Responsible investment is about more than just integrating ESG factors, argues Christopher J Wigley
Responsible investment tends to focus on ESG – integrating environmental, social and governance factors into analysis.
Often, the terms responsible investment and ESG are used interchangeably. However, responsible investment specialists know that responsible investment includes more than ESG.
Responsible investment not only includes the integration of ESG into analysis, it also includes, for example, engagement, microfinance, etc.
I would like to contend that, in the search for above-market returns, there is a responsible investment discipline that has been missing to date. That is, anthropology. Or in French 'environnement, social, gouvernance et anthropologie'.
To be clear, I'm not trying to turn all ESG analysts into Claude Levi-Strauss! However, I do believe there is value in analysing the impact of mankind on the value of securities, and the anthropological study of issuers is helpful to generate alpha.
For analysis, it is useful to first refer to the concept of evolution, as pioneered by Alfred Russel Wallace and Charles Darwin. There are ten evolutionary influences that may be useful to us in financial analysis. They are:
| Influence | Detail | |
|---|---|---|
| 1. | Current environment | More than DNA, and long term |
| 2. | Variation | Create new ideas |
| 3. | Nature harnesses a system of trial and error | Not all new ideas will be successful |
| 4. | The struggle for life | Competition |
| 5. | The risk of extinction | Default |
| 6. | Selection | What works |
| 7. | Continuous improvement | No complacency |
| 8. | Adaptation | Flexibility |
| 9. | Positive change | Small modifications |
| 10. | Relative dominance and growth | Market share |
Translating this into the anthropological study of bond issuers, there may be three main sub sectors:
- Corporate culture
- Executive philosophy
- Adapting business models
1. Corporate Culture
Corporate culture generally is important, as it sets the tone for all the company's activities. Analysts may be looking for some of the following:
Positive opportunities
A positive culture may also help a company grow and thrive. This could, for example, be manifested by:
- Positive environment
- Positive change
- Continuous improvement
- Identity and individuality
- Personal growth
- Projects and achievements
- Wellbeing, etc
Negative risks
We should note here that litigation destroys corporate capital. For example, the following practices are costly to investors:
- Money laundering
- Market abuse
- Mis-selling
- Sanction infringements
- Bribery
- Environmental damage
- Safety issues, etc
In the case of Standard Chartered Bank, it is possible to see from 2001 to 2014 a history of sanction infringements and poor internal procedures. Significant fines from regulators ensued, which were ultimately costly to investors.
Examining the credit spreads of the 1.625% 6/21 issue, it is possible to see that the bond spreads over a period of six years were higher than the high for the European senior bank index and higher on average over the period than the index.
Additionally, Standard Chartered senior debt credit rating fell during the period from AA3 in 2015 to A2 in 2020.
Serial offences historically, indicate that the problem was not one of a rogue employee bit rather a problem of culture itself.
2. Executive Philosophy
The philosophy of the CEO and executive team is exceptionally important. Often with a new CEO and executive, there is an expectation of a 'new broom' or for the CEO to 'make his/her mark'. However, this can increase risk, increase losses and important lessons learned can be lost.
Further, classic mistakes can be repeated. Below are some evolutionary and anthropological characteristics which may also be considered good corporate practices:
| Aspects | Detail | |
|---|---|---|
| 1. | Environment | Fast moving markets |
| 2. | Range of projects | Diversification |
| 3. | Variation | Trial and error |
| 4. | Selection | Of best ideas |
| 5. | Innovation | Research and development |
| 6. | Isolation for brainstorming | Creativity |
| 7. | Decoupling | Risk management |
| 8. | Decentralisation | Local |
| 9. | Frontline feedback | Listening |
| 10. | Adaptive memory | Learning from mistakes |
| 11. | Adaptation | Flexibility |
| 12. | Relative dominance | Information narrative |
If we consider the case of Unilever, first of course no company is perfect. However, Unilever is interesting in that it understood early the importance of the sustainability wave sweeping the planet. Additionally, they emphasised the importance of values, principles and collaboration.
Examining the 1.75% 08/20 senior issue it is possible to see from 2014 to 2020, the highest spread was well below the high for the consumer goods index in euros, well below the low for the index, and also well below the average for the index for the period.
The credit rating remained unchanged during the period and it may be said that investors were rewarded for a leading executive philosophy.
3. Adapting Business Models
However, in terms of anthropology, culture and executive philosophy are not the full story. Crucially important are adapting business models.
In a competitive environment, markets change very fast, and it is important for business models to have the flexibility to adapt also.
IBM may be an example of a company which has adapted successfully over more than 100 years. Starting off producing clocking in machines, it evolved into personal computers and then into research and consulting, for example.
As mentioned previously, there is a sustainability wave sweeping the planet. Those companies which do not adapt may not survive, while those that do may well thrive. It is helpful to look at adapting business models in a bit more detail.
| Elements | Detail | |
|---|---|---|
| 1. | There are occasional but also sudden shifts in competitive landscapes when companies may quickly become dinosaurs | For example, Climate Change and electric vehicles |
| 2. | 'One decade's dominant manufacturer may become the next decade's basket case' | 'Resting on laurels' |
| 3. | Corporate evolution driven by repeated variation and selection | Open to experiment in a controlled way |
| 4. | A struggle for existence and dominance | Competition |
| 5. | Principle of innovation – creating a range of new ideas | First mover advantage |
| 6. | Disruptive technology is successful when old technology lacks the will to innovate | Companies can't stand still |
| 7. | Problems not necessarily technological but also psychological and organisational | Executive philosophy and corporate culture |
| 8. | There are risks of grand projects | 'Biting off more than a company can chew' |
| 9. | There are risks of vested interests and obsolete skills | Avoiding conservative attitudes |
An example of a company with an adapting business model may be Berliner Hyp. Berliner Hyp was one of the first banks to issue a Green Bond, and following its success has embraced sustainability into its full lending and corporate activities.
Examining the 1% Oct/21 senior issue, it is possible to see the issuer had its credit rating downgraded by Moody's in 2018, from A1 to A2, but this downgrade was applied to 18 banks due to a change in bank solvency laws.
However, examining the credit spreads, it possible to see that they did not rise as high as the high for the Euro senior bank index, while the low was lower, and the average was lower than the average for the index. So again, investors seem to have been rewarded.
This may reflect the fact that Berliner Hyp has successfully adapted over the period and become a more sustainable company.
Conclusion
In responsible investment, the integration of ESG is not enough. For alpha, not only is engagement needed, but I would like to argue, anthropological analysis also.
We already know that climate change is the result of human activity. However, so many other issues that may be improved derive from human error.
Responsible investment is more than sustainability. It is about responsibility in terms of stewardship, leadership, care for future generations, etc.
Responsible investment analysis with a focus in particular on ESG and the anthropological subjects of corporate culture, executive philosophy and adapting business models, may also lead to above-index financial returns.
This is the second of four articles Christopher Wigley will write for Environmental Finance in coming weeks.
The first can be viewed here.
The other two will be tackle the following subjects:
- The Holy Grail - how Responsible Investment can deliver consistently above index returns
- A new type of Responsible Investment fund which could replace the ETF
Channels:ESG