policies on local land-use. Initiatives such as the Brazilian Soy Moratorium in 2006 have reduced deforestation in the Amazon biome. But this increased deforestation in other South America biomes, where land costs are lower and environmental protections fewer.
It highlights how divesting from problematic areas may have unintended consequences. Engaging with ‘legal’ deforestation or avoiding sourcing from an area does not mean the problem is solved.
Meat consumption is linked to deforestation in terms of cattle farming and soy as animal feed. As many consumers opt for a meat-free diet due to environmental concerns, it has been estimated that the market of alternative meat will reach ~$140bn over the next ten years, capturing ~10% of the ~$1.4tn global meat industry. Disrupters are arising in both plant based and lab based alternatives. Some companies may invest in both, for example, Cargill (one of the big 4 soy traders) invested $12m in a cell-based meat start-up Aleph Farms to sit alongside its investment in cell-based pioneer Memphis Meats. At present, plant-based is the alternative protein of choice but with increasing interest in lab based proteins this may present a huge growth opportunity.Source: Inverse – Move over, impossible burger: Lab-grown meat will overtake plants by 2040
The climate impact of mass deforestation is likely to translate into market-wide losses. The effect of deforestation on rainfall patterns is reducing agricultural yields. This will impact profits directly.
Since 2002, there has been a significant drop in productivity from soy, maize and coffee industries, largely attributed to changes in rainfall patterns due to forest degradation15.
Further, if market conditions change or regulations limit production from newly deforested land, forestry or agriculture assets could experience write-downs, devaluations or conversion to liability.
The physical impact of climate change could also render newly deforested land unusable. More than six million hectares in Indonesia – 28% of the nation’s land bank – are stranded after the government halted new palm oil licences and imposed a moratorium on permits for forest and peatland. Investors should ask companies if they have quantified the proportion of land at risk of becoming stranded.
Indirect financial losses can also occur. When Malaysian palm oil company IOI Group was suspended from the Roundtable on Sustainable Palm Oil (RSPO) for violating its policy on clearing forests in March 2016, its share price fell 18%.
Other indirect risks include loss in creditworthiness. Deterioration in profit may mean a company fails to service debt obligations on time. There is also a risk that a company’s cost of capital will increase.
If companies are designated to be operating in a ‘sin’ industry, the perceived risk ascribed by banks – and therefore their servicing charges – will increase.
Then there is the risk of legal actions, sanctions and fines. Environmental breaches, and lack of preparedness to comply with regulatory changes, can adversely impact a company’s financial position. In addition, exposure of involvement with illegal activities could cause reputational damage across the supply chain.
There is also a risk that commodities associated with deforestation will see a fall in consumer demand. In 2014, EU labelling laws were changed so products had to state whether they contained palm oil.
Supermarket chain Iceland pledged to remove palm oil from all its products by 2018, but was called out in January 2019 for selling at least 28 own-brand products containing palm oil. Investors need to be cognisant of an investee firm’s pledges and transparency in supply chains to avoid customer distrust and loss of market share.
The drivers for increasing soy yields are three-fold: as a meat alternative; for animal feed; and as an oil for other consumer goods. The global market for palm oil is also projected to rise, driven by its ubiquitous applications, while paper-based packaging is experiencing a resurgence as an alternative to plastic.
It presents opportunities for investors to direct capital towards sustainable practices by demanding transparency and holding companies responsible to meeting targets.
More than 470 companies have committed to removing deforestation from their supply chains by 202016. Through engagement, investors can encourage investee companies to improve supply-chain transparency, set targets and establish a forest policy. Examples of disclosure best practice can be found on Forest 500, the world’s first forest ratings agency.
Separately, ethical consumers will likely pay a premium for sustainably produced items. Financial products linked to deforestation-free commodities or sustainability also offer opportunities, such as sustainable landscape bonds, green bonds and sustainability performance-linked loans.
In addition, sustainable intensification of land should be a goal. This process aims to increase yield per unit of land without adverse environmental impact or cultivation of more land. This may bring investment opportunities in areas such as biotechnology, precision farming, agroecology (e.g. intercropping) and organic farming.
Vertical farming similarly aims to reduce land-use whilst increasing food production, typically in an indoor environment. While critics argue that indoor farms are extremely energy-intensive and that the produce is too expensive to solve food security issues, there are innovators such as SkyGreens. One urban farm in Singapore produced 500kg of product in one harvest17.
The risks from deforestation are significant. Exposure of illegal practices in the supply chain and shifts in consumer demand are likely to hit companies’ reputations. There are numerous potential financial risks. At the same time, investors are uniquely positioned to advocate a harmonised policy response and engage companies to increase transparency and set time-bound targets. Ultimately, companies dealing effectively with deforestation and sustainability issues will perform better than those that aren’t.
Deforestation practices are often illegal, deep in the supply chain and continue despite a company claiming to produce certified products. It underlines the need for in-depth supply chain analysis and improvements in product traceability.
Operating in the private sphere has often been seen to have a number of advantages for investors. Returns are often uncorrelated with those from public markets, and therefore can offer compelling diversification benefits. Similarly an ability to take a long-term view, without the “tyranny” of quarterly reporting alongside the opportunity to have a clear alignment of interests between management and shareholders has been considered a positive. However the latter has, on occasions, resulted in the perception that private companies have avoided the scrutiny of independent boards and the public. In some cases this may have led to a single-minded focus on profits, so that ESG factors have not been perceived as front of mind. This has been an oft-cited criticism of the private equity industry in particular.
The recent postponement of the planned WeWork IPO in the United States, where poor governance was added to concerns on valuation added another example to the growing list of private companies whose governance falls short of the standards required in public markets.
High-profile examples of poor ESG practices in companies such as UBER, which recently went public, have solidified this perception. Meanwhile, Facebook and Snapchat faced similar criticism as WeWork at the lack of shareholder rights when they went public. Clearly there is work to be done; especially it seems in the technology sector.
However, the way in which companies are held in private hands is changing. The quest for returns in a world of low interest rates means there is ample funding available for companies, and funding from a greater variety of investors.
Increasingly, investors are prepared to wait longer for returns. Instead of the traditional model of acquiring businesses, restructuring them and selling them within three to five years, we are seeing companies being developed over a longer period, generating value along the way. This has undoubtedly increased the quality and thoughtfulness of the stewardship of private companies.
In today’s competitive environment, private equity managers are more eager to seek creative solutions such as digital innovation to generate superior returns. The substantial shift over time in the main drivers of returns relied upon by the private equity business model. From the 1980s where profits came from financial engineering based on leverage to the multiple expansion era in the 1990s, to the earnings growth decade in the 2000s toward a great relative emphasis on operational improvements on costs and revenue as shown in Chart 1.
Chart 1 – Drivers of returns in private equitySource: EY Analysis 2019
The main changes we see currently involve improvements in particular areas of supply chain management, increased focus on product design and development, and financial discipline. This optimisation will result in more efficient use of resources, lower energy consumption and more efficient labour utilisation. Implementing these practices can be considered a pro-active approach to ESG – but as importantly, it is just good business practice.
Looking at other private markets, such as infrastructure, real estate and natural resources, investors are becoming involved in areas that have previously been provided by governments. This is resulting in pressure on private equity and infrastructure players – in particular, to be increasingly thoughtful about social outcomes and the part that these businesses and services play in the communities that they serve.
Investments in schools, hospitals, transport and utility assets that directly service the public bring a new set of risks and considerations. One of these is reputational risk, which arises when key performance indicators (KPIs) are not achieved. These include areas such as customer experience, satisfaction, fault and warranty rates, customer complaints and health & safety records for customers and employees. These KPIs are core to the management of private companies. Direct ownership allows investors to affect change at the company level.
The separate elements of ESG vary in importance across the different private market asset classes. So-called real assets (real estate and infrastructure) and private equity manage labour, materials and energy costs in different ways. The heterogeneous nature of the private market asset classes makes it harder to establish a unified ESG benchmark. This contrasts with public markets, where bodies like MSCI are involved in ESG scoring. But the lack of generally available benchmarks doesn’t make it any less important – and it is an area of increasing focus across all private markets.
ESG is a multi-faceted concept, encompassing issues such as climate and environment change, urban living and population dynamics, governance and engagement, and the effects of technological developments. As private owners/managers of those businesses, we have the opportunity to gain a deeper understanding of these complex ESG issues. More importantly, we can drive the changes necessary to truly embed our ESG standards in the day-to-day running of private businesses.
As we have seen, integrating ESG across the activities of private companies will strengthen the selling position when private market managers plan for exit. So hopefully in the future companies following WeWork et al will be better prepared for their public market debuts. And if they choose to remain and grow in the private arena, they will seek to emulate companies such as Mars and Bosch, rather than some of newer companies that have “tripped up” of late.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (a) third party supplier(s) (the "Owner") and is licensed for use by Standard Life Aberdeen**. Third Party Data may not be copied or distributed. Third Party Data is provided "as is" and is not warranted to be accurate, complete or timely.
To the extent permitted by applicable law, none of the Owner, Standard Life Aberdeen** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.
**Standard Life Aberdeen means the relevant member of Standard Life Aberdeen group, being Standard Life Aberdeen plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time.