Nexus and the ESG Integration Approach
Q2 | April 2021
April 30, 2021
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Nexus and the ESG Integration Approach
Q2 | April 2021
At Nexus, we think Environmental, Social and Corporate Governance (ESG) considerations are a helpful input to our investment decision-making process.
There are several ways investors approach ESG, and each way has its own pros and cons. Some investors take an exclusionary approach, which simply means not investing in industries like tobacco, firearms or alcohol. Others move to the other end of the spectrum and try “impact investing,” which seeks to create a positive ESG impact with financial returns as an ancillary consideration.
Our approach to building ESG into our process is known as “ESG integration,” meaning, we incorporate material ESG considerations into our overall analysis of the merits and risks of an investment.
We think ESG integration makes sense—in theory. It improves our ability to identify hidden risks and opportunities in our portfolios. For example, ESG can push us to think more broadly about risks like carbon taxes for airlines or community relations for pipeline companies—and, crucially, how these risks might affect shareholder returns. It can also stimulate us to think about opportunities on which our holdings can capitalize, like participating in the growth of renewable energy infrastructure. In addition, we think ESG integration enhances our search for high-quality, well-run companies that are focused on the long term.
In short, the ESG integration approach doesn’t cost us anything in terms of foregone investment returns, and it gives us the benefit of improving our decision-making process.
In practice, we now have available tools—ESG analysis from Sustainalytics and new ESG resources from our Bay Street and Wall Street research providers—to undertake this research more effectively. However, despite investment opportunities and the latest research tools, the world of ESG comes with complications. Here are four main considerations.
The comparability of ESG data generated by companies
Unfortunately, the ESG data that one company reports isn’t always comparable to the data another company reports, simply because, over the years, various industries, countries and organizations have developed different voluntary ESG reporting standards.
Fortunately, the Sustainability Accounting Standards Board (SASB) and others are working to bring a higher level of consistency and comparability to ESG reporting. The aspiration is to bring ESG reporting standards up to the level of rigour demanded by traditional financial reporting standards.
More importantly, the SASB is also rightly focused on materiality. Materiality—a key concept across all of investing—recognizes that some ESG data (safety data for the software industry, for example) is not particularly relevant. By contrast, human rights and community relations are material for the mining industry, as problems in these areas could mean that a mining company has its social licence to operate revoked.
There is a long way to go to improve ESG data comparability, but progress is occurring.
How ESG rating firms interpret data
Even though we have access to far better ESG data than we ever had before, there is no universal truth in ESG ratings. You can have two ESG rating firms produce conflicting ratings on the same company. One will argue the company is well positioned and managing its ESG risks effectively; another will claim that same company is a laggard with inadequate management of ESG issues. The complication is, of course, that reasonable analysts can disagree about what the data tells you.
The Wall Street Journal recently put it like this: “Professional investors and rating services disagree widely on how to rate corporate responsibility. You could admire Tesla Inc. for reducing society’s reliance on internal-combustion engines—or reproach it for squandering electricity on bitcoin and relying on batteries made with lithium, which can be hazardous and difficult to recycle.”
As such, it’s a matter of interpretation.
Complexity and tradeoffs in ESG
Some parts of investing are black and white: Company A has better profit margins than Company B. However, with regard to ESG, distinctions are not nearly as clear. There is inherently more subjectivity, and any assessment of a company’s ESG characteristics naturally has to be made in a grey area.
For example, take Canadian energy companies operating in the oil sands. On the one hand, they’re good. Society—hospitals, schools, farmers, you name it—need the energy they produce until alternative energy sources are widely available. On the other hand, they’re bad, because oil sands operations are emissions-intensive and so is the eventual combustion of the fuel. On the other, other hand (wait, is there a third hand?), since we need to use oil for the foreseeable future, isn’t it better to source it from a jurisdiction like Canada where environmental standards and human rights are upheld, instead of from another jurisdiction where there may be poor worker protection or non-existent environmental regulations? In other words, it’s complicated.1
As investors, we need to do our best to apply good judgement in this grey fog. That means thinking about the many tradeoffs and rewards associated with an investment.
When it comes to ESG, the situation today is that if you want to own a company that everyone considers an “ESG Leader”, you usually have to pay more. That puts you in the top right quadrant of the illustrative chart below, where the tradeoff for owning an ESG leader is paying a higher valuation. However, paying a higher valuation is often a risky proposition, as, even if the company does well, investors may receive a disappointing return, simply because they paid too much for the investment.
Then again, you may not want to own an “ESG Laggard” for a number of reasons. From an investor perspective, one of those reasons is the possibility of major share price downside if the company doesn’t properly manage its ESG risks.
An alternative tradeoff is to buy an “ESG Improver”, for which you pay a lower valuation. These companies aren’t at the top of their ESG game yet, but they have plans in place and are improving.
When it comes to ESG at Nexus, we’re willing to pay more for a company that’s demonstrably managing its ESG risks and opportunities well. That’s because it’s an indicator of a high-quality company that’s taking steps to reduce its risk and enhance shareholder returns. However, we need discipline and good judgement to ensure we don’t overpay for an ESG leader with a huge valuation that isn’t justified by the fundamentals of the business. After all, being good at ESG doesn’t unequivocally deliver superior shareholder returns. Sometimes, the companies that aren’t there yet—but are improving their ESG profiles—offer the most attractive combination of tradeoffs.
In his recent letter to shareholders, Jamie Dimon, CEO of JPMorgan Chase, made some interesting points about the tradeoffs required to solve climate change: “The fact is we’re long past debating whether climate change is real. But we need to acknowledge that the solution is not as simple as walking away from fossil fuels. We will need resources such as oil and natural gas until commercial, affordable and low-carbon alternatives can be developed…. We can agree on the need to make our energy system much less carbon intensive. But abandoning companies that produce and consume these fuels is not a solution…. Instead, we must work with them.”
These are complex, dynamic problems involving plenty of tradeoffs. Again, however, things are improving.
Fund managers, too, have contributed to the complications. Some have created new ESG-branded funds that make misleading or overstated ESG claims, in the hopes of attracting clients. Others have gone so far as to simply rebrand an existing fund by adding words like green, ESG and sustainability to a fund prospectus (or even the fund name), even if there has been no discernible change in the way the fund is managed.
Greenwashing, as it’s known, is disingenuous, and regulators, such as the SEC, are taking this seriously. The SEC recently noted that it had found that several investment firms were misleading investors by falsely claiming adherence to sustainability-friendly policies. While there’s proof this behaviour is occurring, it remains challenging to decipher who’s honest and who’s bluffing in the subjective world of ESG marketing claims.
Despite these complications, at Nexus, we see the integration of ESG considerations as a way to help us build a better-quality portfolio without sacrificing shareholder returns. Although we remain cognizant of all of these challenges, we do think thoughtful incorporation of ESG criteria is improving our decision-making process. And that should serve our clients well over time.
(1) Of course, this ongoing complication doesn’t preclude humanity from transitioning toward cleaner sources of power. However, these energy transitions usually take time.