Tatjana Raunich – Investment Manager Research Analyst, Momentum Investments and Jana van Rooijen – Responsible Investment Specialist, Momentum Investments
Investment professionals choose to adopt responsible investment principles as guidelines to make sure their business conduct leads to more sustainable, responsible and profitable investments. Investment managers need to understand the impact of environmental, social and governance (ESG) risks on their portfolios by incorporating ESG factors into their investment processes.
The ESG approach to responsible investing primarily focusses on the risks related to ESG factors, and guides the implementation of risk-mitigating approaches in the investment process. Formally incorporating ESG into the investment process ensures the improvement and continuity of responsible investing through time. It also assists in making the reporting of ESG systematic and repeatable. Comprehensive ESG reporting enhances transparency, which enables more efficient and effective decision making by investors.
While simple in theory, this can be challenging to implement in practice and requires a clear consideration of the relevant trade-offs.
South Africa has a relatively small investment universe with limited investment opportunities, be it the listed equity universe or the credit space. This has direct implications for the implementation of ESG-based investment practices. South African investment managers do not have the luxury of choice and therefore it is not always easy to simply exclude a share like British American Tobacco (BAT). The sale of tobacco products has clear social costs, but the company has also generated stable returns for shareholders in the long term and is considered to have attractive rand-hedge qualities. Exclusion can be seen as an opportunity cost from a fundamental research and portfolio construction perspective. ESG can therefore also be applied on a relative basis, where investment managers consider ESG scores relative to their sector and relative to the company’s own historical score. BTI has meaningfully improved its overall ESG score, according to some investment managers, and the company’s investment in new-generation products is seen to have reduced social risk. This is where engagement plays a very important role, because it assists in the improvement of responsible investment practices by the investment managers as well as the measurement and monitoring of those practices.
Another good example of this balancing act is Sasol – a dominant player in South Africa’s energy sector. Besides being a culprit of high greenhouse gas emissions, it was also seen to have poor governance, allowing the Lake Charles Chemical Project to run over budget (the cause of this attributed to ineffective leadership). Investment managers that see potential in this company have engaged with management on governance issues and this led to a change in leadership and the replacement of the joint CEOs, in addition to the changes that were made to general management. The effect of future carbon taxes is an environmental risk that will detract from future shareholder value and Sasol is in the process of addressing this risk. Corrective plans that are being instituted result mainly from engagement by investment managers in collaboration with stakeholders. Where investment managers see steps are being implemented to reduce the risk of increasing carbon taxes, in combination with other risks, and where valuations still hold, they will still be willing to consider investing in Sasol while being consistent with their ESG perspective or mandate.
The impact investing approach
Impact investing is a distinct sub-set of ESG-based investing. Here investments are made into businesses whose purpose and objectives have an intentional positive effect on the environment and communities. These types of businesses explicitly aim to have a direct and measurable effect on society and the environment. However, these investments also need to be financially viable, as impact investing aims to combine intentional impact and adequate financial returns on capital. They aim to ‘do well by doing good’.
The impact investing approach allows the investment industry to move towards integrating sustainability directly into their underlying investments. Impact investing is more predisposed to funding from private equity investors. This is because of the nature of private equity, which is characterised by direct funding of long-term projects with the ability to draw on needed specialist knowledge. Investment managers in South Africa have refined impact investment objectives to be consistent with the goals of National Treasury in terms of structural reforms. This is helping make impact investing more relevant for the South African investor, and there has been an increase in investment products that reflect government initiatives through this approach.
The Risk Mitigation Independent Power Producer Procurement Program (RMIPPP) is an example of a programme implemented by government, which focuses on the expeditious procurement of energy into the national grid, addressing the South African electricity power supply crisis, and also reducing the use of costly diesel generators. This programme also serves to reinforce government’s intention to meet international obligations of reducing carbon emissions by decarbonising the energy system through advancing technologies that emit less carbon dioxide. A report from the desk of President Cyril Ramaphosa (September 2020) confirms intentions for additional energy to be procured from diverse sources, such as solar power, wind and gas. The above supports government’s Integrated Resource Plan released in 2019 (which updates the national energy forecast and provides a roadmap for our energy sector for the next decade). In June 2021, President Ramaphosa announced the draft amendment to Schedule 2 of the Electricity Regulation Act, effectively raising the self-generation capacity threshold below which power plants are absolved from having to acquire generation licenses (from 10 to 100 megawatt). This encourages a broader range of supply options, which includes renewable energy sources. This is a direct boost for impact investment portfolios focusing in this area.
ESG scores and analysis
ESG can be integrated across all asset classes, by incorporating it into valuation models or portfolio construction. The investment manager can use a set of criteria, qualitative and quantitative, to score companies individually in terms of ESG risks. Quantitative and qualitative risks can be determined for each company by scoring them on the individual components of ESG, commonly using ESG score cards.
Third-party service providers can also be used for ESG analysis. This improves objectivity and is beneficial to investment managers when used to complement their own analysis.
To assist in the comparison of ESG scores across industries, ESG components can be weighted based on the industry or sector characteristics by identifying the materiality of ESG factors affecting specific sectors. For example, the governance factor is regarded as having a more direct effect on risk for the banking sector. If a factor weighting is applied in an ESG methodology, then, in this example, it is likely that the governance factor will carry a higher weighting in the overall ESG score relative to the remaining two components. The weighting is then applied to the governance score of the bank, similarly for E and S weightings, to arrive at a total ESG score. In assessing the E score, the physical effect of climate change on a bank’s assets and the challenges faced by banks in transitioning to a low-carbon economy must be considered. Banks also need to move to financing sustainable companies and investments and, in doing so, need to take social implications into account alongside profitability. Investment managers need to examine how banks engage with their regulatory authorities to address risks and whether they are being proactive in identifying solutions.
The above discussion highlights the subjectivity inherent in the implementation of ESG into an investment approach. Not only are ESG risks many and diverse, they are also not always easily quantifiable, which makes measurement a challenge.
However, just as any type of analysis performed on companies by different investment managers will have varying results and degrees of subjectivity, so too will ESG analysis.
These multiple ESG factors are intertwined, influencing one another and hence affecting a business in its entirety. An investment process, where ESG is not integrated but a separate step (where conclusions are drawn independently from company analysis), can lead to the erosion of the benefits of ESG analysis, because an investment manager is less likely to adjust investment decisions based on information that wasn’t part of the company analysis from the outset.
Do South African investment managers walk the talk?
We perform an annual responsible investment rating assessment of investment managers to allow us to better understand how far along these investment managers are on their responsible investment journey. The scope of responsible investment practices is wide, and we therefore assess the investment companies’ overall responsible investment framework and the level of transparency confirming their actions. In addition, as supporters of the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, it is in our interest to encourage investment managers to adopt a climate change focus for a sustainable and Just Transition future. A summary of the key findings of the survey are presented below.
The responsible investment rating complements the appointment, monitoring and reviewing process of the investment managers.