MASTERCLASS: Environmental, Social, Governance

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  • 59 mins 35 secs
Four experts cover the debate around ESG and financial performance, ways to measure ESG, whether ESG is inherently inflationary, what investors need to know about decarbonization, and much more.
  • Mozaffar Khan, PhD, Portfolio Manager, Director of ESG Research - Causeway Capital Management
  • Benedict Buckley, CFA®, Director, Portfolio Analyst - ClearBridge Investments
  • Robert Bush, FRM, CIMA, DWS Research Institute - DWS - Xtrackers
  • Lori Keith, Director of Research, Portfolio Manager of the Parnassus Mid Cap Fund - Parnassus Investments


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Jenna Dagenhart: Hello and welcome to this Asset TV ESG Masterclass. We'll cover the debate around ESG and financial performance, ways to measure ESG, what investors need to know about de-carbonization and much more. Joining us now, we have Mo Khan, Portfolio Manager and Director of ESG Research at Causeway Capital. Ben Buckley, Director, Portfolio Analyst for the ClearBridge Sustainability Leader Strategy at ClearBridge Investments. Robert Bush, member of the DWS Research Institute. And Lori Keith, Director of Research and portfolio manager of the Parnassus Midcap Fund at Parnassus Investments. Well, everyone, thank you so much for being with us today and Mo kicking us off. Why should investors pay attention to ESG?

Mozaffar Khan: Thanks for having me, Jenna. Based on our research, Causeway believes that material ESG factors have the potential to impact investment performance. This is because the ESG characteristics of goods and services are increasingly important to consumers and producers, and that is going to affect the demand and supply of such goods and services. For example, consumer preferences for low carbon or energy efficient products will favor companies that supply those products. Government policies that promote de-carbonization will favor companies facilitating the climate transition, and companies that develop new technologies for a low carbon economy will experience growth. So at Causeway, our objectives of being to identify and quantify through research ESG factors that we believe are material to investment performance and to integrate those factors into our investment processes.

Jenna Dagenhart: And it's no secret that ESG has been in the headlines a lot this year as a growing number of politicians are moving to penalize ESG investors. Want to talk about that, Lori. What do you say to people who are pushing back on ESG investing and why do you think ESG matters to financial performance?

Lori Keith: It's a great question and it's great to be here today. I think part of the pushback is frankly, there's a lot of confusion out there by investors about ESG investing, and there's many flavors of ESG investing that often means different things to different firms. Some firms are focused on exclusionary screens or value-based investing, while others are focused on ESG integration or some are focused even on impact or stewardship. A stock that is in one ESG's portfolio actually may not be in another and as each strategy has different ESG criteria or prioritize different ESG factors. For Parnassus, we're focused on this idea of principles and performance, meaning that we invest with our values and principles in ethical companies, while also focused on investing in high quality companies that can deliver superior long-term results for our clients. We believe companies that have strong ESG profiles are indicative of a company's quality. And companies that are doing an exceptional job with areas such as corporate governance or board and talent, diversity, employee engagement, environmental practices, will generate more sustainable long-term results.

And also, I'd point out as a long-term investor, we see ESG as really additive to our investment process. So from our perspective, for any of our current perspective and current holdings will assess the company's material reputational ESG risk, along with the fundamental investment criteria such as evaluating company's competitive mode and relevancy and management to really identify those stocks that can outperform over the long run. And that means digging into the company, how well are they managing their labor force, their employee turnover, their carbon emissions. For example, companies that have stronger employee engagement and lower turnover will ultimately save money on things like hiring, retraining costs, which will affect the company's ability to outperform over the long run.

I'll also note that ESG is not just about focusing on material risk, but also finding opportunities. And frankly, we found a number of exceptional companies. For instance, we've invested in several water infrastructure filtration companies such as asylum and pin air that provide really mission critical water filtration sensor technology for commercial and municipality customers to deliver that clean and safe water. And finally, we do use our seat at the table as a large institutional investor to really engage with our companies on ESG topics that can enhance their returns and long-term performance over time.

Jenna Dagenhart: And we'll certainly speak more about engagement leader in the panel. But Rob, turning to you, what's your thinking on the debate around ESG strategies and financial performance?

Robert Bush: Well, Jenna, it's such a huge question. It's such an interesting one. And I think as some of the other guests have indicated this is going to be a sort of topic conversation for years, decades to come. So it's really exciting, I think to be having this sort of conversation. The sort important point I would make up front is that in a sense it's not a very helpful question about whether or not ESG per se can outperform. And the reason I say that, Jenna is because there are just so many different ways, as Lori's already indicated of doing it, that it's a little bit nonsensical to believe that it will always work or always won't work. I think that it may sound obvious, but what I would remind listeners is that I think it always has to be evaluated on a case by case or strategy by strategy basis. So I'd be reluctant to make sort of blanket statements about it.

Now, having said that, let me now make a blanket statement, which is that DWS partnered with the University of Hamburg to do a meta study back in 2015. So a study of studies where we looked at about more than 2,300 published papers on ESG since the 1970s. And the goal of doing this was to get some sort of insight into what were most of them saying about this key question of linkage between better ESG and corporate financial performance.

And it was quite interesting, the result of that study was that in around 90% of cases doing ESG in some sort of guise led to either what we called neutral or the same performance as the benchmark or out-performance. So 90% of the cases you were no worse off and oftentimes better in implementing ESG, which is a very, very powerful headline message I think because many of us have been trained to believe in classical finance that if you're going to create a portfolio that is somehow to better suited to you and your preferences, then that probably ought to come at a cost. And I mean a cost in terms of risk and return, not in terms of management fees. And so this meta study sort of repudiates that a little bit. It was interesting that it was even more marked in the emerging markets versus the developed countries. So the percentage of instances where corporate financial performance was stronger when you had a SG profile was even higher in emerging markets, which I think is quite interesting.

But we have, moving aside from a meta study, we've spent a lot of time in the research institute at DS analyzing different strategies, whether they're index based or active based, and trying to look in a very sort of data driven and scientific way at the actual differences. And it's quite interesting because I think what you typically find is that, or at least I have typically not found much evidence that there has been under-performance. What we typically find is that you, you've either sort of matched the market very closely or you have eked out some amount of alpha in some cases economically meaningful, in some cases not so much.

But I think that for investors, whether you're doing this for a sort of value based proposition or whether you're doing this for a return based proposition, either way it's quite compelling and powerful, I would say. I think there's more work to be done, and I still think we're at the early stages, but I do think it's very interesting that there hasn't, at least in what I've seen, been significant evidence of under-performance because that is probably what many of us assumed would be the case 15, 20 years ago when we first started thinking about this.

And the last thing I would say is, look, we all have to get used to things. This idea that traditionally in finance, it used to just be risk and return and that was really all we cared about. But now there is a third component, which is the sort of the values based preferences that you can implement in a portfolio. And it's going to be very challenging to quantify that because they'll be different to everybody. But that's what we need to do. We need to find a way to quantify that because we've got three parts of the financial calculus now, not just two.

Jenna Dagenhart:And turning to de-carbonization, Ben, why do investors need to know about de-carbonization and what are the one or two most important things for investors to understand?

Benedict Buckley: Thanks, Jenna. Yeah, I mean, I think there are really three reasons why de-carbonization needs to be on really every investor's radar. So first of all is the disruptive nature of it. So de-carbonization is going to result in the complete transformation of many industries across the economy, creating new winners and losers in the process. Just look at what's happened in the auto sector. It's a very long term trend is the second one. The de-carbonization of the economy is a theme that is going to play out over several decades. And thirdly, it's a very large addressable market. So to meet the goals of the Paris Climate Agreement, which is to get to net zero emissions around mid-century, we need to invest three to four trillion per year across multiple sectors. So between the three of those things, you really create some significant opportunities for the private sector companies that solve de-carbonization challenges will get rewarded by the market.

But then let's also take a step back and understand sort of what's driving de-carbonization itself because it's not just climate policy. Climate is obviously the key one. A significant portion of global countries around the globe have committed to reaching net zero around mid-century. So there are net zero pledges from countries that account for 80% of the world's population and 90% of the world's GDP. But it's also about energy security. So there's increased focus on domestic energy supply and really reducing dependence on energy that's tied to sort of volatile global commodity prices.

And then sort of thirdly, I would say that the other key driver really is technology advances. So the costs of low carbon technologies have declined rapidly and in some cases are now just cheaper than the traditional technologies. So the first sort of real de-carbonization transition that we're seeing is in the power sector, and that's been due to technology costs as much as climate policy. So the costs of wind and solar are down 50% and 90% respectively in the last 10 years, and they're now the cheapest form of power across 90% of the world's electricity grid. And then you see other technologies like batteries and green hydrogen at earlier stages, but we'll likely see similar cost decline trajectories. So when you combine all those things together, you see why carbonization really, de-carbonization really is a business imperative and I might add is highly desirable for global society and for future generations.

Jenna Dagenhart:Turning to implementation and integration, Mo, how do you integrate ESG into investment analysis?

Mozaffar Khan: At Causeway, we believe one size fits all integration approach is less effective than an approach that's tailored to the investment objective and process of the particular investment strategy. So for our fundamental value equity strategies, we employ a bottom up stock selection process whereby analysts assess mosaic of fundamental company and industry information to form a holistic view of an investment. And material ESG factors are included in this information mosaic. So to facilitate ESG integration, we emphasize repeatability of process. We view integration as requiring two levels of processes, if you will, a set of macro processes that structurally enable integration, and then a set of micro procedures that guide how analysts integrate a given ESG issue for given company. So our macro procedures are built around training, tools, and accountability of fundamental analysts. We provide scheduled training sessions for fundamental analysts and portfolio managers to develop awareness of material ESG issues and their investment implications, discuss research findings and identify emerging themes and trends.

We provide tools including data, ESG scoring templates and desktop applications to analysts. And then we hold analysts accountable for adhering to our integration procedures. Once analysts are enabled, our micro-procedures then provide guidance on how to integrate a given issue for a given company. So analysts reference a materiality map that we have developed that identifies material ESG issues for different industries, and then they assess the level of visibility into how that issue affects fundamental valuation.

For example, if a company is developing profitable renewable power generation projects, those opportunities will be incorporated into cash flow forecasts and ultimately the company's valuation. In our quantitative sustainability focused ESG strategies, the twin objectives there are to invest in companies with strong ESG characteristics and to outperform over a full market cycle. In those strategies, we use our proprietary ESG scores directly in the quantitative stock selection alpha model.

Jenna Dagenhart:Rob, what are some of the ways that investors can implement ESG in portfolio-What are some of the ways that investors can implement ESG in portfolios and how can they gauge the impact and the risk?

Robert Bush:Yeah, I mean in terms of implementation, Jenna, I think you're limited only by your imagination. But as most typically, I mean it's the main way is through some combination of exclusion, which is an extreme form of underweighting, put simply, and integration or overweighting companies that have better ESG profiles. We have index based approaches that are systematically screening out companies that have certain amounts of revenue derived from controversial activities, and then they will look to overweight the remaining companies based on their ESG scores. And we also leverage quite a lot of the firm, our ESG engine, which is something we've devised, which sort of uses a composite of our external data provider's ESG scores. So we're actually able to rate all securities A through F on their ESG profile. And then you can use that in a portfolio in lots different ways, but a typical way might be to say, well, have a starting universe which isn't the whole index, but is one which has actually removed F rated companies or actually doesn't allow E rated above a certain weight, something like that.

So there's lots of different ways of doing it, but if I may share an insight from a separate piece we did, which looked to this. We took a 50-50 stock and bond portfolio, so global portfolio, a hypothetical portfolio, and we looked at different ways you could change the ESG profile of that portfolio. And the three things we looked at were changing the regional weightings, so different country weights, changing the sector weightings, and then a third way was going through each line item and switching out a sort of vanilla market cap exposure for an ESG exposure. So a sort of wholesale replacement, if you like, of your sort of traditional index with an ESG one. And there were I think about a dozen line items, possibly a few more, in this portfolio. So all your traditional, typical asset classes were covered.

And what was interesting, Jenna, is that obviously in every case you get some improvement in ESG profile, however you care to define that. And we can define it in different ways. It could be the biggest underweighting in F rated securities or the biggest overweighting in A rated, or it could be the biggest reduction in carbon intensity. So there's lots of different ways of defining the positive side of this. In terms of the negative side, we used tracking error because we felt that was a very important metric for investors, that they would want to know how far away from the original benchmark were they going. And we focused hard on that trade off, ESG improvement versus tracking error, and that being the key metric to focus on.

And the interesting thing was that although playing with your regional weights and your sectoral weights does help, if you say that you are going to keep the tracking error fixed at a certain very low level of let's say around 25 basis points, then the biggest bang for your buck came from switching vanilla market cap exposures to ESG market cap exposures. And the reason I find that interesting is because it's an approach that allows you to keep all the relevant countries, all the relevant sectors, and all the relevant asset classes that an investor might want, in the portfolio still, but to have a very meaningful improvement in things that they care about, whilst at the same time keeping a very low tracking error to their original portfolio. So that to us was a pretty interesting finding.

Jenna Dagenhart:And Ben, what are some of the ways to invest in climate friendly businesses beyond electric vehicles and renewable energy? I'm sure those are often the first to come to mind, but there are many ways out there.

Benedict Buckley:Yes, there are. Yeah, I mean we really think about it in two broad buckets. So we look at companies that have a product or service that's addressing a climate change issue, all companies that are addressing it through decarbonizing their own operations. So take those in turn. So on the product side you mentioned renewables, EVs, some of the clearer ones. There's also supply chain and sort of second derivative impacts of those to think about. So electrical equipment needed for the grid and for EV charging or components that go into electric vehicles and semiconductors and that kind of thing. So there's a lot of supply chain impacts that will affect those opportunities.

And then there's other areas entirely like buildings which need to become much more energy efficient. And I was actually amazed to learn that the heating and cooling of buildings accounts for 50% of global carbon emissions. And one company we own in our portfolio is Trane Technologies, which is really a leader in low carbon HVAC and is doing that by improving the energy efficiency of the equipment and leading the move away from refrigerants with high climate impacts. And they've really got some ambitious targets to reduce the carbon intensity of their products by 50% by 2030. And they expect that to help their customers reduce emissions by a billion tons between now and then. They're calling it their Gigaton Challenge. So that's equal to the emissions for more than 200 million cars being driven for a year. And that low carbon product development is really the core of Trane's business strategy and underpins our investment pieces in the company. So that's on the product side.And on the operations side, it's really companies whose product is not directly addressing climate change. They're making software, or coffee, or [inaudible 00:21:00], whatever it is, but they're doing it in [inaudible 00:21:01] and aggressively reducing their own impact. I would say that the gold standard in that bucket is Microsoft. So they've set plans to be carbon negative by 2030, so removing more carbon than they emit into the atmosphere. And they hope that by 2050 they'll have removed all the carbon the company has emitted since it was founded in 1975. So that sort of sets the standard. Not many companies that are that bold, but there's a lot of companies setting ambitious targets to reduce their own operations. And we look for companies that are having climate impact either through their products or through their operations or even both.

Jenna Dagenhart: Microsoft is really one uping everyone who's aiming to be carbon neutral. And I mean speaking of Microsoft, tech sector, ESG funds have been more tied to the technology sector, Lori, and as technology stocks have been declining in 2022, is this a buying opportunity and are ESG funds too tied to technology and where are you seeing opportunities? And I guess more broadly in the current market environment, where are you finding opportunities and what types of ESG companies are you buying?

Lori Keith: That's a really interesting question. For us, technology sector is certainly part of what we focus on in our diversified portfolios, with holdings across multiple sectors. And I'd say as we sit here today, technology stocks are largely pricing in that high level inflation, that feds aggressive hawkish policy that we're seeing. And we're certainly starting to see some very interesting opportunities emerge as valuations of these really long duration technology stocks have come down steeply. The software sector I think is one of the most competitively advantaged, attractive businesses, frankly on the planet, with their wide moats, a really high degree of recurring revenues, sticky customer base, and ultimately pricing power. We see some very attractive opportunities with highly innovative companies and services, strong balance sheets, strong employee workplaces, really looking for those companies that can attract, retain top talent to drive that innovation and multi-year secular drivers. And so certainly we have been adding to our portfolios in some of these very interesting areas within software, as an example.

To answer the second part of your question, why ESG funds are often tied to technology stocks. ESG funds really have more exposure to those capital-lite companies, which include technology companies. And I think the bias for this is really because of the types of companies. These types of companies tend to have lower carbon emissions relative to other sectors such as industrials and materials, energy sectors. And certainly as ESG disclosures, they become more robust, more comparable over time, I do think it'll make it easier for investors to make better decisions and discern which of those companies have really those better practices around environment and other factors. But all in all, I think as a long term investor, we're really looking for those highly innovative companies that can sustain durable growth over multiple years in the future that'll have exceptional ESG practices.

Jenna Dagenhart: On that note, Rob, do you think that ESG should be thought of as a factor like value or momentum?

Robert Bush: Well I think, Jenna, that a lot of people probably want to categorize it in that way. I'm not sure we're quite there yet. And I'll maybe say something why I think that. The first thing to remember is that it is very important when you're analyzing any sort of off benchmark approach, and in that I would include ESG or any other active managed, you need to make sure that anything you identify as being performance isn't simply attributable to something else that you aren't labeling correctly. So anytime we're doing this type of work, we're trying to look very forensically for evidence that in fact is ESG or management skill that is driving a good result, if you find one. And that's quite detailed and tricky work, and it's difficult when you bring other factors into play because I think most of us are pretty comfortable with the idea of a higher return to higher risk.

So if a manager has simply a higher beta, it's obviously difficult for them to claim that as being a superior return. That's just being paid for more risk. But when it comes to these sort of more intricate models of really trying to discern, you mentioned value, momentum, quality, other ones, then it can get pretty difficult to do. But it's a challenge we should face up to and try to do. And we've done some of that at DWS, and I would say the early evidence is that we think that ESG does operate quite differently from classic risk factors. So obviously I haven't tested all of them, but of the big ones, the major ones that come to mind, our early evidence is that ESG outperformance where you see it is not simply attributable to unintended or hidden loadings to those other factors. So that we do think it is starting to look as if it is operating independently and therefore a little bit like a factor.

 Not clear to me necessarily that people should be doing it as a pure facts play just now, and the reason for that I think is that if you think about some of those other classic risk factors, they really do have a long heritage. They've been tested over a very long time horizon. I think value's probably getting on for 100 years now, people trying to implement that in portfolios, and it's just too early I think to say that if ESG has had a good five, 10 years, that you can conclude that it always will, or that it's because it operates as a factor. So I apologize, it's a very balanced answer, too balanced. But I guess what I'm saying is I think that we will need much more time to tell. It needs much more testing across business cycles, but there's early reason for optimism if you like.

Jenna Dagenhart: Ben, I saw you nodding your head some while Rob was speaking, so I'll let you weigh in on his comments if you'd like. And then I'd also love to hear your thoughts on some of the new technologies that can help decarbonize the economy and that you think are promising, and whether there are investment opportunities there.

Benedict Buckley: Yeah, I'm just nodding my comment Rob's observation that we don't have enough data yet on these things and you have to wait for multiple market cycles to be trying to make any sort of conclusions and even then you'll be struggling to make them. So wholeheartedly agree with all of Rob's comments there. To your second question on of new technologies that we are following, I think there's really three that we're watching most closely, which are green hydrogen, energy storage, and carbon capture and storage, or CCS. All of which are potential to be really massive markets in the future, but all face some fairly considerable uncertainties at the moment. So for hydrogen, that's really key to decarbonizing parts of the economy that are harder to decarbonize, can't necessarily run on batteries or electricity, things like heavy transport trucks and ships and so on. We own the fuel cell company, Bloom Energy, their fuel cells at the moment run on natural gas, which is still lower carbon than burning the fossil fuels. They're using it in the fuel cell to convert to electricity, but those fuel cells can run on hydrogen and when there's enough green hydrogen infrastructure. And the other thing that we think is really interesting about them from a hydrogen perspective is that they are ramping up sales of their electrolyzers, which is basically a machine that turns electricity into hydrogen. So it's effectively a fuel cell in reverse, if you like. And they have one of potentially one of the most efficient electroltzers on the market, and we think that represents a fairly massive opportunity for them over the long term.And then on the other two, sort of energy storage, that's really key to solving some of the intermittency issues we see in renewables and also increasing the range of electric vehicles, both of which are significant hurdles to overcome. There's a huge amount of innovation going on in that sector at the moment, both in terms of declining costs of the traditional lithium ion batteries, as well as commercialization of other battery types like solid state batteries that could potentially offer step changes in range and charging speed, although we're not quite at commercialization yet. And then lastly on the carbon capture and storage side, the CCS side, that really needs to play a major role-

Benedict Buckley: The CCS side, that really needs to play a major role in de-carbonization. If you look at a lot of the climate models, they all have CCS in there, up to 20% of emissions reductions that need to come from CCS to get to those 2050 targets of net zero. The investible names in that field are mostly, at the moment, the oil majors, industrial gas companies, and a small variety of smaller innovators that potentially look well positioned to capture share, but still, some challenges with getting the economics of that together. I should mention that the Inflation Reduction Act that was passed in the US a few months ago is really a game changing piece of policy for all three of those technologies in the US market, so we really could see some rapid advancements in all three in the US in the next 10 years.

Jenna Dagenhart: I'm glad you bring up inflation, because I want to get your take on that as well, Lori. Given the current market environment, is ESG inherently inflationary? And do you think that ESG strategies drive more inflationary outcomes?

Lori Keith: I don't believe so. Having focused on ESG investing for well over a decade, ESG is about investing with your values, but also, using ESG factors in our investment process to really help us as long-term investors to identify those high quality stocks that can outperform over the long run. We're certainly in this environment today, the labor market is very tight, especially on the services side of the economy. We've seen rising wages, and at the same time, companies that are investing in their workforce, paying fair wages, having really strong practices, will tend to have those [inaudible 00:31:50] employee base with fewer controversies, fewer labor issues. And over time, these same types of companies, we believe, will be competitively advantaged, as they can attract and retain, really, the strongest talent that allow those companies to generate that highly innovative products and services.

I'd also point out that the inflationary pressures that we're seeing around high energy food cost is really driving more innovation in areas such as renewables, clean water technologies, agricultural technologies, which enable, whether it be farmers or others, to really generate, in their case, higher yields on their crops. I believe these inflationary pressures will actually accelerate the adoption of many of these technologies, which in turn is creating, frankly, just tremendous opportunities for long-term investors. Certainly, I've mentioned companies such as Xylem and also CNH, those are very highly innovative companies that will really benefit as they provide very significant and innovative technology around some of these water agricultural end markets. And there may be an increase in short-term cost in some of these areas, but long term I think these technologies will really help these companies become more efficient and more productive and actually lower their cost over time.

Jenna Dagenhart: That's a great point about the long term. Now, spending a little bit more time on the data, Mo, how do you approach the measurement of ESG?

Mozaffar Khan: We've developed a proprietary ESG scoring model that identifies companies with strong ESG characteristics, strong balance sheets, robust earning streams that ultimately translate into significant alpha potential. And this ESG factors orthogonal to traditional style factors and therefore is an independent source of alpha. So our model uses a variety of commercial and non-commercial data as inputs and in our research we use quantitative tools including machine learning and examine a variety of both traditional and big unstructured data. So at a portfolio level then we can measure a company's or a portfolio's ESG score, it's carbon intensity, it's more diversity characteristics among other characteristics and sort of have a sense of how those are related to alpha potential as well.

Jenna Dagenhart: And the same company can get different scores depending on who's doing the rating. So Rob, should investors be concerned about the often quite different ESG scores that companies get from different providers?

Robert Bush: Well, I think they certainly are concerned, Jenna. I get that question a lot, and it does seem to bother people that different people see the same company in a different way. The metric that's often thrown out there, or I often hear sited back at me is that I think it's the credit rating agencies typically have quite a high correlation in terms of their credit scores they apply on the same company, but ESG scores typically have a significantly lower correlation.

Now I have to say I'm less concerned about this than probably many people are, for a very simple reason, which is, I think finance needs and thrives and loves disagreement. If you think about a very quantifiable metric like price earnings or beta, if you asked 20 different people to get you the beta of a stock, I think you'll get 20 different answers. The same with price earnings, there's lots of different ways of doing it. You might get the next 12 months earnings or last 12 months or it depends when they pick the price. I mean, even if you think about a stock price itself, every time that ticks on a screen, that to me is two people disagreeing about the price of the stock. And these are all very quantitative metrics where there's arguably less room for subjectivity. So it doesn't really come as a surprise to me that in a metric where there's far more room for subjectivity, there is far more disagreement, and so I'm relatively more sort of sanguine about that.

And I think that what I would say to investors is, don't be afraid of that. The response that I think is sensible is to engage with the company giving the score or the rating or the metric, try to understand it, try to figure out what it was they prioritized and how they came about with that number. And ultimately in doing that what you might find is that you prefer one way of seeing the world over another way and therefore identify and have sort faith in that. And that's fine, that's perfectly reasonable and there's no shame or problem at all in my mind at having others disagree with that as long as you try to figure out their reasons for doing that.

And that's one answer. You could also do what I alluded to earlier, which is what we sort of do at the firm, which is to take some sort of amalgamation of lots of different providers and in doing that you hope that you're picking up the meaningful information from all of them and trying to sort of cancel out and soften some of the noise. But I like to say, the nice thing about finance is that nobody ever agrees. And so this is just to me another example of where there is significant disagreement, but it's okay, it's really almost what you want, I think.

Benedict Buckley: Maybe if I can just jump in, I think we would completely agree with that. And the way that we look at it is we see them almost as additional sell-side reports, and often sell-side analysts will disagree on a stock. And it's actually helpful to have more than one view, because if you just have one, the analyst tends to think that that is the ESG view of sort of ESG world, whereas actually if you're looking at the various providers you realize that there is no right answer to lot of these things. And actually we want our analyst to be the ones to come up with their own decision and we may well disagree with all three of the ratings providers or whatever is, but the idea is that you're using it as an input to understand where people may have reservations about a company and then coming to your own judgment on that and using, like I said, using these sell-side research and bringing it all together to come up to our own conclusions.

Jenna Dagenhart: Yeah, and if you're the sell-side analyst with the right price target, you don't want everyone else to also have that same price target necessarily, it's what makes markets markets. And great points there. Now, Lori, can you characterize when you're tracking ESG data for decision making what types of metrics or data you're most focused on and what are the biggest challenges you see with ESG disclosures?

Lori Keith: There's certainly a lot of complexity in the sense that there are multiple third-party research providers that provide ESG data sets, and each of those look at ESG factors slightly in a different lens and prioritize these different ESG factors differently. We certainly do use groups such as MSCI, Sustainalytics, ISS, as several of the larger third-party providers that aggregate this ESG data to help us really understand some of these risks broken down by ESG and also key controversies. I will note though, we don't rely on third-party research providers for their rating information. And even among Sustainalytics and MSCI, the correlation of these ratings for the same companies is relatively low. So instead I would say we really use that research in concert with our own research efforts to make really that holistic assessment of companies and we develop our own internal ratings based on really materiality, reputational risk for each of our current, as well as for prospective holdings. At the end of the day, we seek to avoid companies that have severe risk on either the materiality or reputational risk.

I think one other big challenge is really due to the lack of consistent data across companies, and this is often a function of what companies are willing to disclose. For instance, some companies may report employee turnover while others may not, or some may be reporting today their carbon scope 1 and 2 and 3 emissions, while others may only have scope 1 emissions available. So certainly even further as some companies may even report on the same metric differently such as carbon intensity versus absolute emissions. So as a result, I mean we continue to engage with our companies, really to encourage them to disclose more information on these metrics, whether it be on some of the environmental metrics that I mentioned, or even diversity data such as EEO-1 data. And we think over time that will really be additive for us as investors to really be able to compare across companies.

And we're also, I'd note, pushing really our companies to really evaluate what are those most material risks. So conducting that ESG Materiality Assessment to identify what's most important from using the input from their own stakeholders, including suppliers, employees, customers and shareholders, so really that multi- stakeholder approach to understand what are those issues from a materiality perspective that could drive the company over the long run.

 I think, finally, the adoption of standards will create better disclosure and more consistency of reporting across companies and will make it easier for us as investors to understand which companies are performing well on ESG and making progress toward their goals. So certainly I'm very encouraged as we're seeing more adoption of standards today, and certainly with the SEC proposed rules, I think that will certainly be extremely helpful as some of those hopefully do come to fruition.

Jenna Dagenhart: And we've come a long way, but we still have a long way to go in terms of decarbonization. Ben, what are some of the key challenges to decarbonization?

Benedict Buckley: I think there are really four key challenges that we see at the moment. So the first is land availability and permitting, so finding the land and getting the permission to build renewable projects, the transmission lines you need to bring that power from where it's produced to where it's consumed, mines for the minerals, processing facilities, all of these often face local opposition, no one wants to stuff in their backyard and many in the industry view the permitting for new transmission lines is really the biggest long-term bottleneck to some of this development. So that's the first one.

Secondly, raw material availability. So low carbon technologies require large amounts of critical minerals, so copper for conducting electricity, cobalt and lithium and nickel for your batteries, rare earths for your magnets in the EV motors. And really today's supply and today's investment plans for many of those minerals fall well short of what is needed according to some of the studies that have been done.

And then third, deglobalization and trade barriers are a key issue at the moment. So we really need more international cooperation, not less, so things like common standards, technology sharing between countries, removal of trade barriers, and as I think you are all aware, we're kind of moving in the opposite direction at the moment, which poses a challenge for this global issue.

And then the fourth one, which is slightly different, but I think really important is what we call climate justice. So where there are local economies around the country that rely on high carbon industries for jobs in those towns, ensuring those communities are supported and people are not left behind as we move to a lower carbon economy, that's critical obviously from a moral perspective but also from a political perspective. And I would note that the Inflation Reduction Act that was published fairly recently actually has various provisions trying to do just that for what they call energy communities.

And then the second piece that was actually touched on in a previous answer is all about both access and affordability of energy. So the challenge is to make this transition to net zero, but at the same time increasing access to energy. There's, believe it or not, 750 million people in the world who still don't have access to electricity, and ensuring that it's affordable and people aren't falling into energy poverty. In the US for example, 33% of households are in what's term energy poverty already by the government. So any changes to prices would be challenging. So no shortages of challenges to overcome.

Jenna Dagenhart: Circling back to engagement, Mo, what role does engagement play in the process?

Mozaffar Khan: For fundamental value equity strategies at Causeway, we regularly engage with company management on determinants of valuation, including ESG issues that may be material for the company. And these engagements occur with the belief that our dialogue may lead to improvements in both the underlying value of our clients' interests in the company and the way the businesses are managed. And we prefer constructive engagement to negative screening or exclusion. And our engagement objective is generally to understand facts and encourage disclosure of material issues. So our fundamental research analysts will selectively engage with companies where they've identified the most material questions. For example, we'll look at the carbon profile of our representative portfolios, and the biggest contributors, the biggest corporate contributors to the fundamental portfolios carbon footprints may then become candidates for engagement. And the engagement topics could include climate change transition and physical risks and opportunities, labor and human capital management, direct and indirect lobbying and other issues. But these are determined on a case-by-case basis depending on the specific characteristics of a company and its industry.

So our engagement agenda is generally structured around governance, strategy, process, and metrics and targets. And so in terms of governance, we're looking to understand whether there is board and executive level accountability for material ESG issues. Strategy, we're looking to understand whether a company has developed a coherent strategy to mitigate risks and capture opportunities. We're trying to understand their process related to the strategy development and then ultimately to understand their goals, their targets, and the metrics that they use and whether these metrics are then incorporated in, for example, executive compensation plans. So fundamental analysts will log their engagements in a central database that houses all the investment research related to a company. And the information that's received from these engagements is then an input into the information mosaic that's used in our investment decision-making process.

Jenna Dagenhart: Ben, what kind of effect can an active equity manager have in fighting climate change, and how is this achieved?

Benedict Buckley: So as Mo talked about, our view is that [inaudible 00:47:45] action equity manager could take is really engagement with companies in the portfolio, so identifying areas where the company can improve its climate performance and talking to them and giving them that feedback and encouraging specific changes that can lead to emissions reductions. So that's something that [inaudible 00:48:01] be doing for many years on a whole host of issues, not just climate. As you know, we're not activists, but we do give feedback to companies on things they can do better and that we think would also be good for shareholders. So one example of a successful engagement we've had is with AES they're an electric power company. We're one of the top 20 owners of the stock. We're engaging with them for a number of years, both directly and through a collaboration called the Climate Action 100+, really asking them to, in simple terms, accelerate the decarbonization of their asset fleet.

And we see that as completely aligned with shareholder value creation because the market wasn't really ascribing much value to their legacy coal plants, and just speeding the transition away from coal to renewables we thought would actually drive a higher valuation for the stock, even if it meant lower EBITDA in the short term. So since we've begun engaging AES, they've actually stopped investing in coal. They've actually started closing down some of their coal capacity and started investing in renewables and set a target to reduce its submission by 70% by 2030. They were originally targeting 50%. And as we actually had hoped, that strategy has actually coincided with an increase in the valuation multiple for the stock. So I think it's a good example of a sort of win-win-win for the climate and the company and the shareholders. We weren't the only ones engaging AEs on this topic. There's lots of other people asking for the same thing. We do believe that our voice contributed to some of the changes that we've seen in that company.

And then one other thing I wanted to mention on engagement is that we've actually joined a group called the Net Zero Asset Managers Initiative, became a signatory last year. And that, I think, is going to become our sort of flagship climate initiative at ClearBridge. And so we are actually setting targets for our own portfolio now to increase the percentage of companies in our portfolio that have aggressive emission reduction targets. So we'll be using that as a framework to engage with companies to increase their ambition where needed. So that's something we'll be talking more about in the coming months and years.

Jenna Dagenhart: Rob, what are the considerations of divestment versus engagement?

Robert Bush: Yeah, well, its very interesting to hear Ben and Mo talk about this, Jenna, because my sense is that there has been a little bit of a sea change in the way people think about this. And I think it's moving away a little bit from divestment towards engagement more. And that's why I'm interested [inaudible 00:50:32] because I think that's really what they were alluding to as well. Because there was a time, I think, when divestment was probably more common, but now I think engagement now is typically being seen as the first choice answer. It's almost a bit like, to use an unpleasant analogy, divestment is like divorce, and engagement is like marriage counseling. And it's like, do you want to fix a problem first or you want to walk away from a problem? I think it makes sense to try to fix things first through engagement. Ultimately,. There's always the threat of divesting and for shareholders and investors that are big enough, that will be a threat to companies.

But obviously when you're divest, you lose any ability to influence. Whereas if you engage, you've got a sort of seat at the table, particularly if you have the clout to do so, which is an important point because obviously need to be a significantly sized investor. Companies aren't going to take everyone's calls, and they're not going to listen to everybody. The argument that you often hear against divestment is that simply shifting an ownership stake isn't really making a real world change. So if you don't own a company anymore, you're selling it to somebody else and therefore it's not making a real world impact. And so you hear that as an argument against divestment. And I'm sympathetic to it, but I do think that companies ultimately care about who their shareholders are, and they won't simply tolerate constant divestment.

The idea that there's a private market out there that will sort just egregiously suck up anything that's thrown at it is probably not quite right, I would think. Clearly the profit motive will drive some people to take companies private or to own companies that are doing things that other people think are egregious. But ultimately, it's not a cure-all. I don't think it's a panacea to say everything go into the private markets. Companies can and do go bankrupt. And that, for me, is an indication that the capital providers are simply not willing to fund those businesses. So we shouldn't be too critical of [inaudible 00:52:56]. But I do think the trend is towards engagement, and I think that's a good thing. And we certainly do that at DWS.

Benedict Buckley: If I can just jump in there as well, I think I completely agree with that. So we do focus on engagement, but to your point, we do have sort escalation policies in the back pocket in terms of being able to ratchet that up if we're not seeing the progress that we want from companies. So it's not just to sort engage forever and forget about it. We want to see meaningful progress from companies or at least a willingness to engage and a willingness to have those discussions and move that forward, recognizing that they have a lot of different constituents they have to think about, a lot of different impacts they have to think about. They're not going to just take our one opinion and run with that, but we want to be a constructive voice in those discussions with companies up to a point. And then maybe we always have the right to, if we think it's interest of our clients, to sell the stock and move on.

Jenna Dagenhart: And building off of Rob's analogy, you can only fix something if someone physically shows up to the marriage counseling and is willing to listen. So I thought that was a great way of putting it. Now moving forward, Mo, what's the policy outlook for ESG issues?

Mozaffar Khan: When we think about the components of ESG, corporate governance is a perennial importance to investors and to regulators and probably even more so in more volatile conditions. So I think that component is resilient. Environmental issues such as climate change, certainly facing some well publicized short-run headwinds, but the long-run trends are resilient. I think there's increasing policy support for decarbonization, for example, and certainly the physical realities of climate change are going to lead to some policy continuity even across different administrations over time. This increasing regulator attention being paid to corporate disclosure of material ESG issues and metrics, and ultimately measurement and disclosure of these issues, is going to influence progress in the long run on these ESG issues.

Jenna Dagenhart: Lori, I'll give you the final word here. How do you see the ESG landscape evolving regarding the standardization of data, increased regulation and company stewardship?

Lori Keith: It's a great question. First, I would say ESG investing has really become mainstream today. Assets under management today are in excess of 2.7 trillion and with a net of almost 600 billion flowing into sustainable mutual funds and ESGs, focused ETFs per Morningstar. I think there's really a massive demographic shift, and millennials, 90 million of them today, as well as women who are really focused on investing according to their ESG principles. Secondly, I would say every institutional investor, ranging from pension funds to endowment to even sovereign wealth funds, is really facing a unique challenge and mix of how to evaluate ESG criteria. And I think regardless of where the fund is on ESG, there's a really growing recognition that mitigating the ESG risk is really part of a firm's fiduciary duty.

One example would be climate change, which is a risk that every investor must address. I mean, when you think about how companies now must mitigate this risk when they have locations in drought-prone areas or severe storms, companies, for instance in the semiconductor space that really heavily rely on a lot of water usage, these are now becoming material risk if they're located in areas that are very drought-ridden and may not have access to the same level of water that they've had in the past.

Thirdly, I would say really regulatory pressure, very significant driver of ESG adoption. And there's increasing number of countries that are incorporating ESG requirements into the regulations. Even more recently here in the US, the SEC has proposed specifically new disclosure mandates around climate and emission targets for companies. And finally, I do believe that we'll continue to see the use of engagement tools, whether it be through proxy voting, dialogue, shareholder proposals, and formal engagements, as really, investors are using their seat at the table to exert positive influence on their holdings' ESG practices, and really collaborate with them on areas that can help drive that long-term outperformance for their own clients.

Jenna Dagenhart: Well, I wish we had time for more, but we better leave it there. Everyone, thank you so much for joining us, and thank you to everyone watching this ESG masterclass. Once again, I was joined by Mo Khan, portfolio manager and director of ESG research at Causeway Capital; Ben Buckley, director portfolio analyst for the ClearBridge Sustainability Leader Strategy at ClearBridge Investments; Rob Bush, a member of the DWS Research Institute; and Lori Keith, director of research and portfolio manager of the Parnassus Midcap Fund at Parnassus Investments. And I'm Jenna Dagenhart with Asset TV.


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