In search of the holy grail

Christopher J Wigley explains how responsible investment can deliver consistently above-index returns

There is much reference today to the terms 'Transition' and 'Transformation'. However, the differences are often blurred and not always fully understood.
Transition is about energy transition for governments, corporates, etc, and is strongly linked with sustainability. Corporates can also transition to become more sustainable companies.

However, in terms of investment, 'Transformation' is the key word and is not always fully appreciated. It is about a corporate becoming more sustainable, but it is more than that. It is about a company changing so fundamentally that it can become a totally different investment proposal – and potentially, changing from being uninvestable to high impact, and potentially very valuable.

Security Selection

Portfolio construction is an important consideration before investment. A portfolio manager will consider the strategic allocations to, for example, government bonds versus corporates, BBB versus single A, utilities versus financials, etc.

However, once that framework is known, security selection is the next critical step. At this point it is important to remember that responsible investment funds are responsible investment, not because of, for example, their style, etc, but rather due to the constituents of the funds. That is why security selection is critical in the responsible investment or ESG approach.

Within the portfolio construction framework, it is important to have a security selection process. Initial steps may include, an eligible credit rating, an eligible ESG rating, impact, etc.

However, in order to outperform, it is important to also invest not only in eligible securities, but also eligible securities which offer financial value. It is possible to have a portfolio that consists 100% of high-quality US Treasuries, but it is unlikely that that portfolio will outperform a corporate bond index over the long term.

Similarly, it is possible to have a portfolio of 100% high ESG-rated securities or high-impact securities, but they may struggle to outperform a conventional corporate bond index if the ESG value or impact value is already in the price – what some refer to a 'greenium'.

Sustainability

In the last ten years, what many responsible investment portfolio managers have aimed for has been evidence of energy transition.

Responsible investment portfolio managers have not wanted to invest in the companies of yesterday, for example coal companies with increasing default risk, but rather the companies of tomorrow, for example utilities increasingly switching from fossil fuels to renewables, and so better able to capture new opportunities.

It is this 'energy transition' which investors have tried to capture. It is possible that sustainability-linked bonds are symptomatic of this – bonds which will step up in coupon if a KPI, such as the percentage of renewables, does not meet a target threshold by a certain date.

However, for consistently higher investment returns, energy transition is only part of the story.

Governance, including stewardship

Analysing energy transition, and focusing on sustainability trends particularly environmental and social, it is important not to forget the G aspect of ESG. Not only is Sustainability important to transformation, but also governance. Typical aspects of corporate governance include:

• Stakeholders
• Ownership
• Board Structures
• Role of Directors
• Independent Directors
• Chair and CEO role split
• Corporate Ethics
• Transparency and Disclosure
• Bribery risk
• Audit
• Remuneration
• Proxy Voting, etc

The various aspects of corporate governance are too extensive to go into in detail in this article. However, suffice to say, corporate governance is important because it is, within a company, an internal 'regulator' – in the French sense of the word, for example, in the way Paris Metro trains are slowed down or speeded up to 'regulate' or bring into harmony the Metro system. It is also an enabler – good corporate governance will assist companies to find new opportunities.
It is important to note that corporate governance is also about stewardship, which chimes with responsibility. Because, responsible investment is more than sustainable investment, it also involves good leadership or responsibility. That is, being of good character, 'doing the right thing', awareness of impact, and giving thought to future generations, etc.

Anthropology

So far, we have seen that 'transformation' is about sustainability and governance – which are important to ESG – but it is also about what could be more generally described as anthropology (see article entitled ESG is not enough).

There are three important elements of anthropology that are important to security analysis and financial returns. They are:

1. Corporate culture
2. Executive philosophy
3. Adapting business models

As these are dealt with in the above article, I do not intend to elaborate on them here. However, I would summarise key aspects that can make a difference to financial returns:

Adaptation

As evident above, adaptation is key to transforming issuers. It is important for corporates to adapt to new developments, for example, the sustainability wave that is sweeping the planet currently.

Additionally, it is important for corporate cultures to be flexible and improve. Further, for executive teams to also draw on the knowledge of corporate adaptive memory.

Also, critically it is important that issuers have adaptive business models.

Moves towards extinction or relative dominance

There is a further aspect to this, particularly important for security selection and portfolio managers. Investors, anthropologically, seek to avoid those companies moving towards extinction as they represent a default risk.

In the same vein, investors also seek to invest in those issuers that may be said to be moving to relative dominance. That is, they may have adapted early to significant new developments and may be well positioned to benefit from that trend.

Further, and significantly, the potential appreciation may not be fully reflected in the price of their securities¹.

Extended Taxonomy

At this point it is worth noting that there is now an 'Extended Environmental Taxonomy' which may have implications for transformation.

It may be helpful to take a step back and look at the big picture. The EU Taxonomy Report Technical Annex is a useful report. It sets out industry sectors with proposed accompanying thresholds.

It is a 'perfect model'. There is nothing wrong with perfect models. They generate ideas which lead to improvement.

However, the EU wishes the taxonomy to be a driver not only of long-term growth but also of short-term growth. This is problematic, in that the taxonomy then becomes hostage to politicians who may wish to include non-green industries – for example, gas and nuclear – so they too can contribute to economic growth, etc.

Politicians may also, for example, not want some companies to be marginalised before they have had the opportunity to adapt.

The Extended Environmental Taxonomy attempts to address adaptation to some degree. However, there are issues – for example, do no significant harm (DNSH) criteria, that are too extensive to elaborate here – which mean it may be simpler to just have an additional Transition Taxonomy, perhaps a duplicate of the green taxonomy but with additional industries and different thresholds.

This may enable the EU to transition and grow in the short term while also encouraging green growth.

Hard-to-abate industries

This is important for investors. While there are distortions, it may be argued that those issuers that have the

¹A corporate may be a leader in a field but it is rare to have dominance where economic competition is encouraged.
highest negative impact, are less sought for decarbonising portfolios and so may naturally have higher credit spreads and yields.

With the existence sometimes of 'greeniums' in the market, these 'hard-to-abate' issuers may be attractive to investors solely in financial terms. To be acceptable, it is very important that these issuers are aware of, for example, the sustainability wave, the need for improving corporate cultures, to have adaptive business models and, increasingly, transition strategies.

The impact of these entities needs to be known and quantified, but these issuers may then be very attractive investment opportunities in terms of transformation. Transformation must be genuine to be real.

Impact

When seeking above-market financial returns, and seeking transforming issuers, it is important for investors to also consider the type of non-financial impact they are seeking or capturing.

An emphasis on hard-to-abate industries may lead to a high negative impact portfolio. However, it is possible to consider the various types of impact that may be possible. An investor may, for example, seek:

1. High current net positive impact
2. High future net positive impact
3. Growing net positive impact
4. Positive change in net impact, etc.

Conclusion

Transformation is more than energy transition. In investment, it is the issuer's environmental, social, governance and anthropological transformation.
In terms of securities, it may be relatively high yield securities with potential for appreciation and possibly of increasing positive impact. The transformation and appreciation would particularly be seen in extreme credit spread tightening.

Awareness of impact is also important. A priority may not be necessarily 'current impact', but also the anticipated degree of positive change in net impact, for example. This may not just simply generate above-market returns, but may also be revolutionary in terms of protecting and nurturing the planet and society.

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