Tune in and hear more in our latest “Talking Markets” podcast. A transcript follows.
Jenna Dagenhart: Julie, how would you say ESG investing has evolved over time?
Julie Moret: ESG really started out from the traditional values-based socially responsible investing, so very much this predominance on exclusionary criteria and screening out investments. What we’ve seen continue to accelerate is the shift towards positive inclusion and more specifically, the incorporation of ESG information as part of the fundamental research process, and really beginning to understand what are the vulnerabilities and what are the opportunities that these drivers of change represent to the operational resiliency of businesses. So, in short, it’s really been a shift away from the predominance of screening out investments to really an integration of ESG as more of a rounded-out, holistic understanding of evaluating companies. When you look at a lot of the industry studies out there that cite two key reasons for integration, one is risk management and two is the prospect of improved returns. I think what we’re seeing is really a reallocation of capital that incorporates wider stakeholders and beneficiaries.
I think an interesting observation is going to be when we look out over the next two, three years, we’re going to see increasingly a shift from the inputs to ESG integration and what those are, to really measuring what are the outputs and the outcomes, the impact of the investments that we make.
Jenna Dagenhart: How would you describe the ESG landscape today? And we can’t talk about it without talking about COVID too. So how would you say COVID has impacted ESG?
Julie Moret: I mean, really, it’s fascinating that COVID, rather than dampening the interest in ESG-informed investing, it’s actually really accelerated a number of these pre-existing themes. Number one is we’ll continue to see an acceleration in climate-focused investing. And particularly in Europe, that’s being supported by a number of policy and regulatory reforms which are mandating the incorporation of sustainability into capital allocation decisions. I think secondly, what COVID has really exposed is the heightened amplification of societal risks just as, quite simply, growing inequality. So, we’ve seen dislocations in market, and we’ve seen the real impact on the economy, and particularly certain segments of the economies where employees, consumers have been left with very little protection, whether that’s leisure, entertainment, and travel. I think it’s an absolutely reasonable expectation that post-COVID from an investor’s perspective, there’s likely going to be downward pressure on free cash flows.
The messaging that we focused on in our engagement with corporates is really to ensure that there’s operational resiliency, strength of balance sheet, cash flows, and any decisions that need to be taken really are done with a long-term view on the viability of the businesses. I think a lot of these behaviors that we’re seeing are essentially shifting towards a capitalism that takes into account wider stakeholders, employees, consumers, suppliers, as well as the shareholders. I think the underlying takeaway is that it actually pivots a heightened attention on engagement and how we as investors engage with corporates on these issues. A wider stakeholder-orientated model really drives towards ultimately a company’s social license to operate.
Jenna Dagenhart: Julie, what do you think some of the underlying drivers sustaining the growth in ESG investing are? And are people’s motivations for investing in ESG also changing?
Julie Moret: So, there are four drivers that we see sustaining the growth in ESG investing. The first driver is really just the growing relevancy of sustainability challenges, whether those are climate-transition impacts, both policy, risk, as well as physical risk, whether that’s natural resource use and scarcity. The second is really demographic shifts, which ultimately represent changing consumer behavior and changing investor preferences. There’s been a multitude of studies that have shown that millennials are much more sensitized to environmental and social considerations, which is not the same thing as saying that there’s a desire to trade off returns for these positive impacts. I think where the mindset is at the moment is the fact that both generating a positive return alongside a positive impact to an environmental or social consideration aren’t mutually exclusive.
I think the third sustained driver is really the ongoing regulation and policy. The acceleration that we’re seeing, not just actually in Europe, but certain parts of Asia, that are really adopting regulation in a manner that is trying to drive at a cleaner pricing signal on climate-transition issues, but ultimately again, to allocate capital towards more sustainable forms of investing in economic activity. And the fourth point is really just the increasing pressure that corporates face on sustainability disclosures. We’ve seen most recently the big four accounting firms come out with their recommendation on 21 sustainability disclosure standards, which have been informed by SASB, the Sustainability Accounting Standards Board, as well as GRI [Global Reporting Initiative].
And most recently we’ve seen also the IFRS, the International Financial Reporting Standard, also come up with a consultation which is trying to drive out essentially a global standardization framework around ESG disclosures. That fundamentally is a good thing for the industry. I think the one caution that we would have is the desire that all of these frameworks build on existing market-established frameworks that already exist rather than a reinventing of the wheel.
Jenna Dagenhart: And Julie, how would you describe your approach to ESG and how do you interpret ESG data to meet client needs?
Julie Moret: So, in terms of Franklin’s approach to ESG, we very much look at ESG information as pre-financial indicators. What I mean by that is ultimately it’s a pool of information that has financial relevancy. And so, our analysts and our portfolio managers incorporate the assessment of the risks and vulnerabilities as part of the fundamental research. On a practical level, what that actually means is the first step is we perform a risk-based assessment, which is a sector-specific materiality framework. We identify at a sector level the most business-relevant ESG themes, topics, what are the indicators that help us to assess the company’s performance against those issues and how well we believe management is at actually overseeing and managing and mitigating some of these risks.
The next step is really how we reflect that in our valuation models or our financial forecasts. And so typically what we will do is we will either adjust the forecasted financials either through revenues or through costs, adjustments to the CapEx [capital expenditure] or OPEX [operating expense] of certain companies and sectors, or in the actual valuation model, we will make adjustments whether those are adjustments to the discount rate or adjustments to the weighted average cost of capital, which essentially reflect ultimately our view around the risk premia associated with the management of these issues with certain companies.
What we do to help support the research efforts around that is we’ve built a proprietary platform which is essentially ingesting, at the moment, something like 17 different ESG data sources. What we’re interested in is disaggregating all that information into the raw inputs so that we can start to create proprietary scores and signals by blending that information with our own fundamental research. This enables us to just get deeper on the actual research around ESG. Second to that, we’ve also kind of built out a centralized engagement tracker which enables us to capture and quantify in a much more scalable manner and targeted manner, the types of engagement activities we’re having globally on certain topics and certain issues. And so, all of this together combines to, in our organization, continue to further evolve and deepen the actual research capacity around some of these latent issues and risks.
With regards to your second question on how the data is used to meet different client needs, it’s interesting because often the ESG field is referenced as being a spaghetti soup. There are lots of different acronyms, they’re used interchangeably. When you look at the issues and the topics under each of the ESG pillars, they’re relatively consistent in the sense that under environment it’s typically climate emissions, CO2 emissions, it’s biodiversity issues under the “S,” human-capital issues. What leads to the variability is the manner in how that information is used to meet different client goals. And so for instance, we will look at this data set and for the conventional strategies we have, where using that information as really part of the fundamental research in providing an additional input or the mosaic and how we assess ultimately intrinsic value of companies.
For end investors who are interested in aligning their investments with their values, whether those are religious, ethical, or whichever issue, the pool of ESG information is then used to identify certain companies or sectors that go against the values that a particular investor wants to be exposed or not exposed to and it becomes much more of an exclusionary criteria. Where we continue to see more and more client interest is the utilization of the ESG data set for thematic or impact investments. And there within thematic investments, an example of that would be the allocation of capital towards certain companies or issuers who are providing solutions to some of the sustainability challenges. As I’ve mentioned, whether those are doing more with less, whether that’s alternative energy sources or the components that go into building solutions for say better water efficiency in certain production cycles.
Another example on the impact investing side is for clients who are actually wanting to allocate capital in a way where they actually want to drive positive outcomes in certain environmental or social considerations. A particular example of that would be allocation towards social housing or education, where there’s a very targeted direction in how that capital is allocated to actually drive improvements in certain areas. So, what we typically tend to find is the variability is an outcome of the different ways in which ESG information is used to serve different investor needs and profiles. And for us, I think it’s very much about really understanding the motivations behind clients and what they want to achieve.
Jenna Dagenhart: Julie, what do you think has informed the view that ESG means sacrificing performance? Why is that view even out there?
Julie Moret: That’s a great question. More often than not, it’s the question that keeps coming up. And it’s always considerably surprising when you see the growth in empirical research that shows the correlation between companies that perform sustainably and the impact that it has on actually lower cost of capital and when they’re going out to the debt markets to refinance that debt. And so, we believe that part of what’s driving that misconception around ESG having a negative performance impact is tied into some of the early-day kind of concepts around just screening. And so, a tool whereby you avoid risk by screening your investible universe, which inherently, depending on the scale of screening that you do, you effectively shrink down the ability for you to invest in certain sectors.
And so ultimately, I think part of that notion has been informed by really the view that, well, if you take out chunks of the index, you narrow your ability to invest and you narrow your upside opportunity on the alpha side. And really the ESG integration approach flips that on its head somewhat and says, well, if we take a step back and we look at some of the big megatrends happening in the world, generally, whether those are just increasing amount of air pollution, water pollution, rising CO2 emissions, or whether that’s aging population, growing population or the millennials, one can look at those as essentially drivers of change, they’re actually they’re economic issues. You look at the World Economic Forum’s risk perception survey, and you look at the direction of travel on some of these issues, they’re high probability and high risk. Looked at it through those lenses, beyond being just environmental and social considerations, they are actually economic issues that are potential drivers of change, which makes them absolutely relevant for any investor to understand from a risk and return perspective. It also enables investors to use these metrics and these different perspectives as a means of an additional tool to really differentiate between who are going to be the winners of tomorrow that are able to navigate their business and business models and also capitalize on some of the shifts that we’re seeing in consumer behavior, which again, reflects in investor behavior preferences.
Jenna Dagenhart: Yeah, and to all of your points, so much of a company’s value is tied up in those intangibles. It’s not strictly cash flows on the balance sheet. So, a scandal or a damage to a reputation can be really damaging.
Julie Moret: Yeah, I think that’s a great point. What we’ve seen generally is the valuations of companies are really increasingly driven by intangibles. And it’s actually those intangibles that capture brand, reputation, R&D [research and development] intellectual capital. And when you pivot back to ESG information, ESG information is essentially trying to provide insights and capture metrics and data that provide some type of valuation analysis. And so I think absolutely a strong case is that as corporates and companies’ valuations more and more shift away from physical to these intangibles, it poses a question whether the valuation models that are used today are essentially need to be recalibrated to include much more of these intangible pre-financial indicators.
Jenna Dagenhart: And as we wrap up, I want to spend a little bit more time on your outlook for ESG in 2021 and beyond. Julie, what do you think are the key themes that will shape the industry moving forward?
Julie Moret: There is just so much momentum within the general ESG field. If I had to narrow it down to some of the key themes, at the industry-level our view is that number one, we’ll continue to see an acceleration of regulation, particularly around increasing transparency, disclosure, reporting. Number two, we’ll continue to see an acceleration in climate-related themes. What will be interesting to watch and keep our eyes opened on is beyond climate transition, there are some underlying themes such as water and biodiversity, which are increasingly coming up the pipe in terms of our client conversations. I think human capital issues, certainly, which has been amplified by COVID, there’s a lot more research work and disclosure data required there, but that’s certainly going to be a critical theme going forward. And finally, I’d say on the impact and SDG- [Sustainable Development Goal] aligned side, we continue to see active interest from our investor and our client base there. And really just on the broad ESG topic, what we’re seeing at the sophisticated end of the spectrum is really a pivoting towards ESG in alternative asset classes, such as private equity and hedge funds. And we think that’s an area that’s under-explored, and particularly in a low-yield environment can offer some benefits to end investors that are really looking for the intersection between alts and a more sustainable form of investing.
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